Advantage: U.S. Equities
Here we are, another year-end letter. Hopefully, despite the continuous din of global turmoil and domestic politics, we are all feeling a bit better than last year at this time when our wounds were still fresh from a fourth-quarter market decline that was among the worst in decades. This time around, we have just enjoyed one of the stronger markets in years during 2019, which makes us all feel much smarter and wiser than we were a year ago. Or it could simply be mean reversion.
Our equity strategies did well in 2019 versus their benchmarks — there are details later in this letter, even though that is already starting to seem like a long time ago. The biggest drivers to the year, in our view, were the continuing decline in interest rates and the continuing no-show of the imminent yet elusive next recession. With both trade war fears and recession fears receding, risk premiums declined, growth estimates rose, and markets went up. Equity duration arguably sits in the low teens (measured as (1+r) / r), and so a 90 basis point yield decline last year in the 10-year Treasury would suggest roughly a 12% gain in equities on the basis of a similar equity yield decline. With the U.S. equity risk premium also in decline, U.S. equities managed to mostly outperform long-term bonds.
U.S. equities also outperformed most world markets in 2019 with the exception of Italy, Russia and Greece. Outperformance by U.S. markets has been going on for a decade and is particularly surprising in the face of the growing gap between U.S. and Rest-Of-World (ROW) interest rates. With the highest long-term government bond rates in the developed world, recently surpassing Italy, and a yield gap that has been growing for a decade, ROW equities should be outperforming U.S. equities, but they’re not. While posting the highest government bond yield, the U.S. P/E ratio remains the highest in the world and therefore enjoys the lowest equity earnings yield at the same time. Hmmm, that’s odd. Longer term U.S. performance and valuation has gotten so lopsided that many big U.S. brokerage firms and media pundits are recommending increased allocations to ROW assets under primarily the thesis of P/E and performance mean reversion.
We know that mean reversion doesn’t always work, for example when the mean is changing. That may be a good mantra for the decade ahead. It’s certainly possible that the international markets have not made a giant error, but rather, the U.S. equity risk premium is now lower than the rest-of-world for good reason. As a relative mosaic to other countries, energy independence, near labor cost parity to Asia, and a military that can protect all of that seems like a noteworthy strategic advantage from a decade ago. As the world on average becomes older and wealthier, and U.S. based assets grow faster and are safer, demand for U.S. assets goes up and U.S. risk premia go down.
Also, as we’ve said in the past, Grandma does not understand negative interest rates, but there’s a chance that excess capital around the world will keep bidding asset values higher, and therefore push interest rates lower. For dollar denominated assets, not only is there still room to ease rates relative to other countries, but having a central bank that can print money people will accept in an emergency also seems like a plus.
In this new environment, we continue to ply a craft that recognizes we are always in a new environment. Companies that can serve evolving customer needs better than competitors will thrive. It is our job to find those good strategic businesses that have just managed to disappoint investors – to quote Covey – for urgent yet unimportant reasons, and avoid those that are unable to grow the value of their businesses. We hope to continue to do this well, and serve our clients with good returns. Thank you for your interest in Sterling Partners Equity Advisors.
Kevin E. Silverman, CFA
Chief Investment Officer
John A. Schattenfield
Head of Distribution