Can Equities Continue Their Rise? Equity Investment Outlook: January 2014
2013 marked the fifth year of recovery following the near-death experience of the 2008 global financial system meltdown. From a low of 677 in 2009, the S&P 500 Index (S&P 500) finished 2013 at 1,848, delivering a stunning 203% total return from the low. Over the same period, the total return for the Dow Jones Industrial Average was 188%. The tech-heavy and arguably more speculative NASDAQ logged a 249% total return. These very large equity returns reflect both a strong recovery in corporate profits and a dramatic clean-up of our financial system. In other words, the equity gains appear justified.
Nonetheless, with the Federal Reserve (the Fed) beginning to taper quantitative easing and the stock market at new highs, it seems only prudent to ask whether stocks are still attractively priced and whether today’s market now fully reflects both the profit recovery and the likely growth in the economy over the next several years. Our belief is that the stock market remains attractive and is reasonably priced. The S&P 500 is currently trading at price-to-earnings (P/E) of 17x (Figure 1), based on trailing earnings, which is a reasonable valuation based on its long-term average and the fact that the P/E based on 2014 consensus estimates is 15x. The price-to-sales (P/S) ratio, at around 1.6x, is a bit above the historical average, as is the price-to-book (P/B) ratio at 2.5x. As long as interest rates remain subdued, the economy stays in growth mode and corporate profits continue to grow, we think these valuation levels are reasonable and could even track higher in the coming year.
Source: Bloomberg (Data end date: December 31, 2013)
The key question then becomes whether it is reasonable to expect the economy to continue to stay in expansion mode and hence, profit margins to remain above their long-term trend. Again we would argue that for the time being, the answer is “yes” based on a number of factors, including:
- Sufficient slack in the U.S. and global labor markets should keep wage rates quiescent for the foreseeable future.
- Businesses have been successfully substituting capital for labor, thereby becoming more efficient or more productive.
- The use of fracking to produce vast quantities of oil and gas from shale has lessened U.S. dependence on imported oil and lowered energy costs for corporations and consumers.
- New technology such as 3-D printing has further reduced manufacturing costs.
- The general growth of technology throughout the economy has a built-in deflationary effect because technology costs decline over time.
- Moving below the operating income line, interest expense has decreased and should remain lower. Corporations over the last five years have reduced both the amount of debt they carry and, through aggressive refinancing, the cost of debt. This reduction in interest costs is likely to persist even as interest rates rise, because corporations have extended their debt maturity profiles.
Taken together we believe these factors argue persuasively for an extended period of above-average corporate profit margins (Figure 2). Eventually there will likely be some regression toward the mean, but “eventually” appears to be fairly far in the future.
Source: Bloomberg (Data end date: December 31, 2013)
Another concern investors have is over the possible adverse effect that rising interest rates could have on the stock market. We have been trained to think that P/E ratios and interest rates are negatively correlated, i.e. if interest rates rise, P/Es fall and if interest rates fall P/Es rise. In general this is true. So why not worry?
First, we do not expect interest rates to rise precipitously. The economy has been growing fairly slowly and with unemployment high and inflation mild, the Fed has no reason to push rates up. The Fed certainly does not want to trigger a recession and risk an unemployment spike or a deflationary spiral. So it seems reasonable to expect the Fed to move rates higher only to the extent the economy strengthens materially from here. Such growth would imply rising corporate profits. So even if rates do move up and P/Es move down, rising corporate profits should keep the market on an upward path. Our friends at Lombard Street Research have extensively studied the relationship between rising interest rates and the behavior of the stock market and in summary conclude that “with the exception of the inflation-fraught 1970s, periods of rising rates have been good for U.S. stocks.”1 Over the past 20 years there have been three periods of Fed tightening as shown in Figure 3. In each period the S&P 500 rose.
Source: Bloomberg (Data end date: December 31,2013)
Periods of Rising Fed Fund Rates
Change in Fed Funds Rate
S&P 500 Total Return
2/3/1994 to 7/5/1995
3.00% to 6.00%
6/29/1999 to 1/30/2001
4.75% to 6.00%
6/29/2004 to 9/17/2007
1.00% to 5.25%
On the other hand, rising interest rates mean poor performance for fixed-rate bonds (especially longer-dated, investment grade bonds). As a result, when we enter a period of sustained rising interest rates, we would expect to see investors shift out of bonds and into equities. Some have referred to this potential shift as the “great rotation,” which could be further fueled by years of relatively disappointing results by hedge funds and emerging market equities (Figure 4). We would not be surprised if good old American stocks become the asset of choice, which could drive a long upward move.
