A Look at the Bear & Bull Cases for Equities
Equity Investment Outlook
After soaring 40% over the 18 month period from mid-2012 to year-end 2013, the stock market, as measured by the S&P 500, has taken a breather in early 2014. Investors are understandably questioning if it is time to lower exposure to U.S. equities now that the recovery from the 2008-09 lows is five years old, stock market valuations no longer appear cheap and the Federal Reserve is beginning to take steps that may lead to higher interest rates later this year and next. Softer than expected economic readings early in 2014 across many emerging market economies, as well as the U.S., have also raised questions as to the sustainability of corporate profits. In this Outlook, we ask: “How long in the tooth is this bull market?” We start with a short review of how we arrived at this particular moment in both the economic and market cycles and then review both the bear and bull case for staying invested in equities.
Where have we come from? Simply put, we have come from the worst financial and economic crisis since the Great Depression. In 2008, the U.S. financial system was seriously imperiled. A toxic combination of horrendous loans and excessive leverage caused numerous banks and other financial institutions to fail. Many were married off in shotgun weddings or taken over by the federal government before the true scope of their difficulties was fully understood. The economy plummeted, unemployment skyrocketed and markets cratered. They were truly ugly and scary times.
By the second quarter of 2009, the financial system found its footing and the economy began a long, slow climb out of the snake pit. Our view for some time has been that the economy would slowly grind higher as financial institutions and consumers gradually delevered and regained a semblance of financial strength. We expected that the recovery would be characterized by below-average growth, low inflation and prolonged low interest rates. This has been a powerful recipe for stocks and much of the bond market over most of the past five years. In fact, nearly all asset classes have rebounded, including real estate and other hard assets.
We have been somewhat surprised by the vigor of corporate profits. Numerous factors conspired to raise profit margins to record highs. Chief among them was the effect of concerted cost controls resulting in extraordinary efficiency gains. In effect, even just a small recovery in demand for many businesses resulted in an outsized profit recovery as firms discovered that they did not need to hire additional labor to produce more. Also helping was balance sheet deleveraging coupled with low interest rates, virtually no real wage cost increase and lower energy costs due to the shale oil and gas boom.
For several years we have been writing about the long-term bull case for U.S. equities. Besides the factors discussed above, we pointed to the fact that U.S. equities were reasonably priced in absolute terms, and very attractive relative to bonds. We further argued that for 10-20 years investors had systematically reduced their exposure to U.S. equities in favor of bonds, emerging market equities, hedge funds, private equity investments and venture capital. As a result, we believed (and still do believe) that there would be a long-term repositioning of portfolios back to a higher weighting in U.S. equities.
So far we have been right. But now that stocks have performed so well from the depths of the 2008 crisis, what’s next? Do we still hold to our thesis of a long-term bull market in stocks? The short answer is yes, but to provide you with a fuller picture we want to review both the contra argument, i.e. the bear case, and the pro argument, i.e. the bull case.
The Bear Case
The crux of the bear case is that the market is up significantly, price-earnings (P/E) ratios are now above historical averages and valuations appear stretched. Furthermore, profit margins are at record levels and will inevitably regress back towards their historical mean, seriously threatening profit growth rates, as will sluggish growth in the U.S. and declining growth rates in emerging markets, especially in China. The bear case rejects the idea that the U.S. economy will benefit in any meaningful way from improved cost competitiveness globally or will enjoy anything approaching a normal housing recovery. As a result, unemployment will remain structurally high and wage growth will remain low, resulting in anemic consumer spending which accounts for over 70% of U.S. Gross Domestic Product (GDP).
On top of all this, the Fed is starting to taper, i.e. backing away from its very loose monetary policy. As a result, interest rates should go up and higher interest rates could lead to lower P/E ratios for stocks. Rising rates could also entice investors to allocate assets to fixed income and away from equities. Add to this the potential long-term inflation current monetary policy could generate, and P/E multiples have further downside.
In sum, the bear case rests on the twin pillars of declining P/Es or valuations and declining profit margins and earnings disappointments. The bull case, as outlined below, argues just the opposite, i.e. stable or rising valuations coupled with sustained economic and profit growth.
The Bull Case
The bull case derives from the assertion that we are in a very low inflationary environment that is good for both economic growth and stock market valuations. The slowdown in China and other emerging markets means that China’s voracious appetite for commodities, a function of its investment-driven growth, is now over. The commodity supercycle of the last decade is fini. Commodity prices are down and will stay down. Ergo inflation will remain low.
A drop in commodity prices, especially for food and energy, should act as a tax decrease for U.S. consumers. It adds to their discretionary disposable income, which then gets spent on other goods and services, increasing demand and leading to stronger overall economic growth. This sets up a virtuous cycle of higher wages and employment, which further augments consumer disposable income, again leading to more spending, etc. The consumer accounts for 72% of aggregate demand, which makes this cycle extremely powerful.
Furthermore, in the five years since the depths of the 2008 financial crisis, the consumer has deleveraged and is now in relatively good shape. While much has been written about the plight of the long-term unemployed, the fact remains that employment is up and there even appears to be a labor shortage in certain skilled jobs. We are very grateful to Francois Trahan of Cornerstone Macro for the following graph of consumer free cash flow and its relationship to declining food and energy costs. This picture is worth a thousand words [Figures 1 and 2].
