Long term investors must accept the vicissitudes of market cycles in order to capitalize on opportunities. Unpredictability generates a constant tension between short term technical factors and long term fundamentals. For short term oriented investors, relative outperformance requires owning the right mix of assets at the right time, irrespective of valuation considerations. Since March, the stock market has narrowed around a select group of transformational technology stocks, known as the “FAANG” (Facebook; Apple; Amazon; Netflix; Google), that contributed half of the index’s return. There are some worrisome echoes of the dot-com bubble associated with this degree of concentration.
For long term investors, success requires recognizing important trends and identifying undervalued assets in a disciplined manner while ignoring short term swings in sentiment. On June 16, Amazon announced its acquisition of Whole Foods. The combined market capitalizations of the two companies increased more than the value of the transaction. Further, a group of grocery retailers, including Wal-Mart, lost significantly more in collective market value on the announcement. Those two facts suggest the reaction was indiscriminate, irrational and without fundamental justification.
In the past twenty years, Amazon has constructed a business that is formidable and frightening. We marvel at the company’s accomplishments and remain impressed by its reach. Amazon is ultimately a platform company with a highly disruptive business model that can seemingly expand as it wishes. However, by offering to buy Whole Foods, Amazon has, in effect, validated the need for some bricks & mortar. Therefore, it remains to be seen whether Amazon will prove as disruptive in grocery distribution as it has been in other retail sectors.
In the final week of the Second Quarter, the Federal Reserve released its report on the stress tests it administers annually to banks. Because of encouraging results, banks will be allowed to increase dividends and share repurchases, and it implies that the period of post Financial Crisis balance sheet repair has finally concluded. Combined with the Fed’s intention to slowly shrink its balance sheet, our central bank has delivered an unequivocal vote of confidence in the US economy.
A tightening of monetary conditions would normally be associated with rising long term interest rates and a strengthening Dollar. The opposite has occurred. Ten year Treasury yields have fallen since a post election spike. The Dollar index has likewise retraced its post election gains. They send a potentially conflicting signal with the stock market’s performance. The decline in yields could reflect the inability of the new Administration to enact economic measures that the market anticipated would prove reflationary. The bond market could also be responding to certain disappointing economic indicators that are incongruous with sentiment indicators that imply more robust economic conditions. The Fed also seems befuddled by the fact that a tight labor market has not responded with greater wage inflation.
These apparent disconnects are not sufficient to persuade us that a more defensive posture is warranted. In fact, we are most encouraged by economic improvement in Europe, Japan, and certain emerging markets. One year ago, the Brexit vote prompted fears of global populism, protectionism, and trade wars. Instead, we witnessed France elect a moderate; early signs of a Franco-German alliance; resolutions to banking and fiscal crises in Italy and Greece; fringe right and left political parties lose influence in Europe; and continued reforms in India. Finally, the outcome of UK’s snap election affords the European Union significant leverage as negotiations begin.
In the US, we remain hopeful that a more limited domestic economic agenda is still possible before year end. We are encouraged by the recent broadening of the market, but we acknowledge that short-term rotations could prove unsustainable. This tendency of markets underscores our philosophy that investors should remain well diversified even when the market occasionally narrows.