11/18/2013. Rational Optimism. October 29 th, 2013: Dow, S&P 500 close at record Highs CNNMoney.com i

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1 11/18/2013 Rational Optimism October 29 th, 2013: Dow, S&P 500 close at record Highs CNNMoney.com i According to Biriyni Associates, through October net purchases of growth and aggressive growth mutual funds were a negative $24.61 billion ii. Translated, over the last year when the Dow Jones Industrial Average hit 35 separate all-time highs iii, more money has flowed out of growth stocks than into them. In an age of 24-hour news channels and instantaneous information from a multitude of sources including computers, smart phones, tablets, and now even watches, and in a decade where we saw numerous wars, precipitous market declines, and a real estate bubble, it is no wonder that investors still have a pessimistic attitude. The problem with a pessimistic attitude is, though over short periods of time it may prevail, before long people and economies recover. Dr. Nuriel Roubini (aka Dr. Doom) who correctly forecasted the real estate bubble has spent the last three years warning investors to stay away from stocks, only to reverse his position recently and become bullish! iv If you were to take any group of 100 financial advisors across any firm I d be willing to bet you d consistently find at least one gold bug. This is a person who most likely has spent their career essentially bearish, warning of pending inflation, too much money printing by the feds, overvalued stocks, and who suggests that clients consider buying real assets i.e. gold and silver. Yet year by year, markets move forward. Companies grow. As long as Coke sells a little bit more Coke this year than it did last, there is a good chance the stock will be higher. The gold bugs wait for the next shoe to drop and in the meantime, gold prices are down 34% from their highs v and the economy has improved. One of my favorite books is entitled The Rational Optimist by Matt Ridley. It was given to me as gift, and attached to it was a review by Bill Gates. In his review, Mr. Gates who through the efforts of his colossal not-for-profit charity sees more despair and poverty than most would in five lifetimes said There have been constant predictions of a bleak future throughout human history, but they haven t come true. Our lives have improved dramatically Too often this overwhelming success has been ignored in favor of dire predictions.. vi This theme is echoed in the book s introduction: Life is getting better and at an accelerating rate. Food availability, income, and life span are up; disease, child mortality, and violence are down all across the globe. Though the world is not perfect, necessities and luxuries alike are getting cheaper; population growth is slowing, Africa is following Asia out of poverty; the Internet, the mobile phone, and container shipping are enriching people s lives as never before. vii 1

2 As we near the end of 2013, I want to take this opportunity to explain why our outlook is positive and briefly reflect on what is happening around us that not only helps justify why markets have performed well this year, but also may portend to continued strength next year and could even lead to the resurgence of the American economy. This is not to say that risks do still not exist; they most definitely always do. However, rather than spending our time focused on all that could happen, let s spend a moment focused on what is happening. Stock Prices: The Dow Jones Industrial Average has gone from a low of 6,469 in March 2009 to closing at 15,558 at the end of October 2013, 140% higher, while the S&P has gone from a low of 666 (auspiciously) in March 2009 to closing at 1,758 at the end of October 2013, 164% higher. Given the tremendous run, it s natural to think stocks are expensive. However, on a relative basis stocks are trading 14% less than the 15-yr average price / earnings multiple, while at the same time dividend yields are 17.65% higher when compared with 20-year average. Translated: Stocks are not only relatively less expensive compared to historical averages, but also they pay more income. Corporate Strength: If we take the earnings from all of the companies of the S&P 500 (continuing operations formula, quarterly) divided by the number of total outstanding shares, we get a number that shows relative to other periods how much profit companies are making. Prior to the great recession, earnings per share last peaked in Q Compared to that time, Q earnings per share were 9.5% higher viii. 2

3 Furthermore, adjusted after-tax profits as a percentage of GDP and the ratio of total debt to total equity (total leverage) are considerably stronger than historical averages ix. Debt: A topic that seems to be on everyone s mind is the US debt situation. While there are certainly other factors to consider, namely the potentially damaging impact of future entitlements, consider this: Government Debt to GDP (that is the amount we are spending versus bringing in) has fallen from 10% of GDP to an estimated 3.9% in 2013, or a 61% drop x. Forecasts call for debt to stay in the 2-4% of GDP, inline with historical averages. 3

4 Strength of the Consumer: Clearly, the economy has struggled since the great recession, therefore balance sheets of consumers must be getting worse. Wrong! Household debt service, which is debt payment as a percentage of disposable personal income has fallen from 14% in 2007 to 10.4% xi, virtually lower than it has been anytime in 30-years. Again, falling stock and home prices must have dramatically impacted consumer balance sheets; not the case. Household net worth has risen 11% since Q xii. Perhaps tight-fisted consumers may be ready to spend again. 4

