The U.S. stock market's steady and almost uninterrupted advance over the past year has left many investors wondering if a major decline is now inevitable. We are aware of a number of technical, or pattern-recognition, analysts who are calling for such a decline. Others, with a more fundamental approach, have pronounced the market to be “overvalued” at current levels. Finally, the sluggish economic growth over the past several years and the ongoing, less-than- hopeful news reports confronting people every day in the popular media have given many an uncomfortable, cautious feeling about the market.
We want to address some of the issues investors are struggling with as the U.S. market approaches its fifth consecutive year of positive returns but first we want to point out that in managing our equity income, all cap equity and value portfolios, we spend the vast majority of our time looking at sectors and companies with a view toward populating the portfolio with a diversified list of stocks, each of which has — by our analysis — an attractive combination of valuation and growth characteristics. That is, we are not trying to “time” the overall market or spend an inordinate amount of time on “top-down,” macroeconomic analysis. Nor are we well-trained students of technical or pattern- recognition analysis. In our experience, those approaches fail about as often as they succeed.
We believe we can do better with our “bottom-up,” stock-by-stock approach to investment. Having said that, we do have some observations about the overall state of the U.S. equity market. We disagree with the notion that U.S. stocks are overvalued at current levels. There is no denying that stock prices have advanced a lot from the depths that were reached in March 2009. But we must not lose sight of the fact that corporate earnings, one of the key underpinnings of stock values, have advanced right along with prices. In 2009, S&P 500 earnings came in at $57; this year, we expect earnings of around $107: nearly doubling in four years. It is true that stock-price increases have outpaced earnings, rising from around 660 on the S&P 500 at the bottom in 2009 to more than 1,800 currently. So stocks are valued more highly today than in March 2009 but we hardly believe the current level of the market represents significant “overvaluation” on the basis of earnings. The measure has just made it back to the long-term median P/E but remains many multiple points below the bull-market peaks of the late 1990s.
It is also important to remember that during the time when that long-term P/E ratio of around 15 was being established, the average high-quality bond yield was nearly 7%. Today, the yield on the 10-year U.S. Treasury bond, for example, is less than 3%. That comparison becomes more meaningful if one thinks of the price/earnings ratio as a yield or, if you will, an “earnings yield.” Invert the P/E to create an earnings/price ratio: the yield one would receive if one owned the entire market and could take the whole market's earnings as a return on investment. A P/E of 15 becomes an earnings yield of 6.7% (1 divided by 15). Using this measure, it is possible to compare stocks and bonds by considering their respective yields over time.
The gap between bonds' yields and stocks' earning yields is known as the “equity-risk premium,” or ERP. Because of the riskier nature of equities vs. bonds, the earnings yield on stocks is usually higher than the yield on bonds, hence the name. As with the simple P/E measure, the ERP can fluctuate over time. It is a meaningful measure, in our view, of the relative attractiveness of equities compared to bonds.
The ERP is down from the 5%-plus level reached a few years ago but it remains elevated compared to historical experience. To us, this indicator — like the absolute level of P/E ratios — shows that stocks remain attractive. In this case, they are attractive compared to recent history and to fixed-income alternatives.
We believe the U.S. equity market represents good value at current level, notwithstanding the price appreciation of the past few years, but there are two points we should mention:
Valuation measures are a function of the underlying components. In this case, earnings and interest rates. If one has strong conviction that interest rates are going much higher and/or earnings are on the verge of collapse, none of the preceding valuation analysis should be persuasive. It is our base case, however, that — looking at the U.S. economy and likely actions of the Federal Reserve — earnings can continue to grow and interest rates will stay close to current levels over the next couple of years.
It has been our view since the U.S. recession ended nearly five years ago that slower-than-average growth was to be expected. That is the almost-immutable lesson of history: In the aftermath of a severe financial crisis precipitated by over-leverage and widespread credit defaults, economic growth is slower than average as the excesses of the prior cycle are corrected. After those type of events, economic growth has averaged around 2% rather than the 3%-4% or higher that has been the experience after more typical, inventory- or Federal Reserve-induced recessions. The bright spot, however, in an otherwise-mediocre economic recovery has been the corporate sector.
Balance sheets, cash on hand, profit margins and the level of profits have never been better. Corporate profits have recovered and now exceed pre-recession levels. And it is corporate profits that are a principal underpinning of stock prices.
As we move further away from the crisis and as the proximate cause of the crisis (i.e., collapsing home prices) continue to recover, we believe it is likely that some acceleration in economic growth next year is possible. Employment continues to grow moderately, resulting in income growth. Income growth, in turn, leads to growing sales and production, which leads to more employment growth. That is a “virtuous” economic cycle that provides a positive backdrop for equity investing. If this acceleration in gross domestic product (GDP) growth does come to pass, we believe it is worthwhile to ponder this question: If companies could bring profits back to all-time highs with growth at 2%, where would profits be with growth at 3% rather than 2%? We don't have an exact number in mind but it seems clear to us that the answer is: “Higher.”
As for interest rates, we believe the appointment of Janet Yellen as chair of the U.S. Federal Reserve ensures a continuation of current policies at least through next year … and probably longer. Short-term rates will be held at zero-bound level. The Fed at some point will moderate its long-term asset purchases (i.e., the taper) but the magnitude of overall purchases still will be large. As the economy recovers, it would not surprise us to see the yield on 10-year Treasuries gravitate toward the growth of nominal GDP: maybe around 3%.
We don't believe that would do much damage to the valuation argument. Moreover, the outlook for profit growth would be improved in such an environment, likely offsetting any valuation headwinds brought on by slightly higher bond yields.
Valuation is not a timing tool. In our view, an attractively valued market improves the chances of investment success but is no guarantee against short-term fluctuations and drawdowns. The current market has risen for a long time without much of a correction. We can state without fear of contradiction that the market will have a meaningful correction at some point; however, the “when” and “from what level” are the key, but unknowable, issues.
We would make the general observation, based on our time in the investment business, that this is the most unloved bull market we ever have seen. There are many underinvested and underperforming investors today who would like nothing better than a market pullback to enable them to do what they should have done several years ago: invest in equities. There is an old saying that the market will do whatever it takes to frustrate the maximum number of people. Right now, the most frustrating thing the market can do — and has been doing — is to keep going up and not let the underinvested have an easy entry point.
Ed Cowart, CFA, is a managing director and portfolio co-manager at Eagle Asset Management