January 2014 Market Outlook
It cost $0.32 to mail a letter, unemployment was 4.9%, O.J. Simpson was found liable in a civil suit, Hong Kong was returned to Chinese rule, Timothy McVeigh was sentenced to Death, Green Bay defeated the Patriots in the Super Bowl, Titanic came crashing into movie theatres, and Dolly, the first genetically engineered lamb was unveiled to the public; the year was 1997.
1997 also held the distinction of being the year that produced the highest return of the S&P 500 (+31.01%) within the last 16 years—until it was narrowly eclipsed by 2013’s index return of 32.39%. For ourselves, we recall the rather heady days of 1997, a year which was squarely sandwiched within a five-year span that saw consistently out-sized market returns. “Goldie-locks”, “Dot-com”, and “Irrational Exuberance” were a few of the terms that became part of the investment lexicon during this period to describe either the stock market, the US economy, or both (we do not believe “Bubble” came into vogue until a few years later, of course). Ahh, the nostalgia!
To be sure, there have been years within the last decade that were quite good—both 2003 and 2009 produced returns of over 20%, but we would note that these years were more characteristically reversions to the mean rather than organically generated equity performances reflective of underlying economic or fundamental conditions; 2003 was a reversion up from the preceding three years of tech-bubble deflation, and 2009 of course was the reversion following the financial debacle of 2008. So the natural questions we are pondering today are;
- What are the similarities between 2013 and the late 1990’s?
- What are the differences that matter? Are we in another equity bubble?
- And of course, will the Patriots pull it off this year?
As for the first two questions—we think the answer is obvious. While the S&P 500 performances are nearly identical, there are very few similarities between the current underlying economic structure and that which underpinned the stock market 16 years ago, and we actually think this bodes well for equity markets. Economic growth—as measured by GDP—is perhaps one of the most obvious departures in comparing the two eras, as the US economy has struggled though a tepid recovery since the great recession of five years ago. However we would note the most recent Q3 GDP revisions show a growth rate over 4% (4.1%) for the first time in two years. Compare this to 1997’s 4.87% growth rate and its clear the US economy seems to have finally found some traction—despite last year’s “fiscal cliff” and “sequestration” dramas. As the stock market is a generally leading indicator, we are optimistic that current market levels (on average) should be sustainable with an underlying economy which is growing at a faster pace. One additional and important distinction between last year’s returns and that of the late 1990’s includes the fact that last year’s stock market rally was very broad-based, with nearly every sector within the S&P generating positive returns, while the late ‘90’s remarkable stock index advances were marked by a relative few sectors (and often a small handful of very large companies) propelling this market-cap weighted index absent any support from the rest of the market. In our opinion, this is the distinction between broad-based economic profitability (2013) and narrowly focused, even speculative stock “chasing” (1997).
Equating GDP growth to stock market performance can be tricky—and here we point to other measures which highlight a significant difference between the market of today and that of the late 1990’s. We’ve commented in recent Outlooks and reviews on the importance of measuring equity valuations in a manner other than a simply numerical factor which may make splashy headlines whenever it makes a new high. The simplest method is to view market valuations is as a ratio between price (tied directly to market levels) and earnings (tied directly to GDP) to make a more sensible comparison between current stock price levels and those of prior years. Taking an even more specific variation of this ratio, using forward earnings estimates (i.e. looking forward rather than backward), the Wall Street Journal lists the current forward P/E of the S&P 500 as 16x. Looking back to the era of the late 1990’s, we note that the forward P/E for the S&P was over 17x in 1997, and in subsequent years it climbed well into the 20’s, according to Yardeni Research, Inc. These valuation differences are material in our view, and while the markets are certainly richer in valuation than they were a year ago given their rise in price, we do not believe they are “over valued” on a historical basis, or based on evidence of accelerating economic activity.
We think it is important to note that while the Federal Reserve finally announced a modest tapering of their bond purchases, interest rates (i.e. the “Fed Funds rate”) will certainly remain at 0% this year, and quite possibly for the next 24 months. There was little movement in the Fed Funds rate in 1997, but it’s a notable difference that this benchmark rate was consistently above 5% back then—which further contrasts the relative economic strength of that period with the current period. While we think the actual catalyst for further P/E multiple expansion needs to come from further gains in corporate profits, expectations of continued ultra-accommodative monetary policy continues to foster an environment conducive to higher P/Es.
The market obviously accelerated right through a year that was, like the several before it, rife with political rancor and outright governmental dysfunction, beginning with the Fiscal Cliff, and peaking in October with a partial government shutdown. Things ended on a higher note though with a two-year budget deal struck in December. This late-in-the-year deal has created hope that 2014 could be a year of détente. 2014 being a mid-term election year, our bet is that both Democrats and Republicans will be playing a more conservative game when it actually comes to issues of governance this year.
And Lastly, GO PATS!
