Download 4th Quarter 2013 Investor Newsletter

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Q U A R T E R LY
I N V E S T O R
N E W S L E T T E R
F O U R T H
Q U A R T E R
2 0 1 3
IT’S DIFFERENT THIS TIME
2013 was a historic year: the Standard & Poor’s 500 Index
There are two things that jump out of the data. First, U.S. and
outperformed Treasuries by the widest margin since 19581 –
Foreign developed markets were the only asset classes with
55 years ago! No other asset class even came close to the
positive returns in 2013. Every broad sector of fixed income
meteoric return on domestic stocks in 2013. Foreign stock
markets lost money. Emerging market stocks and bonds (as
markets didn’t even return half as much. As a result, this has
well as currencies) declined for the year. Commodities were
been a comparatively disappointing year for globally diversi-
down. Gold lost more than a quarter of its value, ending 12
fied portfolios, particularly those investment portfolios with
straight years of positive returns and posting its worst per-
conservative risk mandates having a material allocation to
centage return in more than 3 decades. Given that most of
fixed income securities.
our client portfolios are broadly diversified across markets
and asset classes, this suggests that the rates of return on
I’d like to examine the past year’s investment returns not only
most client ortfolios were weighted averages of the returns
as we look back upon 2013, but perhaps more importantly as
shown in Table 1.
we look forward through 2014. First the facts. Table 1 summarizes a variety of investment returns for numerous asset
I will take the remainder of this letter to discuss the following
classes (indices) for the full year of 20132.
three issues:
Table 1: Asset Class Returns for 2013
2013
Return
Asset Class
1. The massive appreciation in the U.S. stock market
2. The poor performance in fixed income
Comment
3. Looking forward into 2014 and beyond and the investment
Cash
0.0%
U.S. Treasury Bonds
-2.6%
Worst year since 1994
US Treasury Inflation-Index
Bonds
-8.6%
Worst year ever! (TIPS
first issued in 1998)
Municipal Bonds
-2.6%
Worst year since 1994
Corporate Bonds
-2.0%
Worst year since 2008
Foreign Bonds
-3.1%
Worst year since 2005
The U.S. stock market, as measured by the S&P 500 Index,
Emerging Market Bonds
-4.1%
Worst year since 2008
posted a stratospheric compound return of 53.6% in the past
Domestic Equities
32.4%
Best year since 1997!
Foreign Equities
15.3%
Emerging Market Stocks
-2.6%
two reasons. The first reason is statistical. Returns of this
Commodities
-9.5%
magnitude simply do not happen very often. The last time
Gold
-28.3%
implications
Equity Markets
two years (2012-2013). This is truly remarkable for at least
Worse year since 1981
this happened was in 1998-1999 (which was followed by the
Source: see endnote 2
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end of the technology stock bubble and a near 50% drop in
The second reason why I believe this to be a truly remarkable
the U.S. stock market). The previous time before that was in
2-year rate of return for the U.S. stock market is because it
1988-1989, following the crash of 1987. Historically, these
is almost totally unsupported by corporate profit growth. The
sorts of returns simply don’t happen very frequently. When
chart at the bottom of this page shows the two year cumula-
they do occur it often happens soon after a drop in markets -
tive appreciation in the U.S. stock market as well as all un-
when recent poor returns set the stage for a bounce - or right
derlying sectors, compared to both corporate earnings growth
before a drop in the markets as high recent returns drive mar-
and also to sales growth.
kets to unsustainably high levels. I think it’s fair to say that
the recent appreciation in stocks can be mostly attributed to
On the left hand side of the chart we can easily see the prob-
the adjustment process following the declines in 2008. In
lem: the S&P 500 has appreciated by 54% in the past two
other words, I don’t believe the stock market is necessarily
years yet the growth in underlying corporate profits is only
set up for a major decline at this point in time, but the stage
11% and growth in sales was only 6% - this is 6% total sales
may now be set for many years of flat returns.
