Thursday, April 11, 2013
Q1 2013 Equity Market Review and A Look Ahead:
The first quarter was a very strong one for US equity markets with far weaker performance outside the US:
US total stock market (ETF VTI) 11%
Developed International Markets (EFA) 3.7%
Emerging Markets (VWO) + 3.7%
If the US market rally continues at this rate for the entire year it would mean increase would represent a 40% + gain for 2013 which Is to say the least highly unlikely.
We remain skeptical of the recent price increases and within the discipline of our long term strategy have reduced our exposure to US stocks.
What are the common explanations for the market rally?
Here is a rundown of the “conventional wisdom” and my skeptical response
· Because of low interest rates and uncertainty outside of the US investors have “no place else” to put their money.
True, US interest rates are at record lows and the high valuation of many high dividend stocks that considered stable but low growth indicates many investors are ---erroneously in my view—looking at dividend stocks as a substitute for bonds. Indicative of this is that consumer defensive stocks considered slower growing, but higher dividend stocks and utilities are top performing sectors year to date. These stocks generally trade at a valuation discount to the SP 500 but are now trading at premium of over 10%.
The curious part of this explanation is that the bond market as reflected in market prices —and the conventional wisdom of the bond market analysts—is that the end of the Feds aggressive easing policy is nearing. So if the equity rally is because of low interest rates and bonds are highly risky due to the prospect of higher interest rates it seems that low interest rates are a thin reed upon which to base a 10%+ rally over 3 months…the message of the bond market that the major declines in interest rates are behind us.
· A “great rotation” is occurring in which investors are returning to stocks after missing most of the markets recovery
Great rotation is too strong a term particularly if it represents the beginning of a long term major return of individual investors into the stock market. Anecdotal and fund flow data definitely do show movement of individual investors back into stock funds and ETFs. But individual investors (and the fund managers who try to “catch up” with the market to avoid outflows and attract inflows) can be a fickle lot and many of them will likely flee from the market at the first sign of a selloff.
· Price Momentum: Markets definitely have a momentum factor in which short term trends are self-reinforcing. That makes market timing –trying to pick tops and bottoms—virtually impossible. But high returns make markets more risky, price can deviate from value in the short term and markets tend to revert to the mean. High current returns and valuations portend lower returns in the future. All this means that rebalancing makes sense in response to large market moves (in this case selling stocks and readjusting allocations) but moving all in or all out is not a path for long term investing success
· Improved economic outlook in the US. At the end of the 2012 all the conventional wisdom was forecasting a reversal of the modest of the emerging economic recovery due to the sequester, payroll tax increases and assorted other woes. None of this has changed since the turn of the year , yet the market has shown the strong performance. Macro-economic data particularly in housing show the economy has likely bottomed. But the growth prospects are still modest at best, the employment data and consumer spending and confidence data don’t point to anything close to economic growth above 2.5 -3% with the potential for negative surprises larger than those for unexpectedly good news. The anemic employment figures released on April 5 are a good sign of how fragile the recovery is.
Furthermore, the stronger the economic data the greater the prospects for a change in Fed policy….and higher rates are unlikely to be good for stocks.
· Improved corporate profitability: corporate profitability has improved led largely by the recovery of the devastated housing and financial sectors. Consumer spending has not shown a major upturn.
Furthermore, investors have been bidding up the prices of stocks of large cap high dividend payers many of which are major multinationals with large portions of their revenues coming from outside the US. If the message of the European and Emerging economy equity markets is for slow growth and profitability among those companies there has to be a limit to the prospective profit growth of US multinationals like Procter and Gamble, Ford and McDonalds who depend on foreign markets for a large portion of their profits.
· US markets attractive vs. the rest of the world: The situation in Europe and slower growth in emerging economies certainly raise the risk levels in these markets…but in a global economy does that mean that equity holdings in non US economies justify the divergent performance and valuations are likely to continue?
· Valuations are reasonable: At the end of the day stock prices can go up one of two ways: increased profits or higher valuations (i.e. one dollar invested buying a smaller portion of future earnings because of optimism about the future).
The best long term measure of valuation is the CAPE or Schiller P/E ratio which is based on the average of 10 years of earnings. Markets with high valuations as measured by CAPE have shown to have poor investment returns going forward. The current US S+P 500 P/E are 23.18 well above the historical mean of 16.47. The Price earnings P/E ratio based on 12 month trailing earnings is 17.93 vs. a long term mean of 15.49. In other words the market is anticipating a sustained recovery in earnings….despite economic uncertainty around the world. It is hard for to see the US market as undervalued.
Based on most valuation measures the US market is highly valued although certainly not at “bubble” levels Despite appearances …the higher the market returns the higher risk and the lower the prospective returns indicating caution is in order and the prospects of a “correction” in the near term is high.
Will the pattern of recent years with a selloff after a first quarter (see below) repeat itself? With the large price indices of the past quarter….it seems a reasonable scenario.
Investment implications my general investment approach makes use of portfolio rebalancing, but large scale market timing and believes that “price and value” can deviate in the short term but revert to the mean in the long term. My current outlook and strategy is based upon: Rebalancing between asset classes has been shown to increase return modestly and at lower risk (volatility)
Rebalancing portfolios A rebalancing strategy would take some profits on equity positions and moving to fixed income (more on fixed income strategy in my next email) in order to keep portfolios slightly underinvested in equities vs. target allocations. Of course investing this way goes the opposite of the tendency to buy into momentum. That strategy runs the risk of buying high and selling low. Although rebalancing certainly runs the risk of missing out on some of the moves due to momentum…as has likely been the case for rebalances that have missed the most recent part of the market’s strong rally.
With global valuations as follows (relevant ETF listed in parentheses) price/prospective earnings
US S+P 500 (SPY) 13.5
Europe (VGK) 11.3
Germany (EWG) 12.8
Emerging Markets (IEMG) 10.95
Emerging Asia (11.38)
It is hard to find a rationale for favoring US over non US stocks for the medium to longer term.
The major US and European indices are heavily weighted with global multinationals that compete with each other around the world; it is hard to rationalize European multinationals trading at a 15% valuation discount to the US peers.
Emerging market economies have slowed from their very rapid growth of previous years but still have stronger long term growth prospects than the US. These indices include both major multinationals such as Samsung as well as domestically oriented companies like China mobile. Growth has slowed significantly in China, India, South Korea and Brazil but longer term growth prospects and demographic trends remain positive.
Ironically one of the hot “new ideas” for investing is to invest in merging market corporate government and corporate bonds because of the better economic fundamentals vs. the US. If that is the case and if the major growth market for US multinationals is in the emerging economies then a longer term perspective would see emerging market stocks trading at a 20% discount to US stocks as a buying opportunity.
A valuation based investor looking to initiate new equity positions would likely look outside the US and rebalancers might wind up selling US stocks and adding to their international allocation.