March 11th, 2014 | By Nick Sargen
This week marks the anniversary of the U.S. stock market rally that began when the S&P 500 Index fell to a low of 666 on March 9, 2009. While the market reached a record level above 1880 last week, very few professional investors anticipated how powerful the rally would become. Moreover, the vast majority of retail investors missed it altogether as evinced by net outflows from equity mutual funds over this period. For this reason some pundits have called it the most "unloved" rally in history.
The principal reason is that investors were frightened by the collapse of Bear Sterns and Lehman Brothers and the near collapse of other leading financial institutions that culminated in the worst global recession in the post war era. From October 9, 2007 to March 9, 2009, the S&P 500 Index plummeted by 57% - its worst showing since the Great Depression. During this period, there was widespread flight to quality, with cash, U.S. Treasuries and gold as the only places to hide.
The main catalyst for the market rebound was actions by the Federal Reserve and U.S. Treasury to ensure the safety and soundness of the financial system. They included measures to provide ample liquidity to the banking system and to allow a portion of T.A.R.P. proceeds to be used to recapitalize banks. As investors increasingly gained confidence in the financial system, the stock market surged by 75% over the next 12 months driven by a V-shaped rebound in corporate profits and record low interest rates.
The ensuing period from April 2010 through May 2012 was marked by considerable choppiness, as investors fluctuated between seeking risk and avoiding it – the so-called "risk on" and "risk off" interval. The main development was the revelation that Greece's fiscal predicament was much worse than the government had acknowledged, which fueled worries about other countries – notably, Portugal, Ireland, Italy, and Spain. This culminated in a full-fledged test of the viability of the euro-zone. The crisis was not contained until two years later when Greece voted to stay in the euro-zone and Mario Draghi pledged to do "whatever it takes" to maintain the viability of the euro. At the same time, the Federal Reserve embarked on a bond-buying campaign to reduce U.S. bond yields and to bolster the U.S. economy.
Since mid-2012, the U.S. stock market has risen by an additional 50% as fears about a break-up of the euro-zone and a possible technical default by the U.S. Government have faded. The principal difference from the initial phase of the market rally is that the latest phase has been driven primarily by increases in valuations for U.S. stocks (and a reduction in the equity risk premium) rather than by strong profit growth. During 2013, for example, the S&P 500 generated a return of 32.4% while operating profits rose by only 5.5%. This boosted the forward P/E multiple from 12.6x at the beginning of 2013 to 15.4x at year's end.
In the wake of the stock market's large run-up, one of the main issues being debated today is whether the recent increases are sustainable or whether the market is at risk of a significant pullback. To gain perspective, it is useful to compare two other episodes in which the market achieved comparable gains.
The first episode was the rally that began in mid-1982 and ended with the stock market crash in October of 1987. The market's rise over this period was roughly comparable to the past five years, as the U.S. economy emerged from what had been the worst recession in the post war era. The main problem then was high inflation, and the Federal Reserve under Paul Volcker sought to break the back of inflationary expectations by allowing short-term interest rates to rise to record levels. The very tight monetary policy stance ultimately tipped the economy into a severe recession that, in turn, spawned a financial crisis in many developing countries. The catalyst for the rally was the recognition that tight U.S. monetary policy had broken the back of inflationary expectations, and a period of disinflation and falling interest rates ensued.
During the subsequent period the U.S. and other developed countries enjoyed strong economic growth, and the Louvre Accord was reached in September 1985 to produce an orderly decline in the dollar. However, by 1987 inflationary pressures were building in the U.S., and the dollar came under renewed pressure. When Alan Greenspan replaced Volcker as Fed Chairman, the markets tested his resolve to raise interest rates, and a disagreement ensued when the Bank of Japan and the Bundesbank both raised domestic interest rates. This policy dispute triggered a free fall in the dollar and a surge in bond yields above 10% that ultimately led to a 22% drop in the U.S. stock market in a single day.
