Strategy Monthly
The Horse Latitudes
September 7, 2016
In the days of sail, mariners dreaded passages that took them through the so-called horse latitudes. These regions, roughly 30 to
35 degrees north and south of the equator, are frequently devoid of the reliable winds on which ships under sail relied. Ships could
spend weeks or even months in these oceans, wandering without progress, seeking the scantest breath of air or ocean current to
speed their journey. The origins of the term are murky, but historical accounts relate that sailors, panicked at the idea of never seeing
terra firma again, would occasionally throw their horses overboard to preserve food and water for the crew. Emotion, poor discipline
and inattention often became a greater threat to the ship’s safety than the lack of a following wind.
As we celebrate Labor Day and the unofficial end of summer, investors have sailed into the horse latitudes. Following the brief Brexit
vote panic and recovery earlier this summer, since mid-July the S&P 500 has traded in a narrow range of 2150 to 2190, while the Chicago Board of Exchange Volatility Index (VIX) set a new low
Equity Returns
for the year in August. The equity market hasn’t had a daily
20%
S&P 500 Total Return
move of greater than 1% since July 8 and has risen or fallen
18%
U.S. Small/Mid-Cap Equity
Non-U.S. Developed Equity ($)
15.5%
16%
by more than 0.5% on just seven days.
Emerging Markets Equity ($)
In spite of this apparent malaise and dampened volatility,
the S&P 500 has inched higher, establishing a new high in
mid-August and posting a total return of 7.8% for the first
eight months of the year. Smaller capitalization stocks bested that mark by rising 10.3% so far in 2016, and emerging
markets (measured in U.S. dollars) led the way with a rise
of 14.8%. However, as the nearby graph illustrates, on a
trailing one-, three- and five-year basis, the S&P 500 index
tops the league tables.
14.8%
14%
12%
13.6%
12.5%
12.1%
12.2% 12.3%
10.3%
10%
9.6%
8.8%
7.8%
8%
6.0%
6%
5.6%
4% 4.1%
2%
3.0%
1.7%
0.9%
0%
-2%
0.5%
1.5%
-0.1%
Trailing 3 Months
YTD 2016
Trailing 1 Year
Trailing 3 Years*
Trailing 5 Years*
Data as of August 31, 2016.
*Annualized return figures.
Sources: Bloomberg and BBH Analysis.
S&P 500: The S&P 500 is an index of 500 large-cap common stocks actively traded in the United States.
Small/Mid Cap (Russell 2500): The Russell 2500 is an index of approximately 2,500 small- and mid-cap common stocks actively
traded in the United States.
Non-U.S. Developed (MSCI Europe, Australasia and Far East [EAFE] Index): The MSCI EAFE Index is an index of stocks from 21
countries designed to measure the investment returns of developed economies outside of North America.
MSCI Emerging Markets: The MSCI Emerging Markets Index is designed to measure the equity market performance of 23
emerging economies.
This gratifying performance comes in spite of a mounting
list of challenges facing domestic equities, and the asset allocation group at Brown Brothers Harriman (BBH) continues
to monitor these trends closely as we consider how to allocate client assets across markets.
The ultimate fuel for equity markets is corporate profits, and the fuel is running low. In this eighth year of an economic cycle, companies are finding it increasingly difficult to generate earnings growth. The benefits of cost cutting have waned, unit volume growth is
hard to come by in an environment of modest GDP growth, and the absence of inflation makes it difficult to raise prices. This trifecta
of headwinds has resulted in negative year-over-year earnings growth for the S&P 500 index for seven consecutive quarters. As the
BBH STRATEGY MONTHLY / Private Wealth Management
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The Horse Latitudes
September 7, 2016
accompanying graph shows, bottom-up analyst estimates
call for a rebound in earnings over the next few quarters,
but we fear this says more about the innate optimism of
security analysts than it does about the real likelihood of a
strong earnings recovery.
The collapse in energy prices has something to do with
this earnings recession, as woes in the energy industry
have rippled through other sectors such as materials,
mining and manufacturing. Those headwinds appear to be
abating – at least on a year-over-year basis – and continued
strength in the consumer sector ought to help earnings recover, albeit probably not at the pace indicated by forward
consensus expectations.
S&P 500 Operating Earnings Growth
100%
% Change Year over Year
80%
60%
Consensus
Expectations
40%
20%
na
0%
na
-20%
-40%
-60%
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Data as of September 4, 2016.
Sources: Standard & Poor’s and BBH Analysis.
No assurance that target forecast will be attained.
Not every sector, industry and company is confronted with
these challenges to earnings growth. Our continued allocation to equities is expressed through managers who seek to find businesses that can grow their intrinsic values through a combination of sustainable competitive advantages, robust free cash flow, pricing
power and appealing rates of return on reinvested earnings. This combination of qualitative and quantitative characteristics is rare in
this marketplace, which is why our managers tend to run concentrated portfolios. Concentration is a way of managing fundamental
portfolio risk and a mark of investment discipline.
