Market Insights – Fall 2014
The U.S. stock market hit another record high during the third quarter of 2014. The S&P 500 Index has increased for eight quarters successively reaching new record highs each quarter. While the S&P 500 Index posted a strong return through September, other benchmarks are weaker. Small cap stocks entered a “correction” losing more than 10% from the March highs, and international markets struggled as the U.S. dollar appreciated versus other world currencies. At the beginning of the year, we noted that:
“The Fed’s policies have essentially “pulled forward” returns. The stock market increase of 2013 took gains from the next few years and pulled those gains into 2013. Looking forward, it will be important for investors to temper their return expectations after a strong run in the market in 2013.” ~ Market Insights January, 2014
This has largely played out as expected with global equity benchmarks up only modestly through the first three quarters of 2014 with further weakness in October. Looking forward, we believe near-term weakness will give way to long-term opportunities.
Eighteen years ago, Federal Reserve Chairman Alan Greenspan made his famous “irrational exuberance” comment: “…sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks…how do we know when irrational exuberance has unduly escalated asset prices?” This year, Fed Chair Janet Yellen made similar remarks including “the Fed will not be able to catch every asset bubble.” Further, Yellen said there are “signs of excess” in leveraged loans, biotech stocks and corporate bonds. There are many similarities between 1996, the year of Greenspan’s comments, and 2014. The U.S. economy had similar inflation, market valuations, and comments from the Federal Reserve. While many look back at Greenspan’s “irrational exuberance” quote as reflective of the dot com bubble, the S&P 500 Index actually doubled after he made his comments. Exuberance was in its infant stage in 1996 when the S&P 500 Index finished the year at 741 versus a high of 1527 four years later. The gains were accompanied by difficult conditions overseas as Russia, Thailand, and Mexico defaulted on their debt during that “boom” period. Today’s economic challenges in China, Brazil, and Europe echo a similar macroeconomic environment. The U.S. was then, as it is now, considered to be a relative safe haven.
It is not possible to consistently predict the future; however, it is possible and worthwhile to identify where we are in the cycle. While many say that we are in unchartered territories, we believe that there are similarities between the current market environment and the mid-nineties. Undoubtedly, the following four years will play out differently than the 1996-2000 bull market, but one key observation can be made from the comparison to 1996: the U.S. economy and U.S. equity market have historical precedent supporting the thesis that we are not at the end of the bull market. Our thesis is that we are slightly past the middle of the cycle, but not yet at the end of the cycle. This is consistent with our prior expectations for a longer than normal economic cycle due to delayed bank lending and reduced consumer debt.
Our Take on the CAPE Ratio
Robert Shiller, ironically the author of a book entitled Irrational Exuberance, helped to create the Case-Shiller Cyclically Adjusted P/E ratio (CAPE). The CAPE ratio has been widely referenced in the news and is often cited as an indication that the market is overvalued. The ratio modifies a price-to-earnings ratio, one of the most common valuation metrics, by adjusting for lofty profits during boom periods. The current CAPE ratio stands at 26.4x versus the 21.8x average since 1954. We believe that the current CAPE ratio is overstated because the earnings of the S&P 500 Index from 2009-2011 were significantly depressed and not reflective of the earnings power of corporate America. We averaged the earnings generated by the S&P 500 Index today and that of ten years ago which leads to a reading of 21.5x, nearly identical to the 21.8x average since World War II. Interestingly, the CAPE ratio in 1996 was 28.3x, nearly two points higher than today’s ratio. The bottom line analysis is that the CAPE ratio is not signaling buy, nor is it necessarily signaling sell as many pundits have suggested. The valuation discrepancy of companies within the S&P 500 Index warrant careful selection of undervalued equities as the broad market is no longer cheap or obviously expensive.
