The fourth quarter of 2011 brought a significant recovery in U.S. stocks as the risk of a double dip recession faded and investors came to realize that some of their big picture concerns were overblown. Outside of the U.S., the recovery was more muted as Europe’s debt problems lingered. The total returns for major asset classes are below.
In the end, 2011 turned out to be a sideways year for the U.S. stock market. The S&P 500 index ended up pretty much where it started, although foreign markets are still significantly below their 2011 starting point, hurting investors with globally diversified portfolios.
Out with the Old, in with the New
2011 was a frustrating year for investors, taxpayers, and citizens alike. The anxiety that resulted from political showdowns, wild swings in the stock markets, the downgrade of U.S. debt, and the slow grind of our economic progress was palpable. But in the end, the double dip recession never materialized, Europe is not a smoldering heap, and China is still willing to finance our deficits. This progress in the face of uncertainty (global GDP growth is expected to be 3.8% for 2011) reinforces our faith in the resiliency of the global economy.
There are even some reasons to believe that, going forward, the experience for equity investors could be much better than the recent past.
Equities - a Coiled Spring
There are a few basic truths about equity investing that are worth examining.
- The underlying driver of equity returns is corporate earnings. As earnings grow, so should the value of the companies that produce them.
- The cheapness of the market in any given year, while not a good predictor of returns in the short-term is an excellent predictor of long-term future returns. (See the historical evidence in the chart from JPMorgan below.)
- Therefore, an ideal environment for an equity investor is a combination of strong earnings and low valuations.
Where do we stand today?
Corporate earnings are strong. Despite the recession and muted recovery, U.S. based companies are enjoying record profit margins and earnings. (International companies have not done as well but have grown profits significantly since the recession.) This is a bit of a paradox – companies earning record profits in a below average recovery – but U.S. companies are benefitting from the very trends (high unemployment, lack of credit) hurting other parts of the economy.
Markets are cheap. Over the last ten years, the earnings of the companies in the S&P 500 have roughly doubled while the index is little changed. The net result is that based on next year’s expected earnings, today’s market is more than twice as cheap as it was ten years ago and cheaper than it’s been since the mid 90’s. International equity markets have even lower valuations as evidenced by the very detailed chart below (also courtesy of JPMorgan).
Where will that take us tomorrow?
Low valuations are no guarantee against further declines - cheap can always get cheaper. But as I pointed out earlier, there is a strong historical correlation between how cheap a market is and the actual returns for the following decade (refer again to the first chart). We believe the current combination of strong corporate profits and low valuations may be setting the stage for what could be another sustained bull market in equities going forward.
Bonds - Spring Has Sprung
Our hopeful enthusiasm for equity markets going forward does not apply to bonds. The U.S. bond market had a great run in 2011, returning 7.8%. This strong advance is the result of yields falling to their current level – less than 2% for ten year U.S. Treasury bonds. (When yields fall, bond prices move higher.)
The current yield – roughly 2% - is a good predictor of the bond market’s future returns. While we like bonds for safety and stability in a balanced portfolio, it is hard to get excited about a 2% yield.
We have two responses to the current fixed income environment: 1) Continue to use bond managers who can effectively navigate the risks associated with a low yield environment, and 2) continue to look for other ways to dampen stock market volatility in our diversified portfolios.
There is a clear tradeoff between the short-term security of low-yielding fixed income and the long-term growth potential of equity markets around the world. A cautious stance may feel good for now, but may actually be riskier going forward.