2014 Market Outlook
The debate for investors in 2013 centered around three major questions that continue to be important in 2014:
- What is the correct earnings multiple to use when the government has mandated low long-term interest rates through Quantitative Easing programs?
- What is the normalized level of earnings to use for valuation given historically high profit margins?
- What growth rates should be priced into US equity valuations? Have growth rates for GDP and earnings shifted into a permanently slower gear?
Let's look at each of these in turn.
Multiples & Interest Rates
Common wisdom is that interest rates affect the correct earnings multiple you should use when valuing stocks. Since the value for any stock (or any other investment) is the discounted present-value of the cash flow from that stock, and the discount rate is a function of the risk-free rate of return, interest rates dramatically affect this calculation.
However, analysts correctly point out that a significant amount of a stock's price is derived from cash flows far into the future (50 or 100 years even), and so current artificially low rates should not be used as the discount rate. Using a higher discount rate immediately drops the present value, and so these analysts said equities were expensive all through 2013 and even earlier. These analysts argue the correct multiple should be reasonably constant regardless of interest rates - often the "Shiller PE" based on professor Robert Shiller's work that uses 10-year average earnings for the S&P 500 is averaged over time to give a guide to fair valuation. Over time, the average Shiller PE has been 18, while the S&P 500 started 2013 at 21 (and ended 2013 at 24.5).
If you look at the Shiller PE over time, though, it is clear that the Shiller PE ratio has moved in tandem with prevailing long-term interest rates. The graph below shows this against the 30-year treasury yield.
To us, this data makes it fairly clear that the level of inflation and interest rates is very relevant to stock valuation. What remains is to decide how much to trust the current low level of interest rates given the government-driven "financial repression" through Quantitative Easing. As we mentioned in our investment philosophy above, we can't accurately predict what rates will be in the future - there are many arguments for higher rates, and many for similar or lower rates in the future. So our approach to valuation uses current long-term interest rates with a historically appropriate risk premium added to them.
Normalized Earnings and Profit Margins
Most bearish arguments you can read today will focus on the historically record-high profit margins that companies are enjoying today. The graph below is one of the common ways this is shown, where the profit share of GDP is at 11%. Analysts often point out that Warren Buffett once said this value always stays in the range of 6%, but it has lifted way past this in the past 8 or so years.
However, there are a few aspects to this data that are worth analyzing more deeply before assuming that these profit levels must soon revert to the historical mean. The graph below shows 20-year margin history from an aggregation of 50 S&P 500 companies representing approximately 40% of the S&P's total market cap. While we would have preferred to cover the entire S&P, the data is manually assembled and we don't have historical data for the entire index. Still, 40% of the market cap should be representative. The blue line matches reasonably well with the corporate profit blue line above - margins were at 5% in 2001, up to above 10% in recent years with a brief dip in 2008.
The red line is the margin for these companies before they make interest payments - EBI is earnings before interest. This is interesting because it factors out the capitalization structure of the companies and instead focuses more closely on what their profit margins are. What is clearly visible here is that the red line is more stable, and these EBI margins are not at ridiculously high levels. This demonstrates that most, if not all, of the high profit margins today are from low levels of interest expense for corporations. If rates go up, these expenses will certainly rise and affect margins. But this means the profit margin argument is just an interest rate prediction masquerading as a mean-regression prediction!
Consider one more graph below, this time showing return on equity (ROE) for these same companies over the past 20 years. Different businesses can have very different margins while being very successful. For example Coca Cola has high margins, while Wal-Mart has very low margins, and yet both are very good businesses. While no measure is perfect, the quality of a business is better measured by return on equity, which shows how well they produce profit on invested capital. The graph below demonstrates profitability viewed by this better lens is not historically abnormal at all.
All of this analysis leaves us believing that normalized earnings don't need any adjustment for profit margins, and can be used as they would be in any other years and with the same limitations.
US Growth Rates
The last factor we'd like to analyze is the idea of growth rates, which many analysts have predicted will be significantly lower in the future for the US. There is a widespread belief that the US has "peaked" in terms of economic power, and that the emerging markets of the world (China in particular) will dominate the coming century. We believe that this is a paradigm shift prediction that, as with all such predictions, has many more chances of being wrong than it does right.
Historically, emerging markets are very cyclical in nature, and at the peaks of those cycles the investing world is enamored with the fast-growing, "Wild West" nature of these markets. It is only as risk mounts and some catalyst sends the cycle in reverse that people realize why these markets require additional risk premium.
Consider the graph below, which shows a simple ratio of the MSCI Emerging Market index to the S&P 500.
This graph shows the cyclicality nicely, although we realize there are only two cycles shown. The peak of the first cycle in 1994 was when the Pacific Rim was predicted to take over the world, instead leading to the Asian Flu issues and a low in 1998. The second cycle peaked in 2011, and in the past few years strong US returns have brought the ratio down to near 1.0, which can continue to fall further if the cyclical argument is true.
Incidentally, since we are a Canadian fund with Canadian investors, it is interesting to look at the MSCI Canada index in the same light, shown in the graph below.
It is interesting to see that the Canadian index doesn't show any correlation with the emerging market boom in the mid 1990s, but after 2001 the correlation is incredibly high between Canadian and emerging market indices. The recent cycle has been driven by the Chinese growth story (and the insatiable commodity demand it entails), which looks to have fed the Canadian rally directly.
We view this data as a good reason to expect future tailwinds for our US-focused investments as historical trends repeat.
Looking at US growth specifically, one of the concerns that analysts have is shown nicely with the graph below.
This graph shows that the recent strong GDP growth numbers are still quite poor in the context of past decades of history. The graph below adds an element that is important to consider, which is population. This is important because GDP has a drag from lower population growth over time, while we see per capita GDP as a more relevant metric of economic well-being.
To us, these graphs (especially the red per-capita line) don't conclusively show a much worse economic growth picture going forward - we will have to wait for more data to see where the recent upturn in growth peaks. To get another view on this that is focused more on the S&P 500, the graph below looks at earnings growth over 10 or 20 year periods using 10-year-average earnings.
The earnings growth picture is quite smooth. Using long averages of earnings avoids any debate on profit margins that we have already addressed earlier, and demonstrates that growth rates of near 6% have been fairly reliable over long periods of time and should continue to be reliable going forward.
Synthesizing the analysis above together, we see the valuations entering 2014 as balanced, which implies an approximately 50% equity allocation (to market index funds if you're not interested in individual stock picking - we use SPY). For bonds, short duration or corporate bonds are better (LQD say), and some in long-term treasuries like ZROZ would also be reasonable.
It is likely that very strong momentum will carry markets to higher levels, but the current environment requires some caution, especially if rates continue to rise.
The same concern about rates rising also implies focusing on short duration bonds, although if low levels of inflation hold, the premiums that long bonds provide may get high enough in the near future.