Market Outlook Q3 2016

Clients of the Firm,

As we near the end of Summer and the leaves turn amber and brown, permit us to wax a bit poetic at the season that was and what the turn of autumnal clock may bring for our investments. Recently, several macro-economic themes have become clearer as they often do when the mind opens and we turn the page of the calendar.  We will try to distill them here.

The U.S. Election

The U.S. election has been front of mind for many in the United States, and that view is shared by many in the rest of the developed world.  Indeed, the contrast is quite stark between the two major party candidates and the future uncertain, as proposed trade, immigration, national security and other policies have evolved throughout the campaign.  Whatever the outcome, it is likely that some elevated level of divisive rhetoric and disparate opinions will remain an acute part of the near-term future of the country.  This continued theater of the anti-collaborative is a weight on markets, business and the psyche of an economy that is otherwise poised to break out of the slow growth normative we have come to know over the past 8 years.  Improvement in business, politics and general well-being has historically come from a spirit of working together to solve problems where people are united in a cause of resolution rather than division. This is the American spirit, and we still have confidence it will endure through these divisive times.    

The Federal Reserve

The Federal Reserve is again faced with the decision of whether or not to raise short-term interest rates from the current 0.25% level by another 0.25%.  The first opportunity to do so will occur later this month, followed by meetings in November and December.  Much has been made of this decision in markets, with interest rates migrating up and down based on the latest jobs report, ISM data or Fed Governor sneeze.  The general consensus remains that the Fed is likely to raise rates one more time in 2016.  Our opinion is that this will probably be in December, but the possibility exists that a September rate hike could happen.  However, markets have priced that likelihood, as implied from Fed Funds futures, at about 20% today. 

The implications for equity investments would likely be to favor the financial services sector while being unfavorable to bond proxy investments, such as utilities and telecom.  The ultimate path of the Fed is highly uncertain, and a rate hike of this magnitude is far from large.  Given the rate environment globally, it is very unlikely that the Fed will tighten aggressively in the near-term.  Indeed, rates at 0.5% would remain extremely accommodative.  Therefore, any selloff in equity investments that yield more, with a high degree of certainty, would represent buying opportunities.  

For bond investors, the reaction function to higher Fed Funds is likely to be lower bond prices and higher yields.  Our base case is a lateral move up in the yield curve, meaning long-term rates and short-term rates rise simultaneously. A flattening of the curve would be detrimental for banks who make a great deal of their money from the difference between long and short-term rates, while a steepening would be greatly beneficial.  We do not anticipate an inverted yield curve, as the Fed would probably act to prevent such an event from occurring in order to preserve financial stability.

Capital Allocation Decisions

Strategically, maintaining equity allocations makes sense in this environment as valuations are on the higher end of normal and the risk-free rate is so low.  However, so does preserving dry powder in cash in order to take advantage of disproportionately punished stocks or bonds that overreact to the whatever the Fed decides to do on rates, a surprise election outcome or any other economic shock or binary event risk.  This strategy has been our posture since it became clear in the 4th quarter of 2015 that the Fed was likely to raise rates repeatedly and the geo-political and global business environment became more uncertain.  Prudent risk/reward management leads us to the conclusion that some opportunistic cash is a valid strategy as we navigate these waters.

Earnings Season

Earnings season this quarter for our holdings was a mix of mostly good results, some exceeding and some failing to meet analyst expectations.  As happens often in markets, stocks tend to be measured short-term by how their results compare to short-term projections (i.e. quarterly results).  As you know, our modeling is focused on a much longer time horizon.  Therefore, our intrinsic value and price target estimates tend to be modified only slightly as we digest earnings reports and quarterly conference calls with management of the companies we own.  Of course, the change is dependent upon what we hear from management, our own independent research and general trends in the business cycle and industries we invest in.  Due to this fundamental analysis-based approach, our portfolio turnover is low and so is our trading volume.  We update our models each quarter for our investment ideas or in the interim if material news impacts our analysis. We make decisions based on those analyses.  The aforementioned macro environment enters into the analysis only as it pertains to the businesses and assets we own and is not the primary basis for investment decision-making. 


Interest Rates and Terminal Multiples

Interest rates, for example, represent the opportunity cost of investing in a risk-free asset.  The lower interest rates on risk-free bonds are, the more compelling an alternative investment such as a stock might be.  With rates this low, it is tempting to see many risk assets as superior and to assign a higher terminal multiple and lower required risk premium when determining that investment’s intrinsic value.  We avoid this temptation by assigning a risk-premium rate floor for our investments, assuming that rates will at least partially normalize over the course of our investment time horizon. 

As we have written before, we do not subscribe to the expanding multiple theory of equity valuation.  This theory basically surmises that if times are good and rates are low, that investors should and will pay higher multiples for stocks.  This thinking is used as justification to assign higher terminal multiples to stocks when evaluating their worth.  We avoid this risk by assigning reasonable historic market multiples in our modeling. We will assign a higher terminal multiple to a company that is growing very rapidly and a lower one to a mature steady business that delivers predictive cash flow.             


In investing, there is always some measure of uncertainty.  Sometimes that uncertainty is thrust upon us by unexpected or adverse macro events, like terrorism, economic conditions or natural disaster.  Sometimes those events are transient, others they are not.  Additionally, we are faced with investment specific information that materially changes our analysis of an investment and impacts our estimate of its future value.  As an investor, both of these data sets should be viewed in a rational framework of risk/reward and action should be taken accordingly.  On an individual basis, clients should consider and communicate their own risk preferences to our team so we can continue to personally tailor their allocation and strategy to achieve their personal wealth goals.  Again, we thank you for your trust and confidence in our firm and hope you enjoy the coming Fall season.   



Peter C. Wernau


Wernau Asset Management


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Peter Wernau