Quarterly Perspective for 4Q10, Mark Carlton, CFA
The U.S. stock market posted its second consecutive double-digit quarter as more investors became convinced that the economic recovery was for real. It is well known on Wall Street that stock price movements precede those in the economy. Stocks rallied in the final three quarters of 2009 to signal that the recession was over (in the Spring of 2010 economists finally got around to declaring that the recession ended in June 2009). After a half-year of sputtering while economists debated whether we were going to fall back into recession (the dreaded “double-dip”) stocks began a meaningful surge at the end of August. Recently this has been confirmed by gains in economic performance numbers such as factory orders and industrial production. Employment is expected to pick up as well (note that employment is a lagging indicator of economic performance; typically, businesses do not start hiring until they are forced to by increasing demand). Whatever one may believe about the long term impact of quantitative easing, it is doing exactly what Fed Chairman Bernanke hoped for in the short term.
U.S. stocks gained about 11.3% last quarter, finishing the full year with a 16.4% increase[i]. Small and mid-size companies continued to lead the way as investors looked for those companies with greater exposure to a growing economy. Sectors like mining & materials, energy, industrials, transportation, and retailing performed very well while economically defensive sectors like utilities, consumer staples, and health care under-performed. International stocks rose a little less than 8% in dollar terms last year and only 6.6% in the fourth quarter.[ii] The global economic recovery was already evident in Asia and Latin America, so stocks in those regions modestly under-performed the U.S. market. The Euro declined against the dollar in the fourth quarter, reducing the gain in European stocks to less than 5% for dollar-based investors.[iii]
Bonds finally had the bad quarter market pundits had been warning about since the middle of 2009. While inflation currently remains mostly subdued, concerns arose that today’s economic policy decisions designed to promote employment growth would be harmful in future years. Bonds fell about 1.3% overall.[iv] Municipal bonds suffered the most due to fears of rising defaults. Strategist Meredith Whitney’s dire forecast for the muni market on an episode of 60 Minutes in December helped fuel a 4.2% quarterly drop.[v] Even previously high-flying emerging market debt slipped 1.2%.[vi] On the plus side, high yield corporates had a very good quarter (up 3.2%) and floating rate and mortgage bonds also managed modest gains.[vii]
Stocks defied expectations of an October correction, rising 8% through Election Day. Thereafter they gave back 4% before beginning another 8% surge after ADP reported rising payrolls on December 1st. We felt stocks had become modestly overvalued by the end of October, so the November correction did not surprise us. We expected the traditional year-end rally to get us back to the October highs, but not further. That we are four percent above those levels now makes us reluctant to commit new money. We have trimmed stock exposure in areas that have run up excessively (emerging markets, for example). We have also reduced the interest sensitivity of the bond part of the portfolio. We have trimmed our weighting in government bonds, putting the proceeds in floating rate bonds wherever possible. The latter generally have higher yields and can benefit from a strengthening economy.
Since certain areas of the stock market (large company stocks, especially) have not kept pace, we believe that is the area to look at in 2011. Valuations are much better there than they are in the small and midcap area. Objectively the outlook for stocks is good – interest rates are fairly low, the Federal Reserve has created plenty of credit in the financial system, key measures of orders and production are rising, and employment is starting to improve. The concern we have is that stock prices have already risen and fully reflect the positives. My best analogy is betting on a horse at 1-2 odds. You are likely to win, but since everybody else is betting on that horse you get paid a small amount if it wins and you lose a lot if something goes wrong. I would be more than happy to get more aggressive if we can knock a little of the fluff out of stock prices. Historically, you do a lot better when you buy into worried markets.
Bonds have had a tremendous run over the past decade, averaging almost 6% per year. Since investment grade bonds yield less than 4% on average, there needs to be capital appreciation in order for bonds to return 6% to investors. In other words, interest rates need to fall. With the economy clearly in recovery mode, that appears very unlikely. In fact, if interest rates rise, bonds will return less than the 4% they yield now. This is why many market strategists are very negative on bonds going into 2011. We believe the increase in bond yields will be mild this year and that we will be able to get mid-single digit returns from a combination of corporate, international and municipal bonds.
