State of the Markets
During the third quarter of 2013, stock and bond markets around the world continued the trends that have been in place for most of 2013.
Equity markets benefited from strong price performance in the third quarter of 2013. Leadership shifted away from U.S. stocks (which still performed quite well) to developed international markets, which benefited from a combination of cheaper relative valuations and improving economies (think Europe). Both U.S. and global indices reached new highs for the year just prior to the quarter’s close. Emerging markets were up for the quarter but are still in negative territory year to date. Bonds recouped a small portion of the losses suffered in the second quarter but still have a small, negative return for the year so far.
These results do not imply the quarter was without incident or disruption.
Events of Significance (or not)
The third quarter of 2013 was filled with headline-worthy events that rightly or wrongly got top billing in our 24-hour news cycle. In the view of many, these events could have scuttled the economy or at least triggered a stock market correction. Below is a sampling of the issues faced over the past several months.
- The Federal Reserve’s decision to taper its bond buying program
- The Federal Reserve’s decision not to taper its bond buying
- Egypt’s military overthrew President Morsi and suspended the constitution
- Detroit’s bankruptcy filing
- The Standoff over Syria’s chemical weapons
- Washington Navy Yard shootings
- The rollout of Affordable Care Act
- The Federal Government shutdown
Our point is not to make light of these events, many of which are tragic and with significance consequences. The reality, however, is that the markets digest relevant information in real time and proceed accordingly. Seemingly important incidents often turn out to be nothing but noise in the grand scheme of things. It takes truly significant events to knock our economy on its heels or impair corporations’ ability to earn money, pay dividends, and grow their businesses.
An Anniversary not worth Celebrating
Speaking of events that can knock our economy on its heels, September 15th marked the five year anniversary of Lehman Brothers’ bankruptcy filing. I won’t review the specifics except to say this event took a recession which was the natural consequence of dramatic excesses in our economy (over borrowing, over building, inflated housing prices) and superimposed a system-wide liquidity crisis, taking the situation from bad to worse overnight.
We are still suffering through the long-term consequences of the recession and the excesses which came before it. These consequences – sub-par economic growth, high unemployment, negative home equity, budget deficits, and abnormally low interest rates – weigh on us all in varying degrees. However, it is worth noting that none of these systematic challenges have hampered the recovery in corporate profits, and hence the recovery in equity markets.
Without question, corporate profits and stock prices suffered mightily during the recession, but few would have predicted that five years later we would see record profit margins, record profits, and a 174% peak to trough recovery in the S&P 500.
Looking back at the height of the crisis, we can say that our clients did not panic. They asked intelligent questions, which we answered to the best of our ability. We worked together to understand the reality of the situation; the potential risks and rewards. We revisited financial plans, stress-tested our assumptions, and made adjustments where necessary. In the end, we got through the Great Recession. We point this out, not to boast, but instead because we are humbled by the experience.
- Humbled by the reality that there is always more to learn
- Humbled by our inability to predict the future (as tempted as we may be to try)
- Humbled by the conviction that good financial planning goes hand in hand with good investment management
- Humbled by the fact that buy-and-hold worked (not in the short-run as hoped, but in the long-run as expected)
- Humbled by our clients, who put their trust in us during these most difficult times
As the U.S. stock market has recovered, it has ostensibly become more expensive. We know that future returns are closely related to current valuations, so it concerns us when stock prices increase faster than corporate earnings growth, as has recently been the case.
Valuation is a hotly debated topic. There are many ways to measure the value of stocks and each method has its detractors and supporters. To complicate matters, most commonly used valuation metrics – P/E ratio, dividend yield, price/book value – are based on noisy data which itself can be influenced by optimistic forecasts, accounting methods, and fluctuating profit margins. The true value of a company (or group of companies, such as the S&P 500) is based on a stream of future cash flows discounted back to the present. Everything else is just a shortcut for comparison purposes. (For the record, our preferred method for valuation comparison uses a cyclically-adjusted price to earnings ratio (CAPE), which smoothes out much of the noise mentioned above. The current CAPE valuation for the U.S. stock market is at the high end of historical measurements, but when macroeconomic-based earnings are substituted to adjust for changes in accounting methods over the previous decades, the U.S. stock market is valued at a CAPE of 18.5 at the end of Q2 2013. This is slightly above the average of 16.5 seen since 1962, but not an excessive valuation. Source: Capital Economics.)
While no one valuation method will accurately predict the future, valuations can be used effectively to compare asset classes, countries, and investment style, and hence their future return potential. As noted before, as the U.S. stock market outperforms its international counterparts and becomes more expensive, it sets the stage for a reversal of fortune down the road. Current valuations are not nearly as high as we witnessed in the late 1990’s and don’t warrant extreme action or changes in our asset allocations, but they do warrant changes in expectation going forward. At some point, the U.S. stock market will pause to catch its breath while other asset classes move ahead. Ultimately, this is the nature of asset allocation and diversification.