Rarer still is the opportunity to acquire these businesses at
an appropriate discount to intrinsic value.1 Over the past
five years, the price-to-earnings ratio of the S&P 500 has
almost doubled from 12.1x in September 2011 to 22.1x at
present as the rise in the price of the index has outpaced
earnings. That level is by no means a peak, but at more
than one standard deviation above historical averages, it is
nonetheless rarified territory for market valuations.
Equity PE Ratios (1946-2016)
± 1 and 2 Standard Deviations
30
+2 standard deviations
25
22.1x
20.5x
+1 standard deviation
20
15
25.4x
average
15.5x
10.5x
10
-1 standard deviation
Valuations do not exist in a vacuum, and an environment
of low interest rates, modest inflation and few investment
5.5x
5
-2 standard deviations
alternatives offers some justification for these levels. The
0
value of any security, theoretically, is the net present value
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Data as of August 31, 2016.
of the future cash flows it will generate. As interest rates
Sources: Standard & Poor’s, Robert Shiller and BBH Analysis.
(P/E) ratio is a company’s current share price divided by earnings per share.
fall, so, too, should the discount rate at which those future Price/Earnings
Standard deviation measures the historical volatility of a fund’s returns. The higher the standard deviation, the greater the volality.
cash flows are discounted. Lower interest rates should
support higher equity market valuations. Indeed, one common and simple valuation tool posits that the price-to-earnings ratio of the
stock market should be the inverse of the long government bond yield. With the 30-year bond yielding 2.32% at the end of August,
the implied P/E yield of the equity market would be 45x earnings.
Needless to say, we are uncomfortable relying too much on this argument and in no way believe that markets should trade at that
valuation. In the first instance, our belief that true investment risk is the potential for a permanent loss of capital prompts us and our
managers to identify an absolute margin of safety2 in each and every investment we make. This discount between price and value,
whereas not a guarantee of downside protection, provides a valuation cushion unrelated to the valuation of the overall market. Sec1
2
Intrinsic value: BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
Margin of safety: when a security meets our investment criteria and is trading at meaningful discount between its market price and our estimate of its intrinsic value.
BBH STRATEGY MONTHLY / Private Wealth Management
2
The Horse Latitudes
September 7, 2016
ond, we question whether the market level of interest rates truly captures market risk, as interest rate policy and quantitative easing
have replaced the price discovery mechanism for what interest rates should be.
This combination of poor earnings growth and high valuations is worrisome, but we take some comfort as investors in the observation that what is true of the market isn’t necessarily true of each stock in the market. Although the S&P 500 index (as of September
2) is trading a scant 0.6% off its all-time high, only 35 of the 500 stocks in the index are trading similarly close to their highs. This is a
narrowly led market, and the aggregate index levels obscure a different story as we look through the individual names in the index.
Seventy-nine index members closed last week at 20% or
more below their 52-week peak prices. If we adopt that
20% litmus as a rough definition of a bear market, then 16%
of the members of the index are trading in bear market
territory. This by itself is not necessarily an indication of
investment opportunity, but it highlights the observation
that performance within the market is very different from
the performance of the market. Parenthetically, this is one
of the reasons that we prefer to allocate capital into equity
markets using active managers. The ability to recognize
and exploit valuation deviations within the marketplace is
something that passive strategies do not offer.
Current Price of S&P 500 Index Members
vs. 52-Week High
0%
-10%
S&P 500 index -0.6% from 52-week highs
-20%
-30%
-40%
79 index members down 20% or more from
52-week highs
-50%
-60%
-70%
-80%
Asset allocation at BBH takes into account market con-90%
ditions and aggregate analysis, but as the preceding few
Data as of September 2, 2016.
Sources: Bloomberg and BBH Analysis.
paragraphs make clear, the top-down and the bottom-up
don’t always correlate. Whereas the lack of earnings growth and lofty valuations make us cautious, our investment colleagues and
managers continue to find appealing investment opportunities, so we remain committed to equities as an asset class.
We are, nonetheless, likely sailing in the horse latitudes of a lower return environment, which should come as no surprise after a fiveyear period in which the S&P 500 has compounded at an annualized rate of 15.5%. Without the fair winds of earnings and valuations,
the overall market is likely to struggle to move higher.
Disciplined investing is always important, but particularly so in a period of modest returns in which investors can be tempted to
stretch for return by lowering their investment standards or valuation requirements. Prudent risk management insists that we adhere
to our discipline throughout a market cycle, regardless of the return environment. Don’t throw the horses overboard.
G. Scott Clemons, CFA
Chief Investment Strategist
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© Brown Brothers Harriman & Co. 2016. All rights reserved. 2016.
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