September 25, 2013
- Market performance has continued to support our view that the financial markets have entered a new era for allocation, with increased evidence of a secular bull in equities.
- Stock market performance since 2009 has been consistent with secular bulls and inconsistent with secular bears. If bonds enter a secular bear, stock outperformance could be dramatic.
- The secular bull case would be confirmed by broad record highs, persistent equity fund inflows, and continued improvement in global economic momentum.
The case can be made that there is a new era for investment allocation, in which stocks will consistently outperform bonds over the long-term. The thirty-year bull run for the bond market has come (or, at the very least, is coming to) an end. This lends to the strategy of, on market troughs, selling bonds and buying stocks. This simple strategy could be the difference between winning and losing over the next decade.
Does this mean that the equities have entered a new secular bull market? In our December 2012 Economic Outlook for 2013 report, we said that not only was the probability high, but that later in the year, this would be a much debated topic of conversation (at the time, the thought was on nary the lips of any pundits). We contend that since that report, additional proof has been delivered so as to more confidently proclaim equities to be in a new, secular bull market.
Granted, like a news channel waiting for district data to come in to call an election, not all of the votes have been counted – but we have sufficient evidence to be confident in making such a call. Arguing against the bull call, for example, global breadth has been weak. Stock prices of U.S equities have done the heavy lifting, leaving far behind the returns of many other developed nations. Also of concern, despite the stock market gains since 2009, mutual fund investors have not warmed up to equities. A three-month average net inflow of $9 billion, on a sustained basis, would be good sign. There have been a few spikes toward and around that number, but nothing sustained. And, of course, positive economic trends must continue. Regarding calling the bull case, you really only know these things in hindsight. But we are not historians, we are investors. So we do not have the luxury of waiting until all the good news has reached the headlines. We must, as we did at the trough of the market in 2009 when we started to reinvest all cash held in clients’ portfolios, invest according to what we expect, not what we know.
Still, we admit to not being particularly brave souls in contending that we are in the midst of a new, secular bull market. There, to be sure, have been signs since the market reached its depths of 2009. Since then, stock market performance has been far more consistent with a secular bull than a secular bear. For example, the S&P 500 has gained at least fifteen percent in three of the past four years, beginning with 2009. And with the index up ahead of that mark currently, 2013 will possibly be the fourth year in five with gains of at least fifteen percent.
Such a run for the equity markets is in keeping with secular bull returns. During the secular bull market of 1942 through 1965, the index gained at least fifteen percent in 63% of the years (with a median annual gain of 19%). During the secular bull market of 1982 through 1999, the index gained at least fifteen percent in 66% of the years (with a median annual gain of 21%).
Conversely, the stock market performance has been inconsistent with secular bears, in which fifteen percent up-years have been rare and sporadic. During the secular bear of 1966 through 1981, the index gained at least fifteen percent in only 38% of the years (with a median annual gain of 9%). During the secular bear of 2000 through 2008, the index gained at least fifteen percent in only 22% of the years (with a median annual gain of just 5%).
Stocks over Bonds
- Unless stocks lapse back into a secular bear and bond yields improbably break back to new lows, stock outperformance over bonds will be the norm in years ahead.
For asset allocation, the semantics of whether a new bull has started is less significant than the evidence that stocks have entered a new era of consistent outperformance versus bonds. That evidence has strengthened in 2013.
The U.S. Long-Term Treasury Bond Index is negative year-to-date, heading for its second down year since 2009 and only its sixth losing year since the secular bull market in bonds got underway in 1982. From 1982 through 2008, bonds lost money in only 15% of the years. In contrast, 37% of the years were negative during the secular bond bear of 1941 to 1981.
The outlook for inflation should increase and Federal Reserve policy should tighten in order to officially declare a new secular bear market in many U.S. bond classes. And even if that tipping point has not yet been technically breached, it is likely that the lows made in bond yields will not likely be surpassed on the downside. That alone would make it unlikely for bonds to outperform their own recent rate of return, or that of stocks, in the years ahead. And if stocks have, indeed, entered a new secular bull (which we believe they have), the underperformance could be dramatic.
Unless stocks lapse back into a secular bear and bond yields improbably break back to new lows, stock outperformance over bonds will be the norm in years ahead.
- All other things equal, the lower the interest rates the more attractive the equity valuations.
- All other things equal, the higher the earnings yield the more attractive the equity valuations.
- Equity valuations are “more or less fairly priced”.