The Mighty Greenback
The U.S. Dollar strengthened 7%+ on a trade weighted basis in the third quarter, which contributed to falling commodity prices. Oil, in particular, fell almost 20% during the quarter. Brent Crude prices fell from $115/bbl to under $96/bbl. The rise in the U.S. dollar has been caused mainly by the unprecedented zero interest rate policy in both the Eurozone and Japan coupled with the anticipation of the U.S. Federal Reserve increasing U.S. interest rates in 2015. Currencies tend to appreciate in economies with stronger growth and higher interest rates relative to the country’s inflation (i.e., increasing real interest rates). As Europe and Japan keep interest rates near zero and the expected increase in U.S. interest rates nears, the U.S. dollar is appreciating relative to other currencies. The strength in the dollar is relevant to investors for several reasons: 1. Falling crude oil prices are positive for the US consumer, while hampering energy stocks. 2. Corporate profits earned overseas are repatriated into fewer dollars leading to reduced corporate earnings. 3. A stronger currency makes exports less competitive. The stronger currency is a welcome reprieve for the U.S. consumer after years of a weakening currency, but is not immediately beneficial to equity investors.
The rapid appreciation of the U.S. dollar spurred volatility in the markets in the second half of the year. Big market swings make investors uncomfortable and drive investors to seek safety in cash and bonds. We wrote last quarter about the risk of prolonged periods of low volatility, which had been the status quo for the past two years. Low volatility decreases the perception of risk, while increasing actual risk as valuations become stretched. In contrast, the recent volatility in the market and muted returns in 2014 are allowing companies to grow into their valuations reducing actual risk despite the increased perception of risk. Near-term volatility will create opportunities for investors and keep the market from becoming overvalued.
In the near-term, the stronger U.S. Dollar will weigh on global equities, but history suggests that there are further gains to be made owning high quality companies. The similarities between 1996 and today suggest that we are not at the end of the market cycle. This is consistent with our multi-year thesis that this economic cycle will last longer than average. The market is no longer cheap, while pockets of overvaluation contrast with opportunities being created by increased volatility. Investors will be rewarded by owning quality companies, resetting return expectations to preserve capital, and focusing
on long-term opportunities.
As we prepare to send our quarterly letter, the global markets have shown elevated volatility. On October 8th, the S&P 500 index had its single best day of the year. Subsequently, on October 9th, the index had its worst day of the year (down 2.1%). As investors, we are not swayed by short-term volatility. We have not had a 10%+ correction for the last 29 months. Thus, the pullback we have seen (down about 9.8% so far) is not unusual.
We must agree that there are relevant issues that the markets now find concerning. First, there is a slowdown in Europe and China. Global markets also fear deflation (rather than inflation which had been the worry given multiple rounds of quantitative easing by the US and others). The US Federal Reserve is ending its third round of quantitative easing (QE) and discussing lifting the Fed funds rate from near zero levels. The threat of radical Islamic militarism (ISIS) in the Middle East is also a focus. Finally, and perhaps most disturbing, there is a new fear that the Ebola virus becomes a global pandemic. Admittedly, other concerns also exist that could be added to this list.
Nevertheless, investors must ask themselves when have there not been things to worry about? The markets have always dealt with issues including the Cold War, the OPEC oil embargo, the savings and loan crisis, the Asian financial crisis, the internet bust in 2000, the World Trade Center attack, the financial meltdown in 2008, and failing Italian, Irish, Spanish, Portuguese and Greek economies in 2011. Although they are memories, these events all caused excessive market volatility.
At Whittier Trust, we consistently evaluate the macroeconomic landscape to determine where we stand in the economic cycle. Given an anticipated prolonged period of low interest rates (loan and mortgage rates), lower gasoline prices and 2-3% GDP growth, we believe that the US economy is poised to continue recovering from the 2008/9 downturn. Unemployment claims have also made a 14-year low and bank loan growth continues to accelerate (up 6.5% in September). The forward PE multiple on the S&P 500 is now 14.8x which is fairly valued but not extreme relative to history and prior market peaks (August 2000 forward PE was 26.7 and October 2007 forward PE was 16.6). In addition, third quarter corporate earnings are likely to grow about 5% (based on current Wall Street forecasts). These data points do not indicate a cyclical economic downturn. As we enter the fourth quarter of 2014, we anticipate that the positive effect of quantitative easing in Europe (and, perhaps, additional measures by the ECB) should help to stabilize developed economies in the region. We also anticipate that news flow on the other issues listed above, which has been decidedly negative, will stabilize.
Therefore, we view recent market turbulence as a long overdue mid-cycle correction in an expanding global economy. Should information come to light to indicate a more serious cyclical downturn, we will act accordingly.