Author: Marquette Test

Investing in MLPs: Which Vehicle is Right for You?

October 2014 Investment Perspectives

Since our last Master Limited Partnership (“MLP”) newsletter in 2011, the MLP market has grown from $220 billion to $437 billion as of September 2014. Investors have been on a “search for yield” over the past few years and the MLP space has proven to be an attractive investment with high yields and attractive growth opportunities. In the past, investing in MLPs has traditionally come with complicated tax related issues, which have often deterred institutional investors. As institutional interest continues to expand into the MLP space, however, institutional-friendly products have emerged. This newsletter takes a look at some of the recent developments in the MLP space and examines the channels by which investors can access MLPs in a tax efficient manner.

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Impact of Profit Margins on Stock Market Valuations

This week’s Chart of the Week looks at U.S. (measured by the S&P 500) and Developed International (measured by the MSCI EAFE) equity market valuations. Over the last five years U.S. equity markets have outperformed their developed market peers by almost 10% on an annualized basis (14% vs. 5.3%).

This week’s Chart of the Week looks at U.S. (measured by the S&P 500) and Developed International (measured by the MSCI EAFE) equity market valuations. Over the last five years U.S. equity markets have outperformed their developed market peers by almost 10% on an annualized basis (14% vs. 5.3%). Perhaps most surprising is that, as this week’s chart shows, U.S. markets trade at only a modest premium to other developed market peers (16.5 price to earnings ratio for U.S. stocks versus 14.9 for developed market international stocks). However, non-U.S. stocks are actually much cheaper when normalized for profit margins. Profit margins have a strong tendency to mean revert over time (high profits attract competition which drives down profit margins) and U.S. profit margins, at 9.5%, are at an all-time high. Conversely, non-U.S. developed market profit margins are just 6.6%, below their long-term average. Not since 2009 have international profit margins exceeded U.S. profit margins.1 Investors should be aware that as profit margins revert to their long-term averages it could leave U.S. stocks looking pricy, and their developed market peers looking cheap.

1This is shown in the graph when the red area (EAFE profit margins) completely covers the blue area (S&P 500 profit margins).

Support for the U.S. Equity Market

In this week’s Chart of the Week we look at the recent volatility of the U.S. equity market. Since the fourth quarter began, the S&P 500 index fell as much as 4%, but has recently rebounded, thus bringing its YTD gains to approximately 6%.

In this week’s Chart of the Week, we look at the recent volatility of the U.S. equity market. Since the fourth quarter began, the S&P 500 index (green line in chart) fell as much as 4%, but has recently rebounded, thus bringing its YTD gains to approximately 6%. Issues such as Ebola, ISIS, the Ukrainian Crisis, and a possible recession in the Eurozone have all contributed to the pullback.

However, it is worth noting that U.S. companies traded on the S&P 500 index are reporting strong third quarter earnings. So far this month, a total of 293 companies have released third quarter earnings that can be compared to Wall Street estimates. An overwhelming majority, 218, either met or beat Wall Street earnings per share estimates. As the chart illustrates, the continued good news from U.S. corporate earnings has positively contributed to the S&P’s recent rebound. Any continued volatility should be watched closely for prolonged effects on portfolios, but continued strong U.S. corporate earnings should calm investors’ worries about an elongated retreat for the U.S. equity market.

Speed Bump or Something More?

Over the past couple weeks financial markets have suffered steep declines, with the Dow Jones Industrial Average falling over 800 points, leaving investors to wonder if this is simply the pullback that we have been waiting for or if larger losses loom on the horizon.

Over the past couple weeks, financial markets have suffered steep declines with the Dow Jones Industrial Average falling over 800 points, leaving investors to wonder if this is simply the pullback that we have been waiting for or if larger losses loom on the horizon. While some may be pointing to underlying fundamentals or economic data, one could simply point to history as an indicator. This week’s chart looks at the maximum intra-year drawdown for the S&P 5001 Index for the last 30 years.

Since 1984, the S&P 500 Index has only had five negative calendar years. Despite this fact, 25 out of the last 30 calendar years have had an intra-year drawdown of more than -7%, and the median calendar year maximum drawdown over the last 30 years was just over -10%. Year to date in 2014, the maximum drawdown is what we are currently experiencing, a drop of 7.4%. Based on this data our present drawdown, while significant, is not out of the ordinary. Though it is impossible to precisely predict the length and magnitude of the current market slide, investors can derive some comfort knowing that an intra-year drawdown like this is not uncommon. Additionally – at the time of writing – the S&P 500 index is still positive year to date, and bond returns are also in positive territory for the year.

1We use the S&P 500 instead of the Dow Jones Industrial Average because it is a more commonly used benchmark by institutional investors.

