With the current run-up in stock prices during the first quarter of 2013, the market finally succumbed to a bit of profit-taking last week. Is this weakness a harbinger of things to come, or simply a minor setback during a continued bull run?
To start, I would like to point out that in spite of significant price appreciation in the S&P 500 index (SPY) over the first quarter the overall posture of the market is one of defensiveness. To some, that might appear to be good reason for caution, but it is worth pointing out that the overall price ratio of cyclicals to consumer staples is now approximately where it was following the market crash in 2011 and the market swoon in 2012. Therefore, it must be stressed that investors are not situating themselves in an aggressive manner, in fact looking at the relative performance in cyclicals vs. staples one would have expected a correction to already be upon us. Thus, whenever commentators talk about how weak the economy is and how strong the stock market is they seem to be missing the point. Most shares that are levered to global growth, particularly international stocks (VWO) are, in fact, priced nearly the same as one year ago. This brings one to the conclusion that because investors are expecting a low growth environment, it has already been discounted causing disappointing economic reports to lose some of their market moving power.
So if investors are not situating themselves in an aggressive manner, why do stock prices continue to wax higher? Two words are required to answer that question: interest rates. While a ten-year note may provide value as a hedge against uncertainty, at 1.73% it provides negative real appreciation over the long-term. One simply must look at the stocks that have been outperforming during this rally to realize that fact. A number of consumer staples stocks have recent price performance that could best be described as parabolic, including Coca-Cola (KO), General Mills (GIS), Johnson & Johnson (JNJ) and Pepsi (PEP), several of which are up 25% YTD. Widows and orphans are presently beating the market by leaps and bounds as investors scramble for yield anywhere they can find it. Because rates remain incredibly low, no reason can be seen that would catalyze a reversal of this trend.
I recently finished reading Carol Loomis' book on Warren Buffett entitled Tap Dancing to Work and Buffett made some interesting observations around the conclusion of the 2000 bull market that are worth noting. To start, Buffett summarized two periods that investors in stocks encountered, first the boom times from the final day of 1981 until the final day of 1998 in which the Dow Jones Industrials rose from 875.00 to 9181.43 (while 1998 did not mark the end of the bull run, this was the date Buffett wrote his article). Next, he contrasted that astronomical 17-year performance with the equally long period beginning on the last day of 1964 and ending on the final day of 1981 during which time the Dow Jones Industrial Average started at 874.12 and ended with a price of 875.00. Over that same period the rate on a ten-year treasury note increased from 4.20% to 13.98%, causing profits to be discounted at an ever increasing rate. It was only once rates finally began to decrease that stock prices began to rise. The first hint of falling rates can be seen on the far right hand side of Figure 3.
Figure 3: The 1964 to 1981 Cyclical Bear Market (click to enlarge)It is interesting to note that over the past thirteen years the exact opposite has occurred. The S&P 500 has more or less treaded water, beginning at 1527 in the first quarter of 2000 ending at approximately the same place today. Of course there may be further twists and turns since there is no way of knowing for certain what the future direction of the market will be. However, it is interesting to note how the cyclical bear market encountered from 1964 to 1981 is nearly the mirror image of our current cyclical bear market. The yield on a ten-year treasury bond has over that time collapsed from 6.45% in December 1999 to 1.73% today. Perhaps at the bottom corner of Figure 4 is the first hint of rising interest rates. It is expected that either interest rates falling from highly elevated levels or rates rising from highly depressed levels could fuel a major boom in the stock market. Very high rates caused earnings to be discounted too harshly and choked off the financing required by companies to grow earnings. Ironically, low interest rates encourage speculation in the bond market and discourage banks from lending, both of which are net negatives for the stock market. Because the earnings multiple of the market has greatly compressed over the past thirteen years and has only begun to expand, there is little evidence that investors are discounting earnings at a lower rate, even though they should be.
Figure 4: The 2000 to 201X Cyclical Bear Market (click to enlarge)In 1998, the Oracle of Omaha recognized the significance of investor psychology and interest rates. It is worth quoting Buffett's insight at some length here:
(Near the end of the 2000 bull market) I believed that the favorable fundamental trends (of lower interest rates and the psychology of investors) had largely run their course. For the market to go dramatically up from where it was then would have required long-term interest rates to drop much further (which is always possible) or for there to be a major improvement in corporate profitability (which seemed, at the time, considerably less possible).
Fifteen years later, it should be noted that both lower interest rates and higher corporate profitability have already occurred. Yet, a fair number of analytical methods indicate that the market is presently rather richly valued. Buffett's favorite method to analyze the entire market is by Market Cap/GDP. The present level of which is rather elevated and in isolation would be taken as a sell signal.
Figure 5: Market Cap to GDP of the S&P 500 Index (click to enlarge) However, the question remains: is it reasonable to expect the same valuation of the early 1980s again today, given that a 10-year note yielded 14% then compared to 1.7% today? It instead seems likely that in a lower interest rate environment the average market cap/GDP will be closer to 1, where in the past it averaged closer to 0.67. It is also interesting to note that the huge undervaluation present in the market in 1980 did not arise from a single bear market, rather it was the result of a highly inflationary environment and a market that did not "price in" the inflated value of stocks even though they were priced in dollars that had become worth significantly less.
Thus, it is somewhat difficult to ascertain a fair value for the stock market at this moment in time. At its foundation, the fair value of the market can be assigned by discounting future cash flows. However, when the discount rate has collapsed to nearly zero it would be possible to entertain much higher valuations than the market presently enjoys. As a result, while the market appears rather richly valued, I am still rather cautious about lowering my market exposure, particularly in light of the rather paltry yields that are currently available in the bond market.
To answer the question posed by the title of this article, it is expected that over the next ten years or so investors will most likely reap normal equity returns, perhaps 6% real returns with reinvested dividends. Certainly at some point during that period the market will decline, unfortunately knowing that such a decline must occur at some point tells us nothing about when it will occur. Therefore, while the temptation to take profits after such a strong showing is certainly felt, statistically a weak quarter is not more or less likely to follow a strong one. Furthermore, I have a hard time articulating any bearish argument that is not being mulled over by the investing community at large.
If the market continues higher it would not be all that surprising given the paltry yields available in risk-free investment vehicles. If it does not what's the worry? After all, it's only been 13 years and personally, it wouldn't sadden me all that much to have lower stock prices while I am still accumulating stocks.
Given recent price performance, it is expected that lower risk high quality blue chips should be very well situated to take advantage of the current rally. Some ideas for your watchlist include: Abbott Laboratories (ABT), Discover Financial Services (DFS), Kraft Foods Group (KRFT), International Business Machines (IBM), which sold off last week after a disappointing earnings report, but still represents excellent value as a long-term investment Travelers Insurance (TRV) and Union Pacific Railway (UNP). All are expected to capitalize on strength in their respective markets, while none have a forward P/E of greater than 18x, with most being significantly cheaper than the market as a whole.
Additional disclosure: Some of the positions above are options on the underlying issues.