While the apparent start of a secular bull in stocks and an approaching secular bear in bonds provide a framework for equity outperformance, too much of a bad thing for bonds could also be bad news for stocks. The ideal backdrop for equities would be a gradual rise in rates with intermittent bond price rallies (an outlook supported by the current degree of economic slack). If bond yields rise fast enough to stall economic expansion, equity investors may start to worry about future earnings growth. That concern would cause investors to view valuations in a more negative light, especially relative to higher-yielding bonds.
The key takeaway is that if growth comes through, equities should be able to withstand much higher yield levels than they would otherwise. While it would be tempting to identify a single bond yield level that would represent a barrier for stocks, we should instead view the rate trend in context of the market’s earnings expectations (which is implicit in the earnings yield – a measure of valuation; it is the reciprocal of the P/E ratio whereby dividends per share are divided into share price) as well as the levels of economic growth that either support or lend caution to those expectations. What we can say now is that the mix is conducive to a year-end stock market support and the continuation of the secular bull market.
But regarding equity valuation, as Warren Buffet put it in a September 21st CNBC interview, stocks are now “’more or less fairly priced” – which is a tremendous endorsement considering a) that stocks are up tremendously from the 2009 low, where Mr. Buffet described stocks as “ridiculously cheap”, and b) that this is coming from a famed investor known for only buying stocks that are, well, ridiculously cheap. The S&P 500 earnings yield has dropped from its nearly eight-percent mark, down to about five-and-a-half percent. It does, for the sake of comparison, remain well above the two percent yield reached in 2001, when the secular bear was getting started. And as of the end of August, the earnings yield was still 283 basis points above the ten-year Treasury yield, making stocks more attractive relative to bonds.
It is worth clarifying that even if bond yields rise back above earnings yields, that won’t necessarily mean that the case for stock market outperformance is in trouble. Spreads between the two were negative throughout the 1980s and the 1990s. And that was a time when bond yields were much higher than they are today. The difference, of course, is strength of the economy then versus now. Still though, by the end of 1999, the combination of rising bond yields and falling earnings yields started to become an overwhelmingly negative influence.
- Investor confidence has improved over the last months and year, yet remains dramatically lower than other periods despite marked economic improvement.
- Improved confidence will create a positive feedback loop, benefiting both the equity market and the economy.
While economic and stock market sentiment remain surprisingly and stubbornly negative relative to the 1980s and 1990s, more recent comparisons show that investors are no longer fretting over the crises of yesteryear (cue cynical quip of “We have whole new crises to worry about!”). Instead, investors are finally coming around to the view that in the aftermath of deleveraging, restructuring, and central bank accommodation in so many parts of the world, that global economic growth is heading in the right direction. The more decisive this news becomes, the more resilient the global stock market trend is likely to become, even in the face of the inevitable decline of earnings yields below bond yields.
A continuing secular bull market for stocks would be positively influenced by expectations for sustainable economic expansion and resultant earnings growth, driving long term returns despite rising interest rates and, thus, decreasingly competitive valuations. Equities have benefitted from the ideal combination of improving economic growth, rising confidence, and continued monetary accommodation. Yet, as indicated earlier, there is still that proverbial “wall of worry” for the market to climb. Far from the exuberance and complacency seen at market tops, optimism is returning slowly and the signs of improvement are recognized (even if only begrudgingly recognized).
Especially encouraging for the stock market outlook is the U.S. consumers’ return to health. As household net worth has returned to record levels, multi-year lows have been reached by the debt-to-net worth ratio, financial obligations ratio (comparing debt service to disposable income, a favorite metric of the Federal Reserve), and credit card delinquencies.
The increased willingness to take on equity risk is evident in the rising percentage of stocks in household portfolios, while the bond percentage has been falling. The resultant ratio of stock/bond ownership has been on an uptrend since the stock market lows of 2009. That ratio remains far below extremes of past cycles, suggesting that there is plenty of potential for continued reallocation from bonds to stocks.
As indicated earlier in this report, persistent equity inflows into mutual funds (an average three-month net inflow of $9 billion) would provide secular bull confirmation. It would indicate that equity demand had broadened from institutions to the retail investor, in turn encouraging institutions to further ramp up demand. The bullish feedback loop would help sustain the long-term momentum needed to underpin a secular bull. Mutual fund flow data suggest that investors have started to give up on bonds, with rising interest rates scaring them out of bonds to a record extent in June. We will be watching to see if they shift their buying interest more broadly to equity mutual funds instead, along with persistent inflows to ETFs.