growth in two full years! Stock prices have advanced almost
5 times as much as underlying profits and 9 times as much
Chart 1: Cumulative Stock Returns vs. Earnings & Revenue Growth, 2011-2013
90%
77%
75%
67%
70%
62%
54%
47%
50%
40%
31%
30%
10%
-10%
21%
11%
6%
44%
32%
28%
20%
29%
18%
11%
7%
7% 9%
2%
8%
15%
8% 8%
3%
-1%
8%
-3%
-5%
-7%
-11%
-30%
Market Return
EPS Growth
Sales Growth
Source: Standard and Poors (www.standardandpoors.com)
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as sales. Some of the individual sector returns are even more
ly 6 times earnings. By inverting this number we see that 1/6
astounding. Healthcare stocks, for example, have appreci-
= 16.7%. This was a historically high earnings yield (low valu-
ated almost 10 times as much as the underlying profit growth,
ations) and it represented an exceptional value; a once-in-a-
67% versus 7%. Three other sectors – Utilities, Energy, and
generation opportunity to buy stocks. By contrast, at the end
Materials – have actually exhibited profit declines in the past
of the 1990’s the S&P 500 was trading at a nose-bleed high
two years, yet those very sectors have returned between
valuation level of close to 30 times earnings. Once again, buy
+15%, +31% and+ 44% over the same period! Needless to
inverting we see that 1/30 = 3.3% earnings yield. This was
say, may sectors and individual stocks appear to have got-
about half the yield of treasury bonds at that point in time,
ten far ahead of their fundamental values as a result of the
virtually guaranteeing that the next 10 years would be bad
recent stock market appreciation.
ones for U.S. stock market investments. In other words, in
the late 1990s investors could buy U.S. Treasuries and earn
This leads us to a simple question: Given the massive run-up
6%, or buy the U.S. stock market and earn 3.3%. History ul-
in domestic stock prices in the past two years, is the stock
timately showed that this was a good time to buy bonds and
market undervalued, normally valued, or perhaps is it over-
sell stocks. In both of these examples and in all others before
valued? The general investing public, which seldom pays any
or after, the U.S. stock market has reverted back to the aver-
attention to the long term, often misses a fundamental reality
age long-term level of 16 times earnings, or a 6.25% earning
of stock market returns: over very long periods of time, stock
yield.
markets revert back to average, or equilibrium, valuation levels. Throughout all of history you might see extremes in stock
So, where are we today? Based on estimates for the recently
market valuations, but the U.S. stock market has always re-
completed 4th quarter, the full-year 2013 earnings for the
verted back to the average price-to-earnings multiple of ap-
S&P 500 is $107 per share. With a current S&P valuation of
proximately 16 time earning per share. Many readers may
approximately 1,800, this implies a trailing price to earnings
find it easier to think of stock market valuations as yields,
ratio of 1800/107 = 16.8 – modestly higher than our long-
rather than earnings multiple, and this is easy to accomplish
term average valuation level of 16 times. This suggests that
by inverting the number. Specifically, the U.S. stock mar-
the U.S. stock market is essentially right where it should be
ket has exhibited a long-term average valuation of 16 times
and that stocks are fairly valued.
earnings, and 1/16 = 6.25%, which is the long-term average
Corporate Profit Margins
“earnings yield” of the stock market. Yields tend to be easier
for people to understand and also to compare to bonds. So, if
It turns out that there is one big problem with the conclusion
the stock market has an earnings yield of 6.25%, versus a 10-
of fair valuation (at least). This problem has to do with cor-
year Treasury note yield of 3.0% as of December 31, 2013,
porate profit margins, which are currently at an all-time high
then one might reasonably conclude that the stock market
level of 10.1%, compared to the average of only 6.2% since
is offering a better long-term investment opportunity (albeit a
1950 (see chart on next page).
much more volatile one).
The reason why this is such a problem is because profit mar-
In the 1970’s the U.S. stock market declined more than 50%
gins, like stock market yields discussed previously, have al-
to a point at which stocks were very cheap – trading at rough-
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Chart 2: U.S. Corporate Profit Margins (1950 - 2013)
10%
TABLE 2: S&P 500 at Historic Profit Margins
10.1% Current Profit Margin is 63%
above the long-term average since 1950
8%
6%
4%
Index Characteristic
Actual
Adjusted
S&P 500 Price
1800
1800
Revenue per Share
$1,105
$1,105
% Profit Margin
9.7%
6.0%
Earnings per Share
$107
$66
Price/Earnings Multiple
16.8
27.1
Earnings Yield
6.0%
3.7%
Source: Standard and Poors (www.standardandpoors.com)
6.2% Average
500 would have a fair value as follows: 16 x $66 = 1,056,
2%
which suggests that the stock market might currently be over0%
valued by as much as 40%.
Source: Bureau of Economic Analysis
In a recent client report, the leading portfolio Strategist for
ways reverted back to the long-term average, or equilibrium
Goldman Sachs had the following to say: “The current valua-
level. You can see this quite clearly from the chart above. If
tion of the S&P 500 is lofty by almost any measure, both for
one believes that profit margins are “mean reverting” as a
the aggregate market as well as the median stock: (1) The
statistician would say, then it implies that the current stock
P/E ratio; (2) the current P/E expansion cycle; (3) EV/Sales;
market is grossly overvalued. Note that these profit margins
(4) EV/EBITDA; (5) Free Cash Flow yield; (6) Price/Book as
shown in Chart 2 are representative of the entire U.S. econo-
well as the ROE and P/B relationship; and compared with the
my, so let’s examine this in the context of just the stock mar-
levels of (6) inflation; (7) nominal 10-year Treasury yields; and
ket and the 500 largest companies, using actual data.
(8) real interest rates. Furthermore, the cyclically-adjusted
P/E ratio suggests the S&P 500 is currently 30% overvalued
According to Standard and Poors the profit margin for all 500
in terms of (9) Operating EPS and (10) about 45% overvalued
companies in the S&P 500 index is currently 9.7% However,
using As Reported earnings.”3 Allow me to paraphrase: by any
the long term average profit margin for the S&P 500 is only
measure of sales, operating profit or cash flow, compared to
6.0% since 1950. Table 2 shows the actual data for the S&P
any period in history with varying interest rates and inflation,
500 Index as it stands presently, as well what it would look
the U.S. stock market is overvalued today and it might be
like if the 500 companies in the index were producing histori-
overvalued by as much as 45%!
cal profit margins of only 6%:
That last paragraph was fairly “technical” in nature, so let’s
Note that if the 500 companies in the S&P 500 were produc-
examine what the ever-colloquial Warren Buffett has recently
ing revenue of $1,105 per share (as they are presently) but
said about the stock market. On September 19th, in an inter-
only generating a 6% profit margin (the average of the past
view on CNBC, Buffett was asked a question about the stock
60+ years) then their combined earnings per share would
market at that time and he stated that stocks were fairly val-
only be $66, not $107. At that level of earnings the stock
ued and that “we’re having a hard time finding things to buy.”
market would be significantly overvalued. Said differently, if
Of course it would be even harder today than it was 4 months
the stock market valuation and profit margins revert back to
ago with the S&P 500 already being another 10% higher than
their long-term averages of 16x earnings and 6%, the S&P
it was on the date of that interview.
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The bottom line going forward is this: equity markets should
could bounce up or down by 2% in a single day and it would
trend much closer to the bottom lines (i.e. profits) of the cor-
hardly be newsworthy, but when a bond index loses 2% of its
porations, for better or worse. Let’s assume that we get 3-4%
value people talk as if it the apocalypse was at hand. You can
revenue growth per year and that corporations are able to
hardly miss the media stories about the carnage experienced
preserve their historically high levels of profit margins, then
by bond investors in the face of 2-4% losses this past year.
we would also get 3-4% earnings growth and 3-4% stock market appreciation each year. If margins contract at all, even
Nonetheless, to be fair, 2013 has been an extraordinary year
just back to the levels of last year, then we will experience an
for fixed income securities because we experienced a much
aggregate decline in corporate earnings and it is unlikely that
desired reversal of the negative real return expectations for
equity markets will produce positive returns for the next year
Treasury bonds and all other fixed income sectors adjusted
or two.
accordingly. While the Federal Reserve sets short-term interest rates, long-term interest rates are largely set by market
For the record, I have to admit that I don’t believe profit mar-
participants and their demand to buy or sell bonds based
gins will revert all the way back to the historical average of 6%.
upon prevailing levels of inflation and future inflation expecta-
Our economy has gradually evolved to have a greater share
tions. For the past 50 years, the 10-year U.S. Treasury bond
of higher margin businesses, such as healthcare, services,
yield has averaged 2.6% above the rate of then prevailing
finance, and so forth. However, I
don’t believe that we will be able
to idefinitely maintain the historically high levels that we see today
– some downward adjustment to
Financial markets have a way
of punishing those who
arrogantly believe that
“this time it’s different.”
margins is likely. If one believes
inflation. For the past 10 years this
spread has averaged 1.6%, which is
largely consistent with reduced inflation expectations going forward.
So, where are we today? At the end
differently – if one believes that corporate profit margins will
of December 2013, the rate of inflation was running 1.7%
somehow continue to perpetually levitate at historical highs
per year while the 10-year treasury yield was 3.0%, for a posi-
(or even move higher) – then that someone is implicitly saying
tive difference of 1.3%, which is fairly close to the average
that “this time it’s different” – and those are the four most
of the past 10 years at 1.6% but still well below the average
dangerous words that any investor can utter. Financial mar-
of the past 50 years, which was 2.6%. So, it appears that
kets have a way of punishing those who arrogantly believe
bond markets and most fixed income sectors are still a bit
that this time it’s different.
overvalued as well and that further increases in market yields
are necessary in order to return fixed income markets to nor-
Bond Markets
malcy. Going forward, it would be reasonable to expect yields
to continue to rise and bond prices to continue to fall, albeit
Enough with stocks for now, let’s consider the outlook for fixed
at a much slower pace than what we experienced in 2013. In
income securities. Turning back to the table on page 1 you
fact, more than half of the “adjustment” that was necessary
can see that 2013 was a year of losses for fixed income se-
in fixed income markets has already occurred and so I would
curities. Of course, it’s always a bit odd to talk about 2%, 3%,
expect forward increases in market interest rates to be slow.
or 4% declines as being historically bad. The stock market
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Perhaps we will see another 0.5% increase in market interest
data (i.e., reality) will determine the path forward for financial
rates over the next 12 months, but history suggests that any
asset prices. There is one big “tail risk” to this hypothesis,
increase beyond that level should only happen if we experi-
however, and that is the Federal Reserve. It is impossible to
ence an increase in inflation. However, in order for inflation
know the extent to which Federal Reserve policy has artificial-
to increase we would need to experience many, if not all, of
ly inflated asset prices – stocks, bonds, and housing – and
the following developments: depreciation in the U.S. dollar,
therefore we are faced with a scenario in which the reversal
increasing commodity prices, expanding bank lending activ-
of the Fed’s highly accommodative and highly experimental
ity and wage-price pressure. We had the first three of these
policies could lead to price declines across all asset classes.
forces at work in 2006 and 2007 and yet inflation only averaged 3% for those years. Today, most of the factors that
Given our base case assumption that financial markets will
could lead to higher inflation are simply not present. In fact,
be “data dependent” going forward, we should also not ex-
in most cases we have deflationary forces at work. We have
pect to see a repeat of the massive divergence of returns
negligible bank credit creation, a strengthening value of the
among asset classes that we witnessed in 2013. Such a
U.S. dollar relative to other currencies, declining commodity
performance differential might not happen again within the
prices, and there is minimal upward wage pressure with the
lifetimes of most people reading this letter. Equity returns
exception of a few areas in healthcare and technology. So
going forward will largely reflect nominal growth and produc-
the outlook for is fixed income returns in the next few years
tivity improvements, which suggests 5%-7% average annual
should be mostly commensurate with current yield levels, mi-
returns for the foreseeable future. Even this might be closer
nus a small amount for a continuation of the interest rate
to a “best” case outcome as it would require profit markets
increase we experienced in 2013. Let’s call it 3 - 5% per year
to continue their levitating act. Bond market returns will very
going forward.
closely approximate current yields in those asset classes,
minus an adjustment for another 0.5% - 1.0% increase in
Looking Forward
interest rates within the next few years, suggesting average
annual returns over the next few years of 3-5% for most fixed
We are at interesting points in both equity and bond markets
income asset classes.
where the paths forward should be largely data-driven. Stock
prices have room to move lower, but generally should go up or
How might we be wrong? There are a number of ways in
down based on future earnings growth (which itself is a func-
which these base case projections could ultimately prove
tion of revenue growth and profit margins). Bond prices have
to be incorrect. The most obvious way would be a repeat of
room to move lower as well, but generally should move up
2013 in which investors simply buy stocks and pay more for
or down based on changes in forward inflation expectations,
their earnings and dividends in the absence of commensu-
which should remain low for a long time to come.
