Download Market and Economic Review as of 12/31/2013

Market and Economic Review as of 12/31/2013
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GDP Growth & Outlook (Slides 2 to 4)
Federal Reserve Policy & Risks (Slides 5,6,7)
U.S. Stock Valuations (Slides 8-12)
Profit Margins (Slide 13)
Investor Sentiment (Slide 14,15,16)
Why Stocks May Continue to Rise (Slide 17)
The Safety of Bonds? (Slide 18,19)
Strategy for Higher Risk Markets (Slide 20-23)
Attractive Valuation in Emerging Markets (Slide24,25)
Economic Indicators Are Turning Up
The growth rate for the global economy improved over the
year and seems set to increase at least moderately in 2014
On a year-over-year basis, the U.S. economy grew at a real rate
of around 2%
Europe finally emerged from recession, and the United
Kingdom and Japan also generated modest but positive growth
Emerging-markets’ growth was disappointing overall in 2013,
but should benefit from improved export demand in developed
markets next year
Source: Organisation for Economic Co-operation and Development. Data as of
10/31/2013.
2
The Recovery Since the Financial Crisis Has Been Tepid
Current Expansion vs. Average of Last Six Expansions
Real GDP
120
120
118
118
Average of Last
Six Expansions
116
116
114
114
112
112
110
110
108
108
Recession ends
June 2009
106
106
Current Expansion
104
104
102
102
100
100
Source: Bureau of Economic Analysis. Data as of 6/30/2013.
98
Sep-07
3
Mar-08
Sep-08
Mar-09
Sep-09
Mar-10
Sep-10
Mar-11
Sep-11
Mar-12
Sep-12
Mar-13
Sep-13
98
Mar-14
U.S. Debt is High & Unsustainable but Serious Consequences Are
Years Away--- When?
Total Domestic Nonfinancial Debt as a % of GDP
275%
250%
225%
200%
175%
150%
125%
100%
1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011
4
 Overall U.S. debt levels remain very
high, and the projected growth in
government debt is too high to be
sustainable over the long-term
 Resolving this without causing an
economic contraction is likely to be
challenging, even in a normal growth
environment
 Total nonfinancial debt as a % of GDP
is still near the all-time post-World
War II high, due to continued growth
in government and corporate debt
 Consumers have shed debt but will
likely continue to for a few more
years
The Expansion of the Fed’s Balance Sheet has Been Extraordinary
Data as of
9/30/2013
Federal Reserve Balance Sheet Assets as % of GDP
23%
Fed's balance sheet is now
21%
19%
17%
15%
13%
11%
9%
7%
5%
2003
2004
2005
2006
2007
2008
2009
Source: Federal Reserve / Bureau of Economic
Analysis
2010
And May Prove Difficult to Unwind
5
2011
2012
2013
Fed Policy Has Boosted U.S. Stocks to Levels Beyond What is
Justified by Underlying Fundamentals
The S&P 500 Index and Quantitative Easing
1800
QE2
QE1
1700
1600
QE3
Bernanke sets
stage for QE3
1500
1400
FOMC Press
Conference
and talks of
"tapering"
1300
1200
Operation
Twist is
extended
1100
1000
900
Operation
Twist
Bernanke sets
stage for QE2
800
700
600
2008
6
2009
2010
Source: Federal Reserve and Yahoo! Finance. Data as of 9/30/2013.
2011
2012
2013
Stock Market Gains Have Disconnected from Earnings Growth
Source: Standard & Poor's. Data as of 9/30/2013.
7
Resulting in Historically High Valuations
• Four reliable long-term indicators place the S&P
500 at a price that has been significantly
exceeded only during the once-in-a-lifetime
tech bubble & the Great Depression
• This doesn’t indicate that the market will
necessarily decline in 2014 but that returns
over the next 3 to 5 years will likely be muted
because the starting price matters
8
How Does The Starting Price Matter?
□ Based on history the most likely
outcome over the next five years
is modest 1% to 3% average
annual return. The prospective
returns do not match well with
the risks inherent in stocks
□ The next most likely outcomes are
positive returns of 5% to 10%
annually OR returns of 0% to (5%)
annually
□ Over the next 10 years the most
likely outcome are modest
positive returns 0% to 5% with
the next most likely outcome
being negative returns of up to
5% annually
The distribution of future returns for stock markets is almost random
for shorter periods , while forecasts for periods of five years or more
provide more actionable information
9
□ Current conditions do not warrant
an aggressive position in our view
Bull Markets Start When Stocks Are Cheap and End
When They are Expensive
Bear Markets Start When Stocks are Expensive & End
When They are Cheap
Outside the Outlier ‘90’s, Returns are Not Good From
These Levels
Net Margins are Near Historical Highs
10.0%
9.0%
“In my opinion, you have to
be wildly optimistic to
believe that corporate profits
as a percent of GDP can, for
any sustained period, hold
much above 6%. One thing
keeping the percentage
down will be competition,
which is alive and well.”