A Closer Look into the U.S. Job Market

On October 7th, the Bureau of Labor Statistics released the August Job Openings and Labor Turnover Survey (JOLTS), which showed that the number of job openings waiting to be filled in the United States rose to 4.84 million. The 4.84 million vacant jobs in August is the highest number of job openings in the U.S. since January 2001, and is the third highest number of job openings on record since the inception of the JOLTS survey in 2000.

On October 7th, the Bureau of Labor Statistics released the August Job Openings and Labor Turnover Survey (JOLTS), which showed that the number of job openings waiting to be filled in the United States rose to 4.84 million. The 4.84 million vacant jobs in August is the highest number of job openings in the U.S. since January 2001, and is the third highest number of job openings on record since the inception of the JOLTS survey in 2000. The number of open jobs in the U.S. grew by 910,000 for the 12 month period ending August 31, which is the largest year-over-year increase in job openings since the JOLTS survey began. The large and growing number of open jobs in the U.S. indicates that the strong employment growth experienced recently is likely to continue into 2015.

The fact that there are a near-record number of vacant jobs in the U.S. while the unemployment rate is above the long-term average is a sign that employers are having difficulty finding qualified candidates for open positions. However, if this trend continues it will eventually start to put upward pressure on wages, which could be a bit of a double-edged sword. Higher wages would be a positive development for the overall economy, as the low level of wage growth the past several years has been a significant drag on consumer spending, which is the single largest contributor to GDP in the U.S. However, increased wage growth has the potential to put upward pressure on the inflation rate, which would likely force the Fed to raise interest rates more rapidly than the market currently anticipates, and this has the potential be a drag on the equity markets.

Initial Results of the ECB’s Targeted Loan Operation Fall Below Expectations

This week’s chart examines the results from the first round of the European Central Bank’s (“ECB”) targeted long-term refinancing operation (“TLTRO”) which occurred on September 18th. The ECB announced this program in June 2014 with the goal of encouraging lending to small and mid-size companies in the region.

This week’s chart examines the results from the first round of the European Central Bank’s (“ECB”) targeted long-term refinancing operation (“TLTRO”) which occurred on September 18th. The ECB announced this program in June 2014 with the goal of encouraging lending to small and mid-size companies in the region. The TLTRO essentially provides a four-year loan to banks at a fixed low rate. This serves as one of several tools the ECB has utilized to address the low inflation and contracting credit conditions in the Eurozone.

With 400 billion euros available, only €82.6B were borrowed by banks, well below the €150B estimated by a Bloomberg survey. Considering the initial outcome, investors are starting to question the potential effectiveness of the program. However, it is important to note that in the month of October the ECB will announce the results of the Asset Quality Review (“AQR”), which is a comprehensive assessment of banks’ balance sheets. The Eurozone’s financial institutions may be more willing to participate in the TLTRO after the stress tests are complete. The second round of TLTRO is slated for December and will provide insight into loan demand in the region as well as essential feedback to the ECB about the effectiveness of its policies. Without stronger demand for loans from this program, strong growth in the Eurozone would seem dubious, and thus participation in later rounds of TLTRO bears watching.

Hedge Funds vs. the Equity Market

Recently, the California Public Employees’ Retirement System (CalPERS) announced its decision to completely shutter its hedge fund program. As a result of this news, investors have been asking whether hedge funds still deserve a spot in their portfolios.

Recently, the California Public Employees’ Retirement System (CalPERS) announced its decision to completely shutter its hedge fund program. As a result of this news, investors have been asking whether hedge funds still deserve a spot in their portfolios. In this week’s Chart of the Week, we examine the efficacy of hedge funds compared to equity markets over the last 25 years. To do this, we compare the rolling 3-year Sharpe ratios of hedge funds (using the HFRI Fund Weighted Composite as a proxy) and equity markets (using the S&P 500 as a proxy). As a reminder, Sharpe ratios are a measure of risk-adjusted return, so a higher score represents a more attractive risk profile.

A comparison of the two indices suggests that recent hedge fund performance has been disappointing as the S&P 500 has delivered higher risk-adjusted returns over the last few years. However, most investors who have added hedge funds to their portfolios have done so to add diversification and new sources of alpha to their portfolios, so a comparison based on returns may not be entirely fair when comparing the equity market to hedge funds. Moreover, it is critical to note that the last five years have featured an impressive bull market that will naturally outpace hedge funds, which endeavor to create more attractive risk-adjusted returns by utilizing various strategies designed to limit downside risk, but also limit upside potential in times of bull markets.

