Former Ohio State football coach Woody Hayes was well-known for his conservative offense. He was often quoted as saying, “There are only three things that can happen when you pass, and two of them are bad.” The two bad outcomes are either an incompletion or an interception. Instead, Mr. Hayes favored a methodical, grind-it-out approach, running the ball directly into the line. Described as “three yards and a cloud of dust,” what Mr. Hayes' style of play may have lacked in pizazz, it more than made up for in results. As head coach of the Buckeyes, Mr. Hayes compiled a 205-61-10 win-lose-tie record, three consensus national championships, two other non-consensus national titles, 13 Big Ten Conference championships and eight appearances in the Rose Bowl.
The U.S. economy today is following a similar offensive playbook, but with less satisfying results. Unlike other post-recession recoveries that featured at least one or two quarters of rapid growth — the economic equivalent of a 60-yard pass play — the current recovery has been characterized by quarter after quarter of slow, grind-it-out gains. With the economy moving forward at a consistent, but slow pace, there is both good news and bad news.
The good news is that the economy is inching ahead, rather than slipping back into recession. The bad news is that the progress is modest and unlikely to put much of a dent in unemployment. In fact, a just-released report showed the March unemployment rate at 6.7%, which was unchanged from February and up slightly from January.
The U.S. economy's slow march forward is reflected in most of the leading indicators that I have found useful over the years. In addition, gross domestic product, which is a coincident indicator, has continued to make very small gains. A graph of U.S. GDP since 1947 shows a remarkably smooth trend overall. But if we drill down into the years marked by recession and recovery, we see some significant quarterly fluctuations in GDP's rate of change. In recession years, GDP sometimes fell by over 5% on an annualized basis. However, those declines were often offset in recovery years by gains approaching or exceeding 10% on an annualized basis.
The economy has performed differently during the period that has included the global financial crisis and the subsequent recovery we're experiencing today. In 2008, GDP dropped by an annualized 8.3%, which was painful and on par with some of the worst downturns since 1947. What's different during the current period is that GDP has not spiked back up the way it did after previous economic crises. Since the economic low in 2009, annualized GDP growth has not gotten above 4.9% and the growth rate has averaged only 2.4%. This 2.4% average is certainly not what we'd expect during a “recovery,” considering that the overall average GDP growth rate since 1947 has been 3.2%. Because our current growth rate is below not only past recoveries but also below the long-term trend, you can see why I've dubbed this recovery as “the tortoise economy.”
In the fourth quarter of 2013, the GDP growth rate fell to 2.6% from 4.1% in the third quarter. This trend may have weakened even further in the first quarter of 2014, partly due to the harsh winter most of the country experienced. Frequent heavy snowfalls and cold weather have undoubtedly cut into housing starts, construction activity, retail sales and employment indicators such as hours worked. For the entire year, I expect the overall growth rate to stay below 3%, primarily due to structural reasons including the increasing numbers of retirees and relatively smaller growth rates in the labor force. So, like Woody Hayes' offense, I expect our recovery to continue grinding forward. But as businesspeople and investors, we should also be aware that we're operating within the tortoise economy.
Aside from tepid economic growth in the U.S., another general condition we should consider is the overall level of corporate profits. After-tax corporate profits now account for over 11% of GDP. That's more than 75% above their historical average. Corporate profits have benefited from rising productivity, as well as from the fact that wages and salaries have remained fairly stagnant while prices for goods and services have been increasing. Deficit spending by the government has also helped corporate profits because social programs have allowed more individuals to afford basic goods and services. If these trends reverse to some extent and if after-tax corporate profits eventually come down to more normal levels, investors will need to consider the implications for stock valuations.
Stock prices have certainly gone up a lot since the global financial crisis. For example, U.S. small-cap stocks, as represented by the Russell 2000 Index, have risen more than three-fold since the market's bottom in 2009. Based on the dramatic rise in stock prices and my overall economic concerns, I cautioned investors in my last message that the market may experience periodic “air pockets,” much like an airplane that hits turbulence, drops precipitously and then recovers.
In January of 2014, my caution seemed warranted as the S&P 500 Index fell 3.46% and the Russell 2000 fell 2.77% for the month. But gains of 4.57% and 4.71%, respectively, in February brought both indexes back into positive territory for the year-to-date. While March was bumpy, both indexes remained positive for the quarter with the S&P 500 returning 1.81% and the Russell 2000 returning 1.12%.