S&P 500 Net Margins
Average Net Margins
8.0%
Net Margins
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%Source: Ned Davis Research, Shiller, and S&P. Data as of
1973
1978
1983
1988
1993
1998
2003
Profit margins are among the most reliable mean
reverting statistics in finance. If margins follow
history & decline, then revenue growth would
have to carry the load for improving profits. An
optimistic assumption, in our view
13
2008
2013
-Warren Buffett, 1999
Investor Sentiment is Frothy – Margin Debt
Margin debt—or leverage—at the end of the day,
turns a small downtick in key stock indices into a
more significant market sell-off. As the stock prices
go down, investors' losses are magnified, so
investors liquidate securities to raise cash & pay
down margin debt. In 2007, margin debt on the
NYSE reached an all-time high; a few months
down the road, key stock indices began the largest
decline since the 1970’s
Margin Debt is now higher than in 2007 (prior to the financial crisis
And in 2000 (prior to the bursting of the tech bubble)
14
Investor Sentiment is Frothy- Retail Investors
• For those Investors waiting for the little guy to
show up and boost the market and push values
to a multi-year top.
•
15
In 2012 & 2013 they have arrived and they are
“all in”
Investor Sentiment is Frothy – Institutional Investors
•
Institutional Investors have abandoned caution
as well, with “bullish” sentiment reaching its
highest level since 2007
• Who is left to buy shares?
16
Why Our Analysis May Look Too Cautious, Temporarily
• While “tapering” has begun it was very timid
and policy conditions remain very
accommodative. If conditions remain as
accommodative as they are now through 2015
and if the relationship between Fed policy &
the market remains strong then 2200 on the
S&P 500 is possible.
• Under those conditions the market would be
dangerously stretched under all but the most
optimistic scenarios
• Sustained GDP above 4% annually could drive
earnings that catch up with current valuations
The relationship between the rise in the U.S. stock market &
the balance sheet of the federal reserve has been strong
since the financial crisis
17
The Decline in Bond Prices in 2013 was Unusual
Source: Morningstar / Federal Reserve. Data as of 9/30/2013.
18
In a Low Yield Environment, Bonds Don’t Offer the
Historical Level of Downside Protection
Barclays Agg Returns*
25.0%
Starting 10yr Treasury Yield
23.1%
Starting Yield / Return on Core Bonds
20.0%
15.0%
14.4%
10.6%
10.0%
6.4%
5.1%
5.0%
4.6%
0.0%
Source: Litman Gregory Analytics
19
Aug '81 - Aug '82
Mar '00 - Oct '02
Oct '07 - Feb '09
S&P 500* (-23.4%)
S&P 500* (-22.52%)
S&P 500* (-40.25%)
Equity Market Declines
Investing in Higher Risk Environments
or How the Rich Stay that Way
•
“Bull markets are born on pessimism, grown on skepticism, mature on optimism
and die on euphoria”. --- John Templeton
•
High Stock Valuations
•
Peaking Profit Margins
•
High Investor Expectations
•
A Weaker Safety Net (Bonds)
•
Federal Reserve Policy Transition
• Add up to a Higher Risk Environment in our View
20
Powerful Arithmetic
“Be Fearful When Others Are Greedy and
Greedy When Others Are Fearful” –
Warren Buffett
“I made my money by selling too
soon” -- Bernard Baruch
When Risks Are High Avoid Potential Losses
Small Losses Erase Big Gains
22
When Risks Are High Accept the “Consolation Prize”
An Investor who
correctly anticipated
the bear market that
commenced in
March of 2000 and
reduced his exposure
to the stock market
by half would still
have more money
than the investor
who is fully exposed
to the S&P 500
23
The Performance Divergence Between U.S. and Emerging-Markets Stocks
Is Not Supported by the Long-Term Outlook
 The rally in U.S. stocks has continued
even as the U.S. economic recovery
remains only moderate and corporate
earnings growth has slowed
 Our outlook for U.S. stocks remains
cautious based on our expectation of
slower earnings growth and narrowing
profit margins
 Emerging markets rebounded this
quarter based on improving economic
news out of China
 We continue to view emergingmarkets stocks as attractive over the
long-term, both in absolute terms and
relative to U.S. stocks
Source: Morningstar. Data as of 9/30/2013.
24
The Case For Emerging Markets
Forward P/E Ratio (based on consensus EPS forecasts)
We think emerging-markets’ 2013
performance trends were largely an
overreaction to shorter-term factors not
justified by longer-term fundamentals
15
14
We continue to view emerging-markets
stocks as likely to generate higher returns
than U.S. stocks across most scenarios
13
12
This higher return potential is a function
of more attractive valuations as well as
what we expect to be stronger earnings
growth over our five-year investment
horizon
11
10
9
U.S. Stocks
European Stocks
Emerging-Markets Stocks
8
7
2007
25
2008
2009
2010
2011
2012
2013
We also continue to view the downside
risk and volatility of emerging-markets
stocks as higher than for U.S. stocks, and
we take this into account in our overall
portfolio construction