In an effort to keep interest rates low, the Federal Reserve, along with other global central banks, is flooding the financial markets with liquidity. This additional liquidity is pushing prices for most financial and real assets higher. At some point, the Fed’s policy of easing will end and in some ways will be reversed. Purchases of government-backed securities may end this year (QE3); however, the Fed has signaled that the near zero interest rate policy for Fed Funds is likely to continue into 2015. This policy is guided by threshold rates of 6.5% for unemployment and 2.5% for inflation.

Equities vs. Cash

Despite the strong equity market performance since the beginning of October 2011, for investors with at least a five year time horizon the likelihood that equity returns exceed cash equivalent returns remains high. This conclusion can be supported by history (it is indeed rare to find five-year periods with equity returns less than 0%, the current money market alternative), but also by building a very conservative scenario using assumptions about GDP, corporate profit growth, and valuations.

For example, with continued slow economic expansion (2% real GDP or less), no broad inflation issues (2% or less), and profit margin contraction, it is possible that corporate profits plateau for an extended period. With no further price-to-earnings (P/E) multiple expansion, stock market levels could also plateau leaving the investor with only dividends contributing to total return. However, a 2% dividend yield easily exceeds cash, while rivaling the yield on a 10-year U.S. Treasury. Under any of the three potential market scenarios outlined below, we would expect the S&P 500 Index return to exceed a cash equivalent return over the next five years.

From 1600 on the S&P 500 Index

Potential Market Scenarios

Scenario 1

“Muddle Through”

Scenario 2

“New Normal”

Scenario 3

“Washington Works”1

5-Year CAGR2 Estimates

U.S. Real GDP

1%

2%

3%

Inflation (CPI)

2%

2%

2%

Aggregate World GDP

3%

4%

5%

S&P 500 EPS

4%

6%

8%

S&P 500 Total Return

2%

5%

8%

Expected Price –

S&P 500 Index 3/31/18

1600

1800

2000

1 Significant reform of entitlement, regulatory, and tax policies

2 Compound Annual Growth Rate

Source: Diamond Hill Capital Management, Inc.

The most concerning scenario seems to be a return to “stagflation,” a condition last experienced in this country during the 1970s. Slow economic activity and rising inflation caused valuations to plummet to single-digit P/E multiples, more than offsetting profit growth. While unlikely, this possibility should prevent a return to the irrational exuberance of the late 1990s.

In conclusion, we believe that buying stocks with mid-teen P/E multiple valuations and good competitive positions will most likely beat cash over the next five years even in the event of a short-term market pull back. Neither fast growth in profits nor further P/E multiple expansion should be expected in general, and our conclusion is not dependent on these two factors. Because a company's stock market price tends to converge with its intrinsic value over sufficiently long periods of time (five years or longer), we believe the economic performance of the underlying business in relation to the price paid for its stock will determine long-term investment return. This long-term view is perhaps our greatest competitive advantage and has remained consistent since Diamond Hill’s inception.

Ric Dillon, CFA

Portfolio Manager & CEO

Diamond Hill Capital Management, Inc.

The views expressed are those of the portfolio manager as of May 2013, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

© Diamond Hill Investments

www.diamond-hill.com

© Diamond Hill Capital Management

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