By comparison, the situation today looks vastly different, as the U.S. is experiencing unusually low inflation and record low interest rates. While the Fed has begun to scale back on its program of bond purchases, investors do not expect it to begin raising interest rates until the second half of 2015 at the earliest. Therefore, I do not believe inflation or monetary policy tightening pose an imminent threat to the market rally.
The biggest market rally in the post war era occurred in the second half of the 1990s through the first quarter of 2000, when the stock market tripled in value. In an environment of strong growth and low inflation, investors became overly optimistic that technological advances had paved the way for a "new economy." At the peak of the bubble, Wall Street analysts were projecting overall earnings growth for the next years would be five times faster than the growth of GDP, and the forward P/E multiple for the S&P 500 soared to more than 25x. This level is well above the average for the post war era of 15x-16x.
The catalyst for the ensuing sell-off that began in March of 2000 was a series of earnings (and revenue) disappointments for many dot.com companies and technology in general. The terrorist attack on September 11, 2001 added to investor worries, and in 2002 there was a widespread selloff as a series of accounting scandals caused investors to lose confidence in the way earnings were being reported. At the low in October 2002, the S&P 500 had fallen by nearly 50% from its peak in March of 2000.
In this regard there are several noteworthy differences from the current situation. First of all, while the market has risen by a comparable amount over the past five years, investors are hardly euphoric today, and as noted previously, most retail investors are still waiting on the sidelines. Second, while valuations increased markedly over the past year, they are roughly in line with long-term averages and are not at an extreme for most indicators. Third, earnings expectations are plausible: The consensus among Wall Street analysts is that S&P 500 operating earnings will grow by 8.5%-9.0% in 2014, which is in line with long-term trends.
The bottom line is that many of the factors that contribute to bear markets – notably, excessively high valuations, rising inflation and monetary policy tightening, or credit market excesses – are absent today. Accordingly, I do not see evidence that the stock market is significantly mispriced despite its unexpectedly large rise over the past five years.
This does not mean there are few risks in the market today. The principal ones that I weigh relate to (i) the potential for the U.S. economy to surprise forecasters and (ii) the potential that turmoil in emerging markets could spread.
With respect to the U.S. economy, one of the most surprising aspects of the stock market's advance is that profit growth has been unusually strong (and profit margins unusually high) during this cycle. That said, I believe we are now entering a phase where profit growth will be more closely tied to GDP growth in the future. Currently, real GDP growth of about 3% appears to be the sweet spot for the market. Thus, should the economy fall short of the mark – say 2%, there is a risk that earnings disappointment could trigger a market pullback. Conversely, if the economy should surprise to the upside and achieve 4% growth, it would likely cause investors to move forward the timing of monetary tightening, which could hinder the market's rise.
Regarding the global economy, the biggest threat at the moment is the potential for turmoil in the emerging economies to spread. The focus last year was on the so-called "fragile five" – consisting of Brazil, India, Indonesia, South Africa, and Turkey – which experienced sizable capital outflows when the Fed announced it was considering scaling back its quantitative easing program. This year, the list of countries in the headlines has grown to include Argentina, Venezuela, Russia, and the Ukraine among others that are experiencing political tensions. While I do not foresee a repeat of the contagion that occurred during the Asian financial crisis in 1997-98, the threat cannot be ruled out entirely, especially if China's economy and financial system experience strains. In China's case, there has been a rapid build-up in private sector debt in the past five years that has raised questions about the soundness of the country's shadow banking system.
Weighing these possibilities, investors should be prepared for a pullback of 10% or more at any time, especially considering there hasn't been one since mid 2012. However, I do not believe conditions are ripe for a full fledged bear market, considering that many factors that accompany them are absent today.
The bottom line is that we are continuing to maintain a moderate overweight position in equities in our balanced portfolios on grounds that interest rates are unusually low while the stock market is reasonably priced. This also implies, however, that the period of supra-normal returns for equities is over. Henceforth, we would expect equity returns to average in the high single digits rather than in double digits.