Clients of the Firm,

Markets

The first quarter of 2019 was higher for domestic equity markets, as the market rebounded from the pronounced decline in Q4 2018 and are now approaching the highs achieved in early October 2018.  Earnings for the S&P 500 are expected to decline for Q1 2019 by -4.2% according to Factset consensus.  That said, the balance of the year is expected to see an increase of earnings and revenues bringing S&P 500 earnings in-line with our current forecast of $173 or +7%.  If these estimates are correct, the market is trading at 16.6 times forward earnings which is above the average 15 times multiple we assign to long-term fair value.  Markets trade in wide ranges relative to forward earnings with lower bounds of 10 (extreme bearish) and 20 (extreme bullish) book-ending our 15 years of professional management of funds.  This market level places domestic equity markets, our primary focus, slightly above average for valuation.  

Equities

Long-term, stock values are driven by the expectations of what future profits will be, discounted using the risk-free rate plus an equity risk premium.  The change in the risk-free rate (as measured by the 10-year Treasury yield) impacts what price we should pay for a stock.  The lower the risk -free rate, the higher the expected value of equities.  Conversely, the higher the risk-free rate, the lower the valuation estimate of a stock. 

The inverse P/E ratio or earnings yield for the S&P 500 stands at 6.00% as of this letter, whereas the risk-free rate is 2.47%.   The difference between the two represents the earnings yield premium for stocks, which is currently 3.53%.  This is the risk premium in the market for stocks versus risk-free bonds.    This is a 71 basis point increase over what the equity risk premium was in October 2018 and makes a more compelling case for equities on a relative investment basis to bonds.  

Recent months have seen a significant decrease in long -term interest rates, making this equation more compelling than 6 months ago.  The Federal Reserve has indicated that they will pause rate hikes to see the economic data unfold.  The primary cause for this pause is a slowdown in global growth which began roughly six months ago.  The Fed’s pause has caused longer term rates to contract, thus leading to the greater risk premium offered for equities at this time. 

The challenge for equity investors is determining whether or not the earnings for companies will remain stable, grow or shrink against the macro backdrop.  This estimating process is highly differentiated for the individual companies we seek to invest in and requires a micro analysis of each company individually. 

Volatility

Volatility of price cuts both ways and after the extreme selloff in December we have seen price volatility to the upside for equities and bonds.  This rally has led to a decrease in the cost of Put options or the cost of protecting against market declines.

While this period of rising prices has brought down the VIX and other measures of volatility, it remains noteworthy that volatility can return at any time due to adverse events, excessive prices or for any other reason such as market positioning or currency changes. 

Indeed, we remain at a moment where long-term bonds and equities could be volatile simultaneously as prices for both asset classes increase. Clients can potentially reduce future equity volatility with derivatives or short positions and bond volatility can be reduced by remaining in short-term maturity bonds.  We continue to implement these volatility reducing strategies where appropriate.    

Bonds

With bond yields falling for long-term bonds, the short end of the bond curve has continued to behave largely in-line with our expectations, modeling the Fed rate hikes, as expected. 

We continue to like the short-end of the Treasury curve as a place for bond and stable value invested capital.  Investing in this area will help avoid downside risk, should rates normalize, while achieving similar returns to long-dated bonds with far less risk.  This approach can be achieved through Treasury money market funds or individual bonds depending on the client portfolio size, liquidity needs and risk appetite. 

As we have indicated for several years, there remains substantial price risk in long-dated bonds and especially in junk bonds (bonds below investment grade).  This price dislocation (too high of prices and too low of yields) leads us to avoid this area of investment.  Junk bonds face two primary increased risks: interest rate risk and default risk.  Both of these risk categories are elevated at this time versus historical normative levels. The market is pricing in very low default risk as well as extremely low historical absolute yields.  These two factors make it clear we are not being paid for the risk assumed in high yield debt and therefore we feel it is better to avoid this asset class until the risk reward trade-off improves.  

Politics

The Mueller report, China trade talks, Brexit, North Korea, Iran, Venezuela, divided government and the 2020 Presidential race all continue to stalk the day to day gyrations of the market.  This dynamic political environment will continue for some time with polarization on either side of major issues.  While not to be ignored completely, divided government results in more stability of economic policy and is actually helping to remove a layer of uncertainty from the markets.  The same is true related to Brexit and the extension of time offered by the EU to work out a divorce agreement with the U.K. or even to have a new referendum on leaving the EU.  Parliament is divided on this point and it remains to be seen what will happen with Brexit, although the chances of a no-deal Brexit and disorderly exit have greatly reduced.

International challenges remain regarding Venezuela, North Korea and Iran.  While military intervention in any of these situations is not yet obvious and hopefully will not come to pass, we remain vigilant to this potentiality.  Conflict and uncertainty surrounding these countries has not yet seeped into the broad market except for the current bid to energy prices due to the Venezuela situation. 

Finally, the China trade talks have made apparent progress from our last discussion of this issue.  Substantive progress items have not yet been disclosed, but the market is anticipating some trade deal to be announced over the coming weeks or months that may be a way forward with China on trade. While posturing continues on both sides, consensus is now that a partial trade resolution is likely and our view is that the stock market has priced in a substantial likelihood of that outcome.        

Conclusion

Markets remain a place where one must seek a risk/reward trade-off that makes sense.  Equities continue to offer a compelling risk premium over risk free bonds, but prices have increased. Therefore, we must be patient and careful while selecting investments.  Low risk assets like short term Treasuries offer a positive return over the cost of investment which allows us to be paid for patience.  This was not always the case over the course of the recent market cycle.  Our path forward will be prudence on price with a focus on balancing the barbell of low risk assets with individual investment opportunities we feel offer a compelling price to potential return outcome. 

After celebrating our 15-year anniversary as an independent firm earlier this week, we continue to be amazed by the quality and diversity of our clients and their collective commitment to a shared long-term vision.  Your confidence in the company for all these years and our combined wisdom has helped us navigate the sometimes turbulent waters of markets.  We could not have reached this milestone without you.  Thank you. 

Sincerely,

Peter C. Wernau, CEO

Wernau Asset Management

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