Market Perspectives - January 2014
Outlook 2014: Are we in the eye of the storm?
EquitiesBy John Manley, CFA, Chief Equity Strategist
Domestic equitiesIt will be tough for the U.S. equity market to top its own performance in 2013; but, thankfully, it really does not have to. The real question for investors today is not whether stocks in 2014 can equal or better their 2013 showing but whether stocks can do better than bonds, commodities, alternative investments, and cash in 2014. While predictions can be a tricky business, it strikes us that most, if not all, of the factors that were in place to drive the market higher a year ago are still in place and, in our opinion, should remain so over the course of the next 12 months.
In our analysis of the historical record, a rising stock market one year has not been a good predictor of impending performance. Although valuations have climbed in 2013 by the most straightforward measure, price-to-forward consensus earnings, they remain modest to moderate compared with valuations over the past two decades. Profitability is high by historical standards, but earnings results have continued to rise. QE may be headed for the dust bin of economic history, but the Fed seems bound and determined to continue to keep rates and monetary pressure at the stimulative levels that have been so suitable for equities.
Against this encouraging backdrop, investors have remained generally and profoundly skeptical, in our opinion. The sharp edge of fear and doubt that greeted the last new year have been dulled, but investors seem willing to move off the sidelines in response to any sharp or short pullback in equity prices. Higher prices may have created a bullish veneer to sentiment, but that veneer seems easy to crack or dislodge. We sense little of the profound confidence in the future that has marked many prior market tops. Although it is buried deeper in the collective consciousness, we believe that many investors still believe what they have believed for more than four years: Sooner or later, we are going to have to pay for the excesses of the past 25 years. In our opinion, that lament is the wall of worry that the current bull market can still climb. We are maintaining our year-end 2014 target of 2,000 for the S&P 500 Index based on our anticipation of a 16 multiple on the 2015 consensus earnings expectation of $125.
“Nothing, except a battle lost, can be
half so melancholy as a battle won…”
There is something about a large move in the equity market that frightens investors. The massive decline of 2008–2009 traumatized a generation with the knowledge that stocks can be dangerous to your wealth. Yet, the rise in the market in the past 12 months has also has been unsettling. Numerous pundits recently have commented on the risk created by the rise, and this interpretation has been accepted by investors. Investors themselves have questioned whether they have missed the big run and can only expect the reflexive decline. However, the historical record does not support these viewpoints.
We have examined the annual performance of the S&P 500 Index in the past 75 years. The average annual price appreciation in that period was 7.3%, with a wide dispersion of results. The average annual price appreciation during years following a 20% or more rise in the market was about 7.6%, with a wide dispersion of results. In essence, little inference about the next year could be drawn from the current year. Some subsequent years were great, some were terrible; but, on balance, performance seems to have been driven by specific fundamentals and not by the degree to which stocks had risen in the then-recent past.
Chart 2: Fundamentals are more likely to drive performance
than what happened in the market over the previous year
“Don't fight the Fed.”
To us, recent economic data imply that the economic recovery in the U.S. is gathering some momentum. While that could be a positive for revenue and earnings growth in the year ahead, it also implies that the Fed will likely reduce and then eliminate QE in the not-too-distant future. That need not mean that the Fed is tightening policy. Quite the contrary.
In our view, the Fed will eliminate QE only if, and to the degree that, the economy no longer needs it. We believe that Fed policy will keep interest rates low long after the taper is finished and that, with little evidence of inflation or wage pressure on the horizon, we expect the policy will remain a positive for equities throughout the course of 2014.
We also see little evidence of an imminent decline in earnings for the S&P 500 Index. Forward consensus expectations have defied cynics and continued a slow ascent since 2011. While profitability levels are historically high, they have not been driven by the cyclical excess that marked prior peaks. In our opinion, earnings and profitability have been driven by low interest rates and technologydriven efficiencies. We believe that these forces will be slow to reverse and that earnings may be first augmented by improved economic activity, here and around the world. That keeps us in the equity market and steers us toward more economically sensitive sectors.
Chart 3: The blue line is the one to watch:
Earnings from 2011 to 2013 have defied expectations
“Time heals all wounds.”
We believe it is normal and natural for market economies to expand as their participants labor and plan to improve their individual and collective lots. Economic stagnation and contraction are the exceptions, caused by deliberate, inadvertent central bank intervention or market excesses. We believe that the world is slowly returning to normal five years after the massive disruptions of 2008, and we are recommending that investors overweight the sectors that stand to benefit from such an expansion.
We think the double overweight position is justified in the information technology (IT) sector. We believe that much of the improvement in corporate profitability has been driven by efficiencies derived from investment in IT and that the upgrade cycle is not yet complete. We also believe that this trend can be augmented by a recovery in European economies. The investment implications of corporations selling technology to other corporations has not yet been fully recognized, in our opinion.
We are also overweighting industrials. Here, we foresee a huge expenditure in the years ahead, as America invests in the infrastructure needed to safely extract and deliver the enormous amount of hydrocarbons that were inaccessible until the recent development of new technology. Beyond that, we see a competitive advantage to an American industrial base with access to some of the world’s cheapest oil and gas.
Finally, we are overweight the energy sector. To us, this is not a play on higher energy prices but is rather based on our belief that higher domestic volumes can benefit the downstream operations of large integrated firms (combined extraction and processing firms) and that greater exploration and development expenditures will help the large oil- and gas-services companies. We also believe that the high-quality, strong cash flow and positive dividend characteristics of a number of companies in this sector will become increasingly attractive to individuals seeking to plan for extended retirement.
International equities“And here comes Seabiscuit.”
To us, one of the most successful methods of investing is to identify a sector or market that has become cheap for a specific reason, track that reason, and buy into the area as the reason dissipates. We believe such a situation exists in Europe and, tentatively, in the emerging markets.
In our opinion, Europe is beginning to emerge from the clutches of a two-year, self-induced recession. Stern fiscal repression has weighed upon the economic, social, and earnings fabrics of the region. Valuations have accordingly contracted. We believe that Europe is beginning to emerge from that dark period and beginning to show signs of recovery. As confidence in the existence (if not the speed) of this recovery begins to be felt, we believe that valuations in Europe can normalize and its markets can outperform the U.S. in the process. In other words, monetary pressure in the U.S. is positive and should remain so, but monetary pressure in Europe is becoming more positive as its financial system moves from contracting to stabilizing. When it comes to the efficacy of monetary policy, it’s not just the central bank that matters. Equally important is the financial system that transmits the central bank activity to the rest of the economy. We think that the financial system in Europe is turning from getting sicker to at least stabilizing. That should have a positive impact on Europe’s stock markets.
The emerging markets are less clear but every bit as promising as the developed markets. Rapid growth has its own inherent dangers, and many of those have been made manifest in the past several years. While timing is difficult, we believe that the potential for emerging markets growth now warrants some serious consideration. If we are correct, improvements in Europe and the U.S. should soon favorably affect these economies and move their markets back to a growth track. The timing may be tricky but, in our opinion, the potential gain justifies the risk inherent in timing high-growth economies.