A decisive move into equities may occur when investor confidence rises to such an extent that capital gains become a far higher priority than dividends. Investors have been showing interest in so-called “Growth & Income” mutual funds (again, based on flows of cash), responding to dividend increases and relatively attractive dividend yields. What would motivate such an increase in confidence? More “record high” headlines are the likely answer, as is time. Economic news has been consistently improving since the summer of 2009. But as indicated earlier, that has been begrudgingly accepted information. Behavioral economics argues that people do not recognize trends as existent and persistent until they have been in place, on average, about five years. This suggests that we are another year out before it becomes widely accepted that a new bull market has begun.
The Next Four Years
Should record highs and fund flows provide secular bull confirmation of a trend that started four years ago, it would be natural to consider what the next four years could look like. As discussed earlier, the market’s four year advance from the 2009 lows was similar to the four-year gains following previous secular lows. Should history rhyme, if not repeat, then we could expect:
- Declines in the S&P 500 earnings yield as the market continues to improve. Over the course of secular bulls, valuations move from one extreme to the other.
- Median credit spreads (based on the spread between Moody’s Baa bond yield and the Long-Term Treasury yield), close to the historical median of 1.9.
- Rising industrial production growth. Except for the four-year period after the 1942 low (production slowed as World War II came to an end), the young bull market performance anticipates an improving economic environment.
- Similar levels of volatility – a few ten-percent declines here, a twenty-percent drop there….
If the market developments continue to support the case for a secular bull market in stocks and a new era for allocation, it won’t mean that we can rule out cyclical bear market possibilities. They will still occur. And we will continue to cut client equity exposure accordingly as the risks increase. But we would expect the cyclical bears to be (mostly) relatively short and shallow.
The Rest of 2013, and into 2014
- A short-term threat to the market is overly generous expectations of corporate earnings for the current and coming quarter.
- While there are concerns and headwinds through 2013 and into the first half of 2014, we do not see the type of outsized risks in equities associated with economic recessions.
The Federal Reserve surprised the market by not announcing a reduction in quantitative easing at its last meeting. Taper concerns were compounded by uncertainty over Syria, and the conversation of who would be the next Fed chairperson. As a result, sentiment plunged and the market became oversold.
With the taper on hold, a diplomatic solution to Syria more likely and Lawrence Summers removing himself as a (hawkish) Fed candidate, three major headwinds for the stock market’s advance had been removed. The ensuing rally triggered bullish breadth-thrusts, temporarily pushing the market into a short-term oversold condition. It would not take much of a correction, something in the three-to-five percent range, to offset that optimism and raise some healthy skepticism
But this would not fix the fourth problem: earnings estimates are too optimistic. Single-quarter year-over-year earnings per share (EPS) consensus estimates call for 13% growth for the third quarter of 2013, and for 25% in the fourth quarter. Some of the growth expectation is due to easier comparisons, but forward P/E ratios, we believe, are not as attractive as they appear to the most bullish of bulls.
Using the median trailing P/E ratio discounts some of that overly bullish consensus and bring the valuation of the market to something that can better (or, at least, more conservatively) be described, as Mr. Buffet puts it, as “more or less fairly priced.” Admittedly, broad market valuation metrics are blunt instruments, and one could argue that excess liquidity from low interest rates could widen the margin for error of valuations. Nevertheless, valuations appear to be about neutral. And some earnings growth, even if not as bullish as that of current consensus, can be expected. As such, the returns for the next three months are a toss-up between neutral valuations and actual vs. expected earnings.
Into 2014, it is widely expected that Fed chairman Ben Bernanke will step down and a new chairperson would take office on February 1. The market likes to test new Fed chairpersons and, as such, has dropped an average of sixteen percent over their first six months of office. The timing of such a correction would conveniently align with historical cycles. But the more important elements, of course, will be whether or not the economy will be strong enough to withstand Fed changes and historical tendencies. Absent an external shock, our answer is yes. Job growth may not be up to the economy’s potential, but private consumption expenditures have been steadily improving adding one and two points to GDP growth since 2011. With personal consumption expenditures comprising 69% of the economy, a recession is expected to be absent over this discussed timeline. As discussed earlier, corrections will still occur in secular bull markets. But they will likely be short and shallow. As such, while there are concerns and headwinds through 2013 and into 2014, we do not see outsized risks in equities.
Bottom line: There is a new era for investment allocation, in which stocks will consistently outperform bonds over the long-term. The thirty-year bull run for the bond market has come (or, at the very least, is coming to) an end. This lends to the strategy of, on market troughs, selling bonds and buying stocks. This simple strategy could be the difference between winning and losing over the next decade.