Friday, February 21, Dear Valued Clients and Friends,

Transcription

1 Friday, February 21, 2014 Dear Valued Clients and Friends, Another week behind us, and with it, the vast majority of earnings season is complete (though some results will continue to trickle in). I spend a lot of time in this week s commentary talking about the role of earnings in the present environment AND the ultimate environment in which equity prices live. I also talk about why the big picture economy matters more sometimes than others. Be prepared for a very long commentary next week. Off we go Executive Summary My top points of the week (noted with an asterisk (*) in the commentary) 1) It will be very difficult in my opinion for the returns of the stock market in the next five years to equal what they have been the last five years as P/E ratios STARTED so low five years ago (vs. the normal levels they are at now). 2) The market right now is in an interesting flux. Earnings were quite good; macro economy is quite questionable 3) Generally speaking, earnings always and forever trump EVERYTHING (including the macro economy) when discussing stock prices. However, I believe the macro economy is likely to be more important TO THOSE EARNINGS in the year to come. 4) Total leverage in our society is: a) WAY down for corporations; b) SOMEWHAT down for individuals; and c) WAY UP for governments. 5) Bond portfolios need exposure outside the United States (whether it be emerging, global, sovereign, corporate, etc.) because there is just too much opportunity out there NOT to diversify and create new opportunity sets. * Will the next five years of broad stock market returns look like the last five years? You can t ever say never in my business, but let s just say that I would find that to be highly unlikely. Five years ago earnings were at a trough, and P/E ratios were barely above 10. Today earnings have almost doubled from that level, AND P/E ratios are back to historical averages (let s call it 16 on a forward P/E basis). When one looks at the great run in the market from 1996 until 2000 we saw P/E s START at 16 and get up to the high 20 s before the crash of 2000 began (1). I simply do not see P/E ratios floating to that stratospheric of a level. I believe SOME multiple expansion is possible in the next five years, and I believe continued earnings growth is likely (but at a more modest pace). This forecasted environment would lend itself to an equity market that is positive, but not at a torrid pace, and not without volatility and fluctuations such as what has been typical by any historical evaluation for decades. * With the earnings results of Q4 mostly in now, do you feel prepared to report card the state of the stock market now and where you are going with your allocation positioning in the coming weeks and months? In a sense these results have netted out so far how I would have expected: Earnings results were not disastrous, and in fact are the reason the market rebounded so much after a dropoff earlier in the quarter. Earnings were better than forecasted for more companies than forecasted, and revenues frankly were a surprise too. The issue is that revenue guidance going forward was not stellar, which simply begs the question of where we will be in late

2 April as earnings season starts for Q1 of this year. It seems to me the bottom-up earnings situation has temporarily taken a backseat to the MACRO environment (overall economy, GDP growth, emerging markets currency woes, manufacturing, retail, housing starts, etc.), and the embedded volatility of such metrics likely spells more volatility for equities for a little while. I am keeping my overall allocation across various risk profiles and custom portfolio models where they were to start the year (for the time being), and I am neither increasing nor decreasing the very modest amount of dry powder I have reserved to take advantage of any meaningful dip/correction we may get. * So are you ultimately more interested in the earnings results of the market (and companies you own) or the overall macro environment of the economy and its effect on stock prices? The macro economic environment is not totally divorced from the earnings results of the market, in that most investors seem to buy into this basic syllogism as it pertains to where stock prices will go next: 1) In order for stock prices to advance, earnings growth will have to continue to impress 2) In order for earnings growth to impress, either costs have to come down and margins improve OR top-line revenues have to increase. 3) Costs have already come down so much and margins already improved so much that for #2 to materialize it likely will have to be on the back of revenue growth. 4) For revenue growth to materialize you will need an improving macro economy. 5) THEREFORE, the state of the macro economy in 2014 will determine if we get the earnings growth we need to justify higher stock prices. Please note in this way of thinking that I am not abandoning the immutable law of investing that ultimately stock prices are functions of earnings. Investors cost themselves a LIFETIME OF OPPORTUNITY when they mistook the poor economy of 2009 and 2010 and 2011 as signs of a stock market to be avoided; in that case the economy was poor and the earnings growth of the market was simply incredible. All I am suggesting now is that earnings growth will be unlikely to impress in 2014 and 2015 without a macro-economic environment that is growing. So how do you measure an improving macro economy? I do prefer to see a better GDP growth number, and this has eluded us for over five years now. I would be highly encouraged by anything above 3.5% (which will be a stretch, I fear), and I would be quite disappointed if we cannot even get above 3% for the year. Somewhere between 3% and 3.5% is where I am unsure how to read it. I also would add that REVISIONS to GDP numbers from past quarters is very important. What I do not look at with much significance as it pertains to the overall economy is the current headline unemployment number, based on its inability to reflect quality jobs, and labor participation force. I do not look at housing starts fluctuations as having a lot to say about the real health of the economy. Manufacturing data and industrial production is quite significant. Keep in mind, too, that ALL of the data matters, and much of the data is useful to me in my BOND allocation work, as it gives me a feel for the inflationary environment we find ourselves in and the types of data I believe the Fed to consider important in their analysis. I am simply answering above where I find the low hanging fruit for analyzing the forward health of the overall economy. * Are you not worried about the total leverage in our society?

