Making Sense of it All? What Capital Markets Will Tell Business Owners Before Economists Will

Adrian Cronje, Ph.D., CFA
Chief Investment Officer, Balentine

In October of 2015, I was asked to share my view on the economic outlook to several groups of entrepreneurs within Vistage, a CEO peer learning organization of which I’ve been a member for over five years. Given increased market volatility, my goal was to explain how to make sense of it all, but more importantly, how capital market movements, when correctly interpreted, often provide early warning signals about the future environment. I pointed out three key areas to watch and illustrated how their implications may impact strategic planning for business owners.

TTM

Setting the Stage

After a long period of economic growth and easy lending conditions coming out of the Great Financial Crisis, the environment over the past several years has been kind to entrepreneurs. One potential consequence, however, is that many business owners have built strategic plans using assumptions which may be too optimistic in coming years. Many Vistage members have heard Alan Beaulieu of ITR Economics suggest the next US recession won’t happen until 2019. While this may be a possibility, capital markets are beginning to take issue.

The First Warning Shot

During the summer months, the stock market corrected suddenly and significantly for the first time since 2011. This would not have surprised my late friend, mentor, and long-time Vistage 151 member Kraig Kramers. His “CEO Tools” are used by many Vistage members across the country and by our team at Balentine. Kraig urged CEOs to use Trailing Twelve Month moving averages (TTM) of key metrics to differentiate underlying trends from distractions, or noise, in their businesses. The chart to the left uses his methodology for the S&P 500, with the left hand axis showing the TTM change in underlying earnings for companies represented in the index. It shows how, on the right axis, the multiple (valuation) has steadily increased to above historic average levels in the mid-teens. This has been the only way for the index’s price level to continue to advance, as the trend rate of growth in its underlying earnings base has collapsed. Kraig would have been the first to point out that the S&P 500 was vulnerable to disappointment unless the trend in the collapsing earnings base stabilized and began to reverse.

This is not to say the recent stock market correction portends imminent economic trouble. The roughly 10% drawdown we experienced, while unusual over the past 5-6 years, is actually more common during a sustained bull market than many realize. After all, as the Nobel-prize winning economist Paul Samuelson quipped, “The stock market has predicted nine of the last five recessions!”

What is more concerning this time is that stock market volatility has been accompanied by more sinister developments in three additional areas which, when taken together, often suggest economic growth may disappoint in the future.

What to Watch

Smart investors should carefully monitor commodity prices, financial conditions, and expectations for future inflation and monetary policy. Let’s look at each area specifically:

  1. While the crash in oil prices over the past 18 months has garnered much attention, investors have underappreciated the 20-25% correction the entire commodity complex has experienced over the same period. The proximate cause is China, an economy which has acted as the marginal consumer for everything over the last decade, experienced a significant slowdown over the past year. The Chinese stock market bubble has burst, and its currency, the Yuan, has been devalued. This, in turn, has put serious stress on several large commodity-producing countries including Brazil and Russia in the developing world, as well as Canada and Australia in the developed world. Despite continued progress in the US economy, overseas deterioration has knocked out several important drivers of global economic growth. If commodity prices don’t begin to stabilize soon, global economic growth may weaken more than many anticipate today.
  2. Credit spreads – the difference between high quality and low quality securitized lending – have widened across many sectors in the US economy. When these spreads widen, investors are essentially anticipating higher default rates from a slowing economy, and lending/financing conditions become more difficult. Over the past few months, spreads have begun to widen noticeably across all sectors, not just within the energy sector which has been distressed for some time due to the oil price collapse. After a fall in commodity prices, credit spreads are normally the “second shoe” which drops before the future environment becomes more difficult, suggesting spread widening needs to stabilize and reverse course before the economy can continue to grow robustly.
  3. The third and last “shoe to drop” before a spell of economic weakness is typically yield curve “inversion.” This occurs when long-term rates fall below short-term rates for securitized lending of the same credit quality. For example, when the Treasury yield curve flattens and begins to invert, investors are anticipating a fall in future interest rates or deflation and lower short-term interest rates from central banks. Today, the traditional Treasury Yield Curve (the difference between 10-year and 2-year bonds) can’t invert given that short-term interest rates are at zero[1]. The shape of the yield curve at the very long end (the difference between the 30-year and 10-year bond), however, is worth watching closely. This “third shoe” has not yet dropped, but it has flattened significantly over the past year. Importantly, this indicator has a near-perfect record of signaling significant economic weakness 18 months to two years out.

To be clear, these observations should not be taken to suggest we think a recession will occur in 2016. However, it is important to acknowledge these fundamental indicators have moved from signaling a green light to a yellow light[2]. Just as we have reduced risk across our investment strategies to build up “dry powder” to capitalize on opportunities over the next few years, business owners may need to rethink the assumptions driving their strategic plans in several key areas.

Implications for Business Owners

Here are four areas leadership and management teams should consider revisiting in light of what capital markets are signaling today:

  1. Build an explicit margin of safety into assumptions about revenue growth, pricing power, and market share as it relates to current operations (and especially new initiatives).
  2. Stress test balance sheets and the resiliency of capital structures, especially if embarking upon a merger and acquisition strategy. Similar to how we maintain a liquidity reserve as a key part of our investment strategy when constructing portfolios to meet objectives over time, consider building up free cash flow to provide maximum flexibility over the next few years.
  3. Assume returns on any capital investments may take longer to pay off than in prior years. It is very important to build in realistic hurdle rates to avoid misallocating capital today.
  4. If already selling a business or exiting certain industries, consider the runway may be shorter than 2019 to realize your goals. Late stage venture capital, especially in healthcare and technology, is already exhibiting signs of very frothy activity.

Conclusion

These observations reflect what I have learned as an economist, investor and business owner over the past two decades. Hopefully, it will help you make sense of recent stock market volatility. More importantly, I hope it can serve as an enduring template for business owners and leadership teams to “gut check” the key assumptions driving their strategic plans in any environment. Capital markets, when correctly interpreted, are often a better leading indicator of the future environment than predictions by economists, who are typically more astute at explaining what is happening today or what happened yesterday. The rewards from capturing opportunities as business owners over the next few years may come to those who are most disciplined today.

Important Disclosures

The views expressed represent the opinion of Balentine. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Balentine believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Balentine’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results.

[1] Other countries, however, including several in Europe, have already begun to institute negative short-term interest rates.

[2] Fundamental indicators including the ones mentioned above are monitored as part of the Balentine Investment Strategy Team’s model-driven approach to risk management, which is designed to narrow the range of potential outcomes for portfolios.

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