Source: RIMES: S&P 500 Index and MSCI Emerging Markets Index; Credit Suisse website www.hedgeindex.com: Credit Suisse Hedge Fund Index.
Having said that, we are acutely aware that the financial equivalent of the law of gravity has not been repealed. There are still numerous headwinds that could cause meaningful turbulence for the stock market. A collapse in the euro would be one such risk. Others could be a cataclysm in the Middle East or an economic stall that moves us into a deflationary spiral. Most economists we follow believe that despite a slowdown in the housing recovery, the economy is likely to accelerate in 2014 as fiscal restraints become less onerous, businesses and consumers continue to invest and credit continues to flow.
Given all of the above, we remain long-term bulls. Even in a market that appears fairly valued, our team continues to find interesting new opportunities that may have been overlooked or stocks that have been unfairly punished by investors. We think our evolving collection of unloved equities can serve us well in the year to come. We continue to focus on companies whose profit and cash flow growth should be strong even in a weak economy. We are also looking for firms that have a history of generating significant free cash flow that can be used both for increasing dividends and for share repurchases. Additionally, we are attracted to restructurings that could result in a discontinuous increase in profitability. Conversely, we are avoiding purely cyclical bets, most commodity companies and companies experiencing declining prospects due to technological change or competitive threats. Although we expect some market volatility, we believe it is better in the long term to maintain high levels of equity exposure when we feel underlying economic fundamentals are strong, and we can invest in what we view as attractively valued companies.
We want to thank you, our clients, for your loyalty and understanding over the years, and to wish you all a healthy, happy and prosperous New Year.
Matt Berler, John Osterweis
Andrea Cicione, “U.S. Market – Who’s afraid of higher rates?” Equity Strategy Research, Update: Lombard Street Research – 05 Nov 2013.
Past performance is no guarantee of future results. This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
Stocks are generally perceived to have more financial risk than bonds in that bond holders have a claim on firm operations or assets that is senior to that of equity holders. In addition, stock prices are generally more volatile than bond prices. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. A stock may trade with more or less liquidity than a bond depending on the number of shares and bonds outstanding, the size of the company, and the demand for the securities. Similarly, the transaction costs involved in trading a stock may be more or less than a particular bond depending on the factors mentioned above and whether the stock or bond trades upon an exchange. Emerging markets stocks generally have more risk than U.S. stocks. Depending on the entity issuing the bond, it may or may not afford additional protections to the investor, such as a guarantee of return of principal by a government or bond insurance company. There is typically no guarantee of any kind associated with the purchase of an individual stock. Bonds are often owned by individuals interested in current income while stocks are generally owned by individuals seeking price appreciation with income being a secondary concern. The tax treatment of returns of bonds and stocks also differs given differential tax treatment of income versus capital gain. Hedge funds are generally perceived to be more risky than stocks due to their use of leverage, illiquid securities, etc. Additionally, hedge funds generally have higher fees than equities or stocks and may have limited liquidity. Hedge funds may have differential tax treatment due to their partnership structure.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.
Price-to-Earnings (P/E) ratio is the ratio of the stock price to the trailing 12 months diluted EPS.
Price-to-Book (P/B) ratio is the ratio of the stock price to the book value per share.
Price-to-Sales (P/S) ratio is the ratio of the stock price to the sales per share.
Operating Profit Margins are calculated as (Net Income/Net Profit (Losses) / Sales, Revenue, Turnover) * 100.
The Dow Jones Industrial Average is a price-weighted index historically regarded as a barometer of stock market performance. It is composed of 30 selected blue chip stocks.
The S&P 500 Index is an unmanaged index which is widely regarded as the standard for measuring large-cap U.S. stock market performance. This index reflects the reinvestment of dividends and/or interest income and is not available for investment.
The Nasdaq is a market-capitalization weighted index of more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The index includes all Nasdaq listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
The Credit Suisse Hedge Fund Index is an asset-weighted hedge fund index and includes only funds, as opposed to separate accounts. The index uses the Credit Suisse Hedge Fund Database, which tracks approximately 9,000 funds and consists only of funds with a minimum of US$50 million under management, a 12-month track record, and audited financial statements. The index is calculated and rebalanced on a monthly basis, and reflects performance net of all hedge fund component performance fees and expenses.
One cannot invest directly in an index. 
© Osterweis Capital Management