Portfolio Manager & Chief Investment Officer

Article By Joshua E. Betancourt – Portfolio Manager, Financial Planner

The economy continues to expand in the first half of 2015, albeit at a slower pace than the previous 3 years. From September 2014 thru March 2015 the Leading Economic Indicators have increased at a rate of 1.8% versus the prior six month period growth rate of 2.3%. The rapid acceleration of growth and recovery is tapering off as we converge into a slower modest growth environment. Of the 10 components contributing to the Leading Economic Indicators, the weakest are Building Permits and ISM New Orders, both posting negative growth. All other 8 components such as Average Consumer Expectations and the availability and use of credit are in positive territory.

LEI Thru March 2015

Our interpretation of the most recent data signals a healthy economy with no probability of a recession over the next 12 months. Forecasting further out beyond 12 months is difficult due to the lack of accurate leading data and the large quantity of changing variables which impact our expectations. While the economy maintains its healthy footing, we do not conclude that there will be a significant positive correlation with equity markets and the economy. We could experience a disconnect between the real economy and the equity markets as the rise in interest rates negatively impact the “Equity Risk Premium.” We discuss the ramifications of Equity Risk Premium on the overall market in our Equity Market Analysis below.

Equity Markets Analysis

As I previously forecast in our 2014 newsletters, we projected a fair value of the S&P 500 of 2,100 based on earnings expectations derived from fundamental analysis. We have since reached this price target and new data suggests lower guidance. We have lowered our 2016 earnings expectations for the S&P 500 given recent reported earnings and corporate visibility. While more than half of S&P 500 companies exhibit stretched valuations, pockets of discounted companies with intrinsic value, robust earnings, and growth do remain. At this juncture we believe “Value Investing” a more resilient strategy versus investing in the overall S&P 500 benchmark. We favor companies with increasing retained earnings, earnings growth, and earnings to book value yield of over 15% and limited corporate debt on the balance sheet. Historically, companies exhibiting this criteria have fared better in a declining or corrective market environment versus the S&P 500 benchmark.

The equity risk premium (the difference between the 10 year note interest yield and the earnings yield on the S&P 500) has narrowed substantially and will continue to narrow as interest rates rise. The wider the premium, the more favorable the equity markets are versus bonds on a relative basis. However, in a narrowing equity risk premium environment, equities are less favorable.

In narrowing risk premium environments, “Value Investing” becomes increasingly important. When a bull market ends, the ability to breakdown a financial statement and balance sheet similar to a seasoned professional analyst is critical to long term success. Unfortunately there are no second chances when planning for retirement as time is not on our side. At QCI we specialize in fundamental analysis to uncover long term opportunities by investing in deep value. We attempt to avoid many of the value-trap pitfalls many investors encounter due to lack of experience and expertise in analyzing income, balance sheet, and cash flow statements.

Bond Market Analysis

Given the recent rally in interest rates, we believe investors should maintain bond durations between 3 to 10 years and invest in bonds trading at a discount to face value. Premium bonds are likely to under-perform  discount bonds in a rising rate environment due to their lower yields. High-dividend stocks with no prospects of dramatically increasing the yield and no internal capacity to increase Return on Equity are also likely to under perform in a rising rate environment. Real Estate Investment Trusts (REITS) are also likely to under perform due to their static interest rate payouts and a slowdown in the industry. Obviously, bond price fluctuations are irrelevant if holding to maturity as the investor is guaranteed the face value at maturity barring any default. However, more attractive yields to maturity can be achieved with discounted bonds given the interest rate climate.

Based on our bond market expectations, the QCI bond holdings are exclusively invested in bonds trading a discount to face value and have been resilient during the recent rising rate environment. Our bond allocation has continued to outperform the bond market benchmark year to date.

If you have any questions regarding our newsletter, or would like a comprehensive portfolio review and update of your financial plan please feel free to contact us.

Kindest Regards,

Joshua E. Betancourt

Chief Portfolio Strategist/Financial Planner
Quantum Capital Investment Inc.