So while hedge funds may surrender some return in times of significant market rallies, they can be expected to offer protection from market corrections, which are a part of every market cycle. Over the long term, the graph shows that hedge funds have indeed delivered higher risk-adjusted returns, in spite of the recent dip. Given the long-term cyclical nature of the market, when equities exhibit a correction, hedge funds should see a shift in relative performance, and once again demonstrate their utility to investors.

S&P 500 Dividends and Stock Buybacks Hit Record Levels

This week’s Chart of the Week examines increases in dividends and stock buybacks for companies within the S&P 500 index during the prior six years. Following a recession low of $71.8 billion during the second quarter of 2009, combined dividend and buyback expenditures established a record high of $241.2 billion in the first quarter of 2014.

This week’s Chart of the Week examines increases in dividends and stock buybacks for companies within the S&P 500 index during the prior six years. Following a recession low of $71.8 billion during the second quarter of 2009, combined dividend and buyback expenditures established a record high of $241.2 billion in the first quarter of 2014. The previous record occurred during the third quarter of 2007 when companies spent a combined $233.2 billion on dividends and buybacks.

Stock buybacks reduce the amount of shares outstanding for a company which causes earnings per share (EPS) to increase since the same amount of earnings over fewer shares outstanding creates a higher EPS value. EPS is a metric used in the determination of stock price, so a higher EPS value provides support for the stock price to appreciate in the near term.

A significant source of funding for stock buybacks in recent years came from the ability to borrow at short-term rates near zero. As interest rates are set to eventually rise, companies will be less inclined to fund buybacks in this manner. Compared to dividends which typically don’t experience large changes from period to period, stock buybacks are more dynamic in nature and can be quickly reduced if needed. Going forward, a potential concern for future stock market returns is that if buybacks are scaled back significantly, returns will likely be adversely impacted by such a contraction in buybacks.

Weak Loan Demand in Euro Area

Due to stagnating growth and marginal inflation in the Euro area, Mario Draghi recently announced that the European Central Bank (“ECB”) would reduce the interest rate on main refinancing operations from 0.15% to 0.05%.

Due to stagnating growth and marginal inflation in the Euro area, Mario Draghi recently announced that the European Central Bank (“ECB”) would reduce the interest rate on main refinancing operations from 0.15% to 0.05%. Reductions would also occur for the rate on the marginal lending facility from 0.40% to 0.30% and the rate on the deposit facility from -0.10% to -0.20%. In addition, the ECB will start purchasing asset backed securities in an attempt to facilitate new credit flows into the economy.

This week’s chart examines the balance sheet of euro area monetary financial institutions (“MFIs”). In particular, the chart illustrates the year-over-year growth of loans in the region. Notably, the growth rate has been negative since the end of 2012. The low lending levels are likely due to poor demand as a result of the subpar economic situation in the euro area, particularly countries on the periphery.

While yields on European government debt have tightened dramatically since Mario Draghi pledged to do whatever it takes to preserve the European Union in mid-2012, the underlying economic environment has remained challenging. The unemployment rate is currently 11.5%, the inflation rate is a paltry 0.3% and projected euro zone growth for 2014 is just 0.9%. The lack of loan demand, slack in labor markets, and overall low growth point toward the likelihood of a protracted period of low inflation.

The potential for deflation has led the ECB to initiate its most recent rate cuts and asset purchases. Similar to the effects of the Fed’s quantitative easing, markets may react favorably to the ECB balance sheet expansion, albeit at the cost of the euro currency. It is important for investors to monitor the ECB monetary policy and structural reforms that have been implemented by many euro zone countries to gauge whether they are effective in stimulating growth, and by extension, promoting positive investment returns from the region.

Real Estate: The Income/Appreciation Story

Income and appreciation are the two main components of returns to any investment, including real estate. Core real estate returns, as measured by the NCREIF Property Index (NPI), have been driven by the appreciation component over the past several years…

Income and appreciation are the two main components of returns to any investment, including real estate. Core real estate returns, as measured by the NCREIF Property Index (NPI), have been driven by the appreciation component over the past several years, and this has naturally been accompanied by a compression in capitalization rates.

In this week’s Chart of the Week, we look at the income and appreciation components of core real estate returns and how they have contributed to total returns over the past twenty years. We can see that income has historically contributed approximately 60% to the total returns of core real estate.

The income component has been below this long-term average for most of the quarterly periods since real estate’s performance returned to positive territory in 2010, as appreciation and cap-rate compression have been the main stories since the rebound from the financial crisis. However, with the expectation for a rising-rate environment on the horizon and an end to cap rate compression looming near, we anticipate that income will start to represent a larger fraction of total returns over the medium term. This should provide comfort to investors with allocations to core real estate funds and even core-plus and value-add real estate funds that have meaningful exposure to healthy, stabilized, income-generating properties.