Market Outlook and Perspective
The fearmongers are back, with articles and newsletters predicting the next “50% crash” and numerous opinions about valuations, with Professor Jeremy Siegel and Nobel Prize winner Robert Shiller engaged in a public debate. We thought it would first be helpful to put in perspective how rare it is to have a 50% equity market correction. We share below a chart maintained by Dimensional Fund Advisors (DFA), our passive manager, which illustrates Bull and Bear Markets from January 1926 through June 2013, its last update. Following the market crash of 1929 (during which there were no margin borrowing limits), it was only during the recent credit and liquidity crisis that the S&P 500 market declined 51%; the next largest drops were 45% due to the technology bubble in the 2000 to 2002 bear market, and the 43% decline in the 1970s “Nifty Fifty” period. While steep declines can happen, severe bear markets are typically predicated by an overreaction by investors, which corrects over time. We generally use the word “correction” to imply a down market, as in “we are prepared for a correction in the range of 15% to 20%.” A correction may also be on the upside, as investors realize that their worst fears were not realized.
As we have discussed in prior Commentary, investors seem entitled to their skepticism in light of the series of market events since the technology bubble burst. We decided to examine current market levels, using the DJIA at the 17,000 level, from Gilligan’s perspective. In the television series Gilligan’s Island (which aired from 1964-1967, with a movie in 1978, and sequels in 1979 and 1981), the Skipper, Gilligan and their “three hour tour” guests were blown off course and lived on a deserted island. What if investors had all lost connectivity to market data during the credit and liquidity crisis? Would current market levels seem high? In the chart below we illustrate the annualized returns for the Dow based on several investment periods. An investor in 2006 who stayed invested has seen the market recover and start a new leg of growth. For the opportunistic investor who put new money to work in January 2011, they have been well rewarded.
Annualized returns smooth out the bumps and the drama along the course of history. In our depiction, the sharks are poised to attack those who “bail” or go to cash. We offer a few observations:
- The period from March 2009 to the present has not felt like a Raging Bull; we propose that it was a correction of the overreaction that caused the 2007-2009 decline. It took until late 2012 for the DJIA to stay above the 14,000 level, which it first reached briefly in 2007.
- Once the DJIA crossed the 12,000 level again in 2011, it was the next leg up for the market; this move was interrupted by the government shutdown in August.
- The recovering equity market had the headwinds of a weak economy; imagine the possibilities of earnings improvements in a growing economy. The next phase could feel more like a Bull Market, while many continue to stay on the sidelines.
- While the massive Fed intervention in the bond market has helped bond investors, it seems to have little impact on driving investors back to equities. We see some high dividend payers that are at stretched valuations because of the search for yields, yet the broad market is not valued at extraordinary levels.
The Debate about Valuations: Shiller (Yale) versus Siegel (Wharton)
Nobel Prize winner Professor Robert Shiller (who rang the alarms of the housing bubble) developed a “cyclically adjusted price-to-earnings (P/E) ratio” referred to as the CAPE method. As of June 30, 2014, the CAPE P/E was 25.6 versus its 25 year average of 25.1. Professor Jeremy Siegel has been a vocal dissenter with a point. Siegel gives more credence to the traditional P/E methodology which gives a P/E of 15.6 as of quarter-end, versus a 25 year average of 15.5.
Siegel cites the changes in accounting rules (FASB Ruling 115 in 1993, and Rulings 142 and 144 in 2001), which forces companies in the S&P 500 to lower their earnings based on losses in asset values, but which do not allow companies to increase earnings when the asset values recover, unless they sell the asset. As a consequence, the S&P earnings history relied upon by Shiller has some skews that make historical comparisons difficult. Both CAPE and traditional methods are indicating fair valuations for the market as a whole, which includes some overvalued securities (which we believe are those chased by yield hungry investors) and undervalued securities.
Some Thoughts on How We Measure Economic Growth
The Gross Domestic Product (GDP) metric has been relied upon to assess the financial health of a country. In the U.S., recently announced revised numbers for first quarter GDP growth (-2.9% versus the seasonally adjusted annual rate of +0.10% earlier reported) have people shaking their heads. The change apparently came from how the government estimated health care costs; the new numbers assumed that health care spending fell in the first quarter, possibly because people deferred non-emergency health care until they enrolled under the Affordable Care Act and started coverage in the second quarter.
This year alone we have had a weather impact and a policy impact, neither of which is uncommon in making the GDP number a variable, and sometimes unreliable statistic. This has prompted renewed discussion about whether GDP is keeping up with the digital age, or with innovation in general. For such a commonly cited statistic, it has its flaws. What we know is that the economy has improved, and is not at risk of a recession. The S&P 500 ratio of debt to total equity was 102% at the end of the first quarter, down dramatically from its average of 171% (and from more than 200% in 2004 and 2008). We believe the economy is stronger than most investors think.
Shifts in the U.S. Economy
The U.S. economy has experienced significant shifts in its history, with another major shift underway. Based upon 2013 data, the Table below illustrates the magnitude of the renaissance that mining and energy production has had on the economy – driving GDP growth in 60% of the Top 10 Strongest Growing States. Agriculture is also an underappreciated area, driving growth in 30% of the Top 10 list.
We remain optimistic that this bull market is in its early stages and that the innovation and productivity gains, combined with the new opportunities from domestic energy production, will be strong tailwinds for the economy, which will support earnings growth. There is nothing to gain from greed, however, and we are carefully monitoring target equity allocations to rebalance on market developments. For our clients approaching a transition to retirement, we welcome an opportunity to discuss whether it is time to moderate your equity exposure to reduce portfolio volatility, and to be prepared to generate cash flow from the portfolio.
An original article authored by the Investment Research Group of Wescott Financial Advisory Group LLC
© Copyright 2014, Wescott Financial Advisory Group LLC All Rights Reserved