For bonds, the ride was considerably smoother. The intermediate-term Barclays Capital U.S. Aggregate Bond Index rose 1.84% and the long-term Barclays U.S. 20+ Year Treasury Bond Index rose 7.73%. But at current prices, I believe that U.S. government bonds are more expensive than at almost any time in over 50 years. And while I don't have a strong view regarding the near-term direction of interest rates, I continue to warn investors that if interest rates rise substantially, the declines in bond prices — particularly in long-term bond prices — could be devastating.
I was recently asked if there are any particular market indicators that suggest whether the overall stock market is likely to move up or down over the short to intermediate term. From my perspective, I acknowledge there are many well-documented indicators that have historically been good predictors of overall stock-market performance. And perhaps the majority of these indicators now suggest that the market is headed for at least a moderate correction.
For example, the cyclically adjusted price-to-earnings ratio measures current stock prices relative to average inflation-adjusted earnings from the previous 10 years. Similarly, the Q ratio for a group of companies is the total stock-market value of those companies divided by the replacement value of the companies' assets. Both of these ratios now indicate that the U.S. stock market as a whole is somewhat overvalued. In addition, the current frothiness in initial public offerings is another potential indicator of excessive speculation in the market.
While I concede that the economy is sluggish, that overall stock valuations are relatively high, and that some well-documented indicators are pointing down, I still remain cautiously bullish. Here are my reasons: First, I believe that all market indicators must be taken with a grain of salt because the level of monetary stimulus by the Federal Reserve and other central banks around the world has been massive, unprecedented and beyond any investor's experience. We're in uncharted territory, so I wouldn't automatically assume that any indicator, positive or negative, is necessarily predictive in the current environment. Second, the ratios that indicate overvaluation are for the market as a whole. At Wasatch, we invest in individual companies that we believe are unique. Third, I also monitor several technical indicators that were flashing warning signals prior to the global financial crisis. These same indicators are giving me reasons for optimism today. Unlike fundamental indicators that focus on specific company characteristics, technical indicators can provide measures of overall investor psychology because they focus on the action in stock prices.
From my experience, I believe it is very unlikely that any portfolio manager will be able to correctly move in and out of the market to consistently capture most of the upside and avoid most of the downside. Instead, my job is to analyze companies and assemble a diversified basket of quality stocks. In the process of selling what I consider to be overpriced stocks and maintaining my discipline to only buy reasonably priced stocks, my cash level will fluctuate. In the portfolios I currently manage, I'm maintaining a cash level of about 10%, which is relatively high for portfolios that are usually closer to being fully invested in stocks. I consider this cash to be “dry powder” that I can use as I find more reasonable valuations over time.
Other than maintaining a relatively high amount of cash, I'm sticking to the basics — like Woody Hayes — in an attempt to reduce risk in the current speculative environment. I'm operating under the philosophy of “When in doubt, throw it out.” I'm continually reviewing my portfolios for holdings in which the stock price has gotten ahead of the company's fundamentals. And I'm pruning those holdings so the portfolios are only left with the companies in which I'm comfortable with the valuations.
I'm also placing additional emphasis on companies that pay dividends. When a company pays a relatively attractive dividend, this usually indicates that the company is sufficiently profitable to cover the dividend, and that the company's management team is confident this level of profitability will be maintained or increased. Regarding business characteristics, I'm focused on companies that are growing their earnings, while at the same time maintaining or increasing their market share. This investment discipline causes me to stay away from social-media companies, for example, which may be increasing their market share, but are generally light on earnings.
Aggressive investing may have its place during a more normal economic recovery, with lower overall stock valuations and typical monetary policies in place. Today's environment is much different. We've never been down this road before, and now is not the time to put the pedal to the metal. But, for the reasons discussed in this message and in prior messages, I don't think it makes sense to abandon stocks, either. I'm simply proceeding with caution.
Despite the challenges and uncertainties we face, I'm optimistic about the future. And this optimism extends well beyond the U.S. I recently returned from a trip to Southeast Asia and France. While traveling, I couldn't help but notice the increased diversity of the other tourists I encountered. In Myanmar, for example, there were some Americans and Europeans, but also Chinese, Thais and others. This increased diversity is clear evidence of the prosperous middle class that's spreading around the globe. While the rise of the middle class is gratifying to see because it means that overall living conditions are improving, it's also a good sign for investors in companies that are serving the growing demands of middle-class consumers all over the world.
Sam Stewart is chairman and chief investment officer of Wasatch Funds