2013 was a great year for stocks, but less so for earnings. As a result, equity valuations rose sharply. Given higher multiples and the magnitude of last year's rally, many investors are wondering whether the gains can continue, and just how high stocks can go this year.
I foresee U.S. equities posting more muted gains in 2014. Why? The interaction of two factors that defined the market last year - significant multiple expansion and higher interest rates - represents a headwind for stocks this year.
Most of last year's stellar advance was powered by higher multiples. In other words, investors were willing to pay increasingly more for a $1 of earnings. Over the course of 2013 the trailing price-to-earnings (P/E) ratio on the S&P 500 rose from 14.2 to 17.50, a 22% increase. Based on P/E measurements, stocks are commanding the highest valuation since early 2010, when multiples were still high due to depressed earnings. Using a different metric, price-to-book, the S&P 500 is now trading at the highest multiple since before the financial crisis.
While I don't believe that stocks are in a bubble, last year's multiple expansion does matter for future returns. Historically, markets have done slightly worse in years following multiple expansion. Since 1954, the return, net of dividends, on the S&P 500 has averaged 5.85% following years in which stocks got more expensive. In contrast, the average return following multiple contraction was more than 10%. Admittedly, the results seem to be disproportionately impacted by a few bad years, such as 2000 and 2002. If instead of using average returns you focus on the median - which is less impacted by outliers - the difference is smaller: 9% in years following multiple expansion and 12.5% in years following multiple contraction.
However, investors should still be a bit nervous for another reason. Not only did multiples rise last year, but interest rates increased as well. In the past, higher multiples and higher rates have represented a challenging combination. In those instances when multiples rose but rates were lower, the average return for the market was more than 9%, in-line with the historic average. In other words, to the extent that rates are dropping, rising multiples don't represent the same degree of headwind as when rates are rising. However, in the 14 instances between 1954 and 2013 when multiples rose and interest rates rose, the average return on the S&P 500 in the following year was a relatively paltry 2.3%.
That said, I don't believe that the U.S. market is necessarily condemned to a year of near zero returns. I expect U.S. stocks will finish 2014 with a mid- to high-single digit gain. First, rates are rising from unusually low levels. The yield on the 10-year note is still barely 3%, well below its 20-year average of 4.5%. At these levels, bonds still represent little competition for stocks. Second, a stronger economy this year should translate into faster earnings, which means stocks can advance without a further jump in valuations. Still, last year's multiple expansion and higher rates arguably constitute a yellow flag for U.S. stocks. Given this, I continue to advocate that investors raise their exposure to international markets and focus on cheaper parts of the U.S. market, such as large and mega cap stocks and the technology and energy sectors.