EQUITIES:
We have already taken considerable space commenting about US equity valuations and, as mentioned, we remain comfortable with our allocations. There is little evidence for an S&P 500 earnings decline in 2014, and continued accommodation by the Fed should allow US companies, particularly large-caps, to operate at relatively high profitability levels. We see meaningful expansion in sectors which will likely benefit the broader economy, including technology (which has had a hand in corporate profitability enhancement across all sectors), energy (which will continue to innovatively exploit domestic reserves, driving down the actual cost of energy, and thereby continue to benefit the broader economy), and the industrial sector (which has arguably gained the most from lower energy prices, and stands to gain further from a potential global economic up-tick).
A tried and true equity strategy is to identify a sector or market that has become relatively cheap for a particular reason, understand the reason, and buy-into the investment as confidence increases that the reason will dissipate. CCR Wealth Management increased our allocation to non-US developed markets, and European markets specifically for just this reason last summer. Europe has been in a two-year self-induced recession caused by stern fiscal austerity which has weighed on the economic climate across the continent, in-turn causing valuations to compress—certainly in comparison to the US. Despite the monetary and economic “union”, as we have highlighted before, the European economy is still largely divided among its geopolitical constituents, and we can value these constituents individually. Forward P/E ratios for France, Germany, Italy and Spain respectively are 12.9x, 12.2x, 12.1x, and 13.9x—all well below the aforementioned 16x the S&P 500 trades at. As in the US, the economic recovery in Europe has been slow—but it is happening. We think more and more this process of stabilization will be recognized, and investors will follow suit with greater allocations to EU stocks and markets, possibly producing 2014 returns greater than those in the US.
Emerging markets are less clear, and economically speaking, potential is even more disparately distributed over even more individual economic zones than in the EU. Never the less, we view the potential as compelling. Certainly the MSCI Emerging Markets Index greatly underperformed the US and developed markets in 2013 (-2.60%), but we continue to shun the broad-index play with emerging markets, focusing on a managed approach which can uncover fundamental values within regions and countries. Our preferred manager returned 8.68% in 2013. Importantly, as economic recovery continues to accelerate in Europe and the US in 2014 and beyond (according to our thesis), developing economies stand to benefit enormously, and we anticipate their equity markets will reflect these expectations. Investors in this space should continue to have patience.
FIXED INCOME
Clearly 2013 was one of the most challenging environments for bond investors within recent memory. Our fixed income model acquitted itself well—finishing with positive returns while the Barclay’s Aggregate Bond Index lost 2.02% for the year.
We’ve been warning for some time about an imminent end to the fixed income “party”—and at points last summer, it seemed the end would arrive dramatically following Ben Bernanke’s tapering comments. The municipal bond market was particularly spooked by the concurrent Detroit bankruptcy. So here we are, officially within the “tapering” window, and with a seemingly accelerating GDP; as a recent research piece from Wells Fargo asked, “Are We in the Eye of the Storm?”
We surprise ourselves a bit by being somewhat less negative on bonds (in general) than we were a year—even two years ago. Let there be no misunderstanding; bonds, and the aggregate bond index specifically, will continue to underperform relative to the last 5, and even 10 year averages, in our view, and investors should adjust their expectations accordingly. We fully expect the bond market to underperform the stock market again, which will again provide heavily bond-allocated portfolios with subdued returns.
On a more positive note, we reiterate that actual raises in the Fed Funds benchmark are likely 24 months away, and while the Ten Year Treasury yield rose nearly 70% in 2013, the current yield of ~3% is at a more “normalized level” given the underlying economic performance. In short, “duration risk” (down-side volatility due specifically to higher interest rates) is lower than it was a year ago in our opinion—though it still exists. So while we still view bonds as having very limited upside, our return expectations are driven almost solely by portfolio yield, rather than total return metrics, and this is how we are positioned. We remain “allergic” to aggregate index-hugging bond portfolios.
ALTERNATIVE:
CCR Wealth Management has always included an allocation slot to investments which are generally uncorrelated with stocks or bonds (it should be noted that an “uncorrelated” investment may at times move with or against either stocks or bonds, but for reasons not specifically tied to the equity or fixed income market drivers). Over the years this category has included precious metals, oil, particular commodity exposures, and publicly traded REITs.
Two years ago we began reducing—and most recently eliminating our precious metals positions. While a direct Brent Oil position remains in the portfolio—all other commodities have also been phased out. In fact the current combination of oil and listed REITs represent the lowest publicly-traded allocation to this investment category we’ve expressed in our models in the last six to eight years.
While our listed “Alternative” allocation has dwindled over the past two years, diversification principals fully support a portfolio allocation to investment elements not correlated to equity or fixed income drivers. This position may or may not include hedging characteristics, and it may or may not include income or total return characteristics or stocks and bonds. What it should exhibit over time though is a long-term “smoothing” effect on portfolio volatility. These characteristics are found in our non-traded REIT model portfolio allocation, an alternative investment which over time may provide both income and total return characteristics, but which is generally insulated from traded equity and fixed income market gyrations. Due to the liquidity characteristics of non-traded REITs, we recognize that this alternative is not broadly applicable to all clients, and allocation discussions are based on individual circumstances.