Lower inflation should be helped by a stronger U.S. dollar. As the Fed tapers, interest rates in the U.S. are likely to be biased upwards, while the slowdown in emerging markets and sluggish growth in Europe and Japan should result in loose monetary policies and lower interest rates in those countries. If this scenario of higher rates in the U.S. and lower rates for our trading partners proves to be correct, the dollar will strengthen vis-à-vis the other currencies, making our imports cheaper and thus lowering inflationary pressures in the U.S. and again helping to bolster the spending power of the U.S. consumer.
Another factor that could enhance growth over the next several years would be an increase in capital spending. Since the financial crisis, U.S. corporations have been more focused on repairing and strengthening their balance sheets than on expansion. As a result, balance sheets are now much stronger and our capital base (plant and equipment) is aging. Hence conditions appear ripe for a pickup in capital spending [Figure 3].
Given all of the above, we think that continued low inflationary economic growth could be a good bet going forward. Since the factors that have caused profit margins to reach their current high levels still appear in place, profit growth should mirror economic growth. Of course, there will be differences among various industries and among companies within specific industries, but on balance, corporate profits should continue rising.
On a cautionary note, we are aware that growing shortages of skilled labor could put upward pressure on wages, which in turn could cause companies to begin raising prices more aggressively. We are closely monitoring this trend and others that could undermine the low-inflation thesis.
So now the question is: “What about valuations?” P/E ratios are slightly above average, but not excessive. Francois Trahan argues quite convincingly that P/E ratios are driven by inflation more than by interest rates. Since inflation is expected to remain low, P/Es should remain high. This makes sense because we use long-term interest rates (e.g. the 10-year U.S. Treasury rate) in our dividend discount models to calculate a theoretical market P/E, and long-term interest rates are really a reflection of inflation and inflation expectations.
Trahan argues that because inflation is likely to stay low, interest rates may not rise all that much as the Fed tapers, and more importantly that the market’s P/E ratio is likely to rise as it is ultimately more tied to inflation than interest rates. He further argues that P/E cycles are typically measured in decades (not quarters) and that we are only a couple of years into a rising trend [Figures 4 and 5]. From a slightly different angle, we have argued for some time that if one uses the current low level of the 10-year U.S. Treasury rate and a dividend discount model, the market’s theoretical P/E would be roughly twice today’s actual P/E. Therefore, either the market is already pricing in higher rates or the P/E has room to expand further.
P/E Cycles Are Typically Measured In Decades
Source: Cornerstone Macro LP (Data end date: 3/31/14)
The 90s Saw A Lot of P/E Expansion…But Not Every Quarter
Source: Cornerstone Macro LP (Data end date: 1/1/2000)
In summary, the bull case rests on expectations of low inflation, continued economic and corporate profit growth, and rising equity valuations. If all this comes to pass, U.S. equities may have a long way to go. Over the past several years we have shared data that illustrates just how dramatic the flow of funds trend has been both in terms of years and dollars out of U.S. equities and into non-U.S. equities [Figure 6]. This trend was not just a case of irrational investors following the ignorant herd. For many years, the return on assets and the return on equity in the emerging markets were rising faster than in the developed markets and ultimately eclipsed returns in the developed markets [Figure 7]. Investors understandably chased both the higher growth rates as well as the higher returns offered by emerging market equities. Some observers have recently observed, however, that excess investment across the emerging markets has now driven down returns in recent years while returns by companies in the developed economies, especially the U.S., have rebounded resulting in the disappearance of any premium return in emerging market equities.
Mutual Funds Cash Flows
Source: Bianco Research (Data end date: 1/31/14)
Gap Between EM & DM Non-Financial Sector Returns
Source: DataStream/Worldscope: Minack Advisors (Data end date: 2/28/14)
Markets, of course, never go straight up or straight down: they zig-zag. Short term, we would not be surprised if the market took a breather after its strong gains last year. Additionally we may see volatility related to news coming out of the Middle East and Russia. But longer term, we remain very optimistic on the outlook for U.S. equities. In addition to the reasons we discussed above we believe U.S. equities are very attractive relative to the alternatives. The great bull market in bonds appears to be over. The great decades of emerging market growth appear to be behind us. Hedge funds in aggregate have been mediocre performers for some time. We expect money to flow back into stocks, particularly U.S. equities. This is a technical (money flow) argument for a continued bull market. It augments the fundamental case based on earnings and valuation.
In closing, despite our overall bullish outlook, we remain cognizant of both market and security specific risks. Our main focus continues to be on individual companies which we believe have attractive investment attributes over and above the macro outlook and whose long-term growth prospects are largely independent of the macro outlook. This is important because random events in the broader economy are by definition hard to predict. We want to own reasonably valued companies that can plough ahead even if the seas get choppy. To a large extent, this intense focus on individual companies is the basis of our investment strategy regardless of our outlook.
We thank you for continued confidence in our management.
John Osterweis Matt Berler
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.
Price-to-Earnings (P/E) ratio is the ratio of the stock price to the trailing 12 months diluted EPS.
Return on assets is an indicator of how profitable a company is relative to its total assets.
Return on equity is the amount of net income returned as a percentage of shareholders equity.
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.
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.
Datastream Global Indices draw on Datastream’s coverage of currently 40 equity markets and provide an independent
standard for equity research. A representative sample of stocks has been chosen for each of the markets. Using FTSE Actuaries classifications, the constituent stocks are allocated into industries/sectors, and the Datastream Global Indices calculated.
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. Depending on the entity issuing the bond, it may or 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 a secondary concern. Cash is highly liquid and does not have the risk of capital loss. The tax treatment of returns of cash, bonds and stocks also differs given differential tax treatment of income versus capital gain.
One cannot invest directly in an index. 
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