3 Let s define leverage as the percentage of total debt to total equity. The S&P 500, for example, has seen its debt-to-equity ratio drop essentially in HALF over the last five years (from over 200% to right around 100%). This is a stunning DE-leveraging in corporate America (2). Total household debt has declined as well, with mortgage balances and credit card balances all down from where they were, and household net worth up as stock portfolios and 401k s have improved, etc. Savings is still low (based on where this NON- Keynesian would like to see it), but I digress. So the total leverage I fear is not so much in corporate America or individual households; it is in sovereign debt - the federal government, state debt, county debt, city debt - and I should add, the sovereign debt of FOREIGN countries as well (perhaps much more so). So the answer to the question is: Yes and No. We have one side of society deleveraging, and one side leveraging up. A tale of two cities, indeed. Do you see big similarities between what happened to our economy and banks in 2008 and what Japan went through in the early 1990 s? I do believe there were some similarities, particularly in that both events were caused by a crazy asset bubble that had to burst. I am defining a housing bubble as something that defies valuation common sense, and then some. Japan had a real estate and stock market bubble many times over, and it burst, and burst badly. We had a housing and credit bubble that burst badly. But the focus on similarities is trumped by the focus on differences, most notably this one: Japan never acknowledged that their banks were holding bad debt - they didn t write it down - they didn t raise capital. They were in denial, and that led to a society of zombie banks and total economic dysfunction. I have a million things to say about our own financial crisis and what caused it and what was done well and what was done poorly after the crisis (I have a long list on both counts), but we did not pretend our banks were not impaired. They took on massive write-downs, and raised massive capital. The economy in Japan suffered mightily after their crash because of their denial. That was a big difference. How should a financial system deal with losses? One of the economic truisms I have learned is that losses do not happen when banks write them down (or when a business writes down its own loss in a particular investment); they happen WHEN THEY HAPPEN. Bad news does not get better with age. A loss has either happened or it has not, and to me, as a big believer in wise allocation of capital, the more honesty and transparency in the numbers, the better. Hiding from losses creates more bad investment and delays recovery. What fixed income asset class is cheaper - High yield bonds or leveraged loans (floating rate)? Neither are particularly cheap, as spreads are roughly basis points less than their 20-year historical averages. However, neither are anywhere near their peak valuations either, and spreads should be a little compressed right now given the very low default environment we are in. To re-state this paragraph in English, the cost of junky corporate bonds and the cost of bank loans RELATIVE TO TREASURIES is higher than its historical average, but lower than other points it has seen. * Why do you believe Global bonds have become such an important addition to a fixed income portfolio?

4 In 1989 U.S. corporate and sovereign debt represented 62% of the total worldwide bond market. Today, it is 42%. Developed countries around the world (so excluding the United States and emerging markets) were 38% of the global bond market, but now make up 54% (3). This simply means we ignore fixed income opportunities outside the United States at our own peril. Could the stock market end the year up 8% or more even if we drop 10% or more along the way? The answer to that question is not just a simple yes ; it is that that is what NORMALLY does happen. Of the 27 years that were positive in the S&P 500 out of the last 33 years, in all but a mere three of them did we drop 7% or more along the way to a positive return (4). GLOSSARY Sovereign Debt Debt issued by a nation. In the United States we call sovereign debt treasury bonds (or treasury bills if short term). QUOTE OF THE WEEK If I have seen further it is by standing on the shