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Q 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 -1BLACKHAW WEALTH MANAGEMENT | INVESTMENT ADVISORS | WWW.BLACKHAWWEALTH.COM | 512-865-4045 | [email protected] 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) -2BLACKHAW WEALTH MANAGEMENT | INVESTMENT ADVISORS | WWW.BLACKHAWWEALTH.COM | 512-865-4045 | [email protected] 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- -3BLACKHAW WEALTH MANAGEMENT | INVESTMENT ADVISORS | WWW.BLACKHAWWEALTH.COM | 512-865-4045 | [email protected] 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. -4BLACKHAW WEALTH MANAGEMENT | INVESTMENT ADVISORS | WWW.BLACKHAWWEALTH.COM | 512-865-4045 | [email protected] 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 -5BLACKHAW WEALTH MANAGEMENT | INVESTMENT ADVISORS | WWW.BLACKHAWWEALTH.COM | 512-865-4045 | [email protected] 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 DISCLAIMER: The communication is intended only for the use of the addressee and may contain information that is privileged and/or confidential. Any material contained herein is provided for informational purposes only and is current only as of the date hereof and may become outdated or subsequently changed without notice. No information,opinions, or suggestions, explicit or implied, shall be deemed to constitute investment advice, or a recommendation to buy or sell any financial instrument or security, or to pursue any investment strategy. Blackhaw Wealth Management only renders investment advice to its clients. -7BLACKHAW WEALTH MANAGEMENT | INVESTMENT ADVISORS | WWW.BLACKHAWWEALTH.COM | 512-865-4045 | [email protected]