5 Housing and Real Estate: While the housing market has somewhat recovered, the cost of owning a home nationally (based on 20% down on an average home price with a prevailing 30-year mortgage rate) relative to the cost of renting is still considerably less expensive than it has been in the last 25 years xiii. US Oil and Gas Production: When I set out to write this newsletter, my first inclination was to discuss the longer-term implications of what an energy-independent America could mean for the United States. However, after further thought it made more sense to touch upon the current economy and save that topic for a deeper dive later. This is an area that in my opinion could be the single biggest game changer for the US economy in decades. 5

6 US Energy imports continue to shrink while domestic oil and natural gas production continues to grow. In fact, U.S. Oil production grew more in 2012 than in any year in the history of the domestic industry and according to the International Energy Agency the U.S. is expected to surpass Saudi Arabia in crude production by 2020 xiv. According to the Energy Information Administration, US Natural Gas production should continue to grow year over year through 2025 xv. In summary, with markets up significantly from their lows, now may seem a little late to take a rosy view. After all, investor psychology suggests that investors tend to buy high and sell low, so when investors begin to get to positive it is usually a good time to take pause. However, five years after the greatest market calamity since the great depression, investors continue to question the validity of the rally despite improving economic data. If the data continues to improve, interest rates will most likely rise, forcing investors to seek shelter from at risk bonds and underperforming fixed income assets, potentially setting up the next wave of stock buying. Improbable as it may seem, we could very well look back a year from now with another positive year under our belt. 6

7 As the great Winston Churchill once said A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. Though a positive outlook may not alter the future, it certainly may help. Nicholas J. Paget, CFP, CPM Wealth Advisor / Vice President Senior Portfolio Manager i Points, The Dow Jones Industrial Average Jumped More than 100. "Dow, S&P 500 Close at Record Highs." CNNMoney. Cable News Network, 29 Oct Web. 12 Nov ii Birinyi and Associates, comp. "Reminiscences." Market Commentary November (Nov. 2013): 8. Print. iii Valetkevitch, Caroline. "Dow Ends at Record High in Light Trade; Focus on Fed." Reuters. Thomson Reuters, 11 Nov Web. 12 Nov iv Lewitinn, Lawrence. "Roubini: Why I'm Bullish on the USA." Yahoo Finance. CNBC, 14 Oct Web. 12 Nov v Sim, Glenys. "Gold Tops $1,910 for First Time." Bloomberg.com. Bloomberg, 23 Aug Web. 12 Nov vi Gates, Bill. "Africa Needs Aid, Not Flawed Theories." WSJ.Com. Dow Jones & Company, 26 Nov Web. 12 Nov vii Ridley, Matt. The Rational Optimist: How Prosperity Evolves. New York: Harper, Print. viii Standard & Poor s, Compustat, BEA, J.P. Morgan Asset Management. EPS Levels are based on operation earnings per share. Most recently available 1Q13 as 2Q13 are Standard & Poor s preliminary estimates. ix Standard & Poor s, Compustat, BEA, J.P. Morgan Asset Management. EPS Levels are based on operation earnings per share. Most recently available 1Q13 as 2Q13 are Standard & Poor s preliminary estimates. x U.S. Treasury, BEA, OMB, CBO, J.P. Morgan Asset Management Federal budget is based on the CBO s May 2013 Baseline Scenario xi BEA, FRB, J.P. Morgan Asset Management. 2Q13 and 3Q13 household debt service ratio are J.P. Morgan Management estimates. xii BEA, FRB, J.P. Morgan Asset Management. 3Q13 household net worth is a J.P. Morgan Management estimates. xiii Census Bureau, J.P. Morgan Asset Management. Analysis based on median asking rent and median mortgage payment based on asking rate xiv American Funds from Capital Group. Building on a Boom: Energy Is Powering the U.S. Renaissance. Publication. N.p.: n.p., n.d. Print. xv EIA, J.P. Morgan Asset Management. Forecasts are from EIA Annual Energy Outlook and start in Dow Jones Industrial Average is a price-weighted index of the 30 blue-chip stocks and serves as a measure of the U.S. market, covering such diverse industries as financial services, technology, retail, entertainment and consumer goods. An investment cannot be made directly in a market index. S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. An investment cannot be made directly in a market index. Information contained herein has been obtained from sources considered to be reliable, but we do not guarantee their accuracy or completeness. The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. 7