April 2, 2018
Volatility finally returned to the stock market in the first quarter. After returning about 22% in 2017, the S&P 500 rose another 7 ½% before January was even complete, before declining more than 10% over the next two weeks. Then over the next month the Index rose 8%, before losing 7% over two weeks in mid-March. After all these ups and downs, stocks finished down by less than 1% for the quarter, including dividends.
The Volatility Index, which had been calm (low) for so long and had settled near all-time lows around 10 for most of the past year, spiked to 37 in February, a level reached only once in the previous five years (in 2015).
It is often hazardous to attempt to explain market moves, but the leading candidate for the downdraft in February was inflation concerns, rekindled by accelerating wage growth. It is interesting that this was being seen as potentially negative news since for the past several years higher wages/prices were seen as desirable because of worries about the health of the economy. The shift in perception might signal that the economy has turned a corner. Of course, this turn isn’t all good, as it makes one wonder how much the Federal Reserve will have to raise interest rates and how much that will impact the economy – and stock prices.
The volatility in March was likely caused by a different issue: US trade policy. President Trump’s protectionist rhetoric has concerned us since the day he was elected. Many commentators have dismissed his words as negotiating tactics, but his feelings on the subject are genuine and he has surrounded himself with advisers that also have protectionist tendencies. His top economic adviser, Gary Cohn, who opposes tariffs, resigned in March after he failed to sway the President, who announced the imposition of import taxes on steel and aluminum.
There are multiple reasons this is such an important issue. First, free trade allows the global (and domestic) economy to grow at a faster rate, which raises employment and lifts incomes. Second, it raises the standard of living for people around the world, including in the US. Third, it has underpinned the transformation of how companies do business, with supply chains global and more specialized, creating greater efficiency (the ability to produce more with less). This has allowed profit margins to expand while keeping capital spending and inflation low, a combination that has lengthened the economic expansion. As always, there are some who are hurt by the current system, and we should do things to help those individuals, but erecting trade barriers would do far more damage than good. It is funny how humans fall prey to the same temptations as past generations even after the lesson of history.
Restrictions to trade would raise prices, stunt growth, hurt corporate profit margins, and can create geopolitical hostility. This of course would be bad for stock prices. How far Mr. Trump goes with all this (and how other nations reciprocate) remains uncertain. It is entirely possible that new trade barriers will end up being modest and not derail the global economic symbiosis that has taken root. But the risk of a trade war has risen, and as money managers we have become incrementally more defensive.
Another noteworthy development is the weakness in the shares of several large tech companies. This was triggered by the revelation that a consulting firm used the Facebook data of 50 million people without their permission for political campaigns. Facebook lost more than a sixth of its market value in the wake of this news, as investors worried about repercussions like legislative changes or upset customers leaving. Other tech stocks declined as well, either because of fears over greater scrutiny of business practices or simply because the great growth stock trade of the last 15 months was perceived as being wobbly. Alphabet (Google) lost 10% of its value over the two weeks, as did Netflix. While its business would appear to be unaffected, Amazon was not immune, as it fell 9%, partly due to critical comments by President Trump.
Facebook and Alphabet are now trading at a free cash flow yield of about 4%, which is not very different from the broader market’s valuation. Over the last four quarters Facebook grew its revenues 47% and Alphabet 23%. These are staggering numbers for such large companies, and the growth is almost all organic (as opposed to growing through acquisitions). For such rapid growers to be in the same ballpark as the market on a valuation basis it would suggest that they are either attractive or discounting a lot of bad news or both. Our instinct is that these companies remain good investments.
Mark Oelschlager, CFA
Co-Chief Investment Officer & Portfolio Manager
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