Commentary – How We Arrive At Our Market Forecast
Plain and simple, the return on stocks is equal to the growth (or contraction) in corporate earnings plus or minus the change in the multiple of earnings investors are willing to pay. The latter is historically much more volatile than the former. It follows that you can make money during periods when the economy performs poorly (without being short) as long as investor expectations improve. We have had two consecutive years of well above average stock price gains largely because the preceding year (2008) was so bad. Earnings contracted and investor expectations plunged that year, combining to drive stocks down 37%. Even with 2009’s gain of roughly 27% and last year’s 16%, the stock market is still considerably below its late 2007 peak. That makes it hard to say that the market today is expensive. And based on the levels of 2000 or 2007 it clearly isn’t. Yet if you change your frame of reference from three to thirty or a hundred years, we are clearly above the average in terms of valuation. (For an outstanding chart see: dshort.com) If you have a strong conviction that there is something about the past fifteen years that suggests that stock prices should trade above their long term averages, you will be cheered that we have a long way to go to reach previous valuation peaks. On the other hand, if you see this chart as showing that we have always had multi-decade high and low valuation periods, you may be concerned that we are in a multi-year transition process from an above-average valuation era to a below-average one.
This concerns me a great deal. As I stated before, over time corporate profit growth is fairly consistently in the 6-7% range. You can add about two percent to that for dividends. If I want to earn double-digit returns, therefore, I must either invest at a time when I believe investors are going to become more optimistic in general, or I must identify an area of the market that will enjoy a much better than average rate of profit growth and/or investor enthusiasm (like technology in the 1990s, or emerging markets in recent years). And it follows I must avoid (or at least under-weight) those sectors likely to fall out of favor in investors’ eyes.
So what are the prospects for investors to be willing to pay higher earnings multiples in the future? The chief components of P/E multiples are:
- Liquidity, or the credit available in the financial system to buy stocks;
- Inflation expectations (in other words, how much a dollar earned in the future is worth today);
- Profit margins, or how vulnerable earnings are to changes in input costs, wages, tax rates, etc.
- Cultural factors (in other words, how popular culture is supportive of or hostile to the notion of stock ownership, as opposed to investment alternatives such as bonds, real estate, gold, etc.)
Let us take them one by one. Liquidity could hardly get more favorable. Interest rates and borrowing costs are low, and the Federal Reserve is actively friendly in this regard. As long as this lasts, it is a positive for stocks. It is very hard to believe, however, that this component won’t be less favorable several years down the road. Inflation expectations are well behaved at the present time, but investors are clearly concerned about the future (as evidenced by rising gold prices and the political success of the Tea Party). Inflation might not rise much in future years, but it almost certainly won’t decline. Profit margins have been at record highs as a percentage of sales for most of the decade partly due to technological advances in inventory management and very modest wage pressures. The only short-term threats here are higher corporate tax rates (highly unlikely) and rising input costs (raw materials, transportation) that can’t be passed on. Rising oil prices may hurt on both counts, as much of our products and packaging is petroleum-based. Finally there are cultural factors. Investor willingness to hold stocks took a significant hit in 2008 and 2009. A third straight year of double-digit gains could do a lot to restore confidence. So would a sub-par bond year and a sell-off in gold. This component has the greatest chance of contributing to stock price gains. Frankly the best we can hope for out of the other three is that they don’t deteriorate.
The implication in this analysis for me is that while we have the hope of multiple expansion (and double digit returns) this year tied to improving investor psychology – it is likely that over the next five to ten years stock investors receive less than the 8-9% annual returns implied by earnings growth and dividends. Our hope has to be that none of the components gets meaningfully worse such that valuations don’t fall in to the “bad period” range. Remember, it took ten years of essentially 0% returns to bring valuations from their peak in 2000 just to average by 2009. If we are destined to see below average valuations, stock returns going forward may be closer to the 3-6% range. That said, there is reason for hope. What could render this analysis too pessimistic would be a major breakthrough, perhaps in medical science or transportation, which would bring major profit gains to a particular sector and/or cost savings across all industries. In transportation at least, we are more than overdue. Absent an unforeseen advance, however, stocks are priced for a scenario that almost certainly cannot last. Caution is warranted.
Past Performance is no assurance of future results.
All index data provided by Telemet Orion or Morningstar Advisor Workstation. Numbers do not reflect fees, brokerage commissions or other expenses of investing.
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[i] As measured by the Wilshire 5000
[ii] As measured by the MSCI EAFE (dollar terms)
[iii] As measured by the MSCI Europe (dollar terms)
[iv] As measured by the Barclay’s U.S. Aggregate Bond
[v] As measured by the Barclay’s Municipal Bond Index
[vi] As measured by the Barclay’s Emerging Market Debt Index
[vii] As measured by the Barclay’s High Yield Debt Index