rate growth (recall, that in the past two years the stock market
has returned 54% with only 11% corporate profit growth and
In many ways these are both welcome developments because
6% revenue growth). This is really the same phenomenon
it means that financial markets may be finally be out of the grip
that drove stock markets to extraordinary highs in the late
of emotional and sentiment-driven movements as we’ve seen
1990’s – investors simply paid more for stocks even though
for many years now. In other words, financial markets may
those companies didn’t have the earnings growth to justify
finally be near a state of normalcy in which future economic
-6BLACKHAW WEALTH MANAGEMENT | INVESTMENT ADVISORS | WWW.BLACKHAWWEALTH.COM | 512-865-4045 | [email protected]
the stock appreciation. That particular period of time didn’t
for a quarter or two, pas it did in the second half of 2013, but
end very well. Nonetheless, it is impossible to forecast a
the economy is highly unlikely to achieve a return to sustained
bubble and the massively one-sided investor psychology that
levels of GDP growth above 3%. We haven’t experienced any-
would be necessary to create such a price movement, but
thing like this in almost two decades.
that possibility does certainly exist.
Finally, as we discussed multiple times in the past, the U.S.
We could also be underestimating the appreciation potential
economy continues to be affected by a trifecta of deflationary
for stocks if the U.S. economy begins to grow much more rap-
forces: technological innovation, globalization and aging pop-
idly and sustainably, such as 3.5% or more for many years.
ulation demographics. All three forces reduce domestic wage
This could happen as the continual improvement in the hous-
growth for the majority of the population, inhibit new job cre-
ing market increases the wealth effect for owners and in-
ation (particularly for lower and middle class individuals) and
creases local government property tax receipts, both of which
lead to shrinking labor force participation. These are secular
have a positive effect on employment and spending and leads
trends that will persist far into the future and will continue to
to a self-reinforcing cycle of growth. While this is certainly
weigh upon economic growth and equity market returns.
possible it seems unlikely because we simply don’t have the
broader ingredients that would be required to sustain such
As usual, clients of the firm are encouraged to call or write
growth, including an expansion of bank lending (tighter regu-
with any specific questions that they may have about this let-
lations are curtailing lending, not increasing it), increasing
ter or the investments that we manage on their behalf.
corporate capital expenditures (could happen soon, but only
if we get more demand growth), and increases in personal
Sincerely,
consumption (which would require growth in real wages and
we haven’t seen this in many years). Even during the seem-
Ian McAbeer, CFA
ingly good times from 2003 through 2007 – after the tech
bubble but before the financial crisis – real GDP growth in the
1 Based on a comparison of the S&P 500 Total Return Index to the 5-year
United States only averaged 2.9% per year and this was with
U.S. Treasury Note.
2 Asset class returns based on the following indices: Cash = Citi Treasury
Bill 1 Month Index, U.S. Treasury Bonds = Barclays U.S. Government Total
Return Index, U.S. Inflation Indexed Bonds = Barclays U.S. Treasury TIPS Total
Return, Municipal Bonds = Barclays Municipal Total Return Index, Corporate
Bonds = Barclays U.S. Credit Bond Total Return Index, Foreign Bonds = Barclays Global Aggregate ex/US, Emerging Market Bonds = Barclays EM Aggregate USD Total Return, Domestic Equities = S&P 500 Total Return Index,
Foreign Equities = MSCI All Country World Index ex/USA Net Return USD,
Emerging Market Stocks = MSCI Emerging Markets Net Return USD, Commodities = DJ/UBS Commodity Index Total Return, Gold = Price Change from
LME Spot Close Data
3 Goldman Sachs: US Weekly Kickstart, January 10, 2014
the artificial benefit of a housing bubble! In the absence of
the artificial growth due to unnecessary creation of new housing units, real economic growth would have been much lower
than 2.9%. So, why would it seem likely that real GDP growth
today could somehow achieve sustainable, higher levels than
what was possible 10 years ago before the financial crisis?
Well, it doesn’t seem very likely and it’s not reasonable to expect this to happen. It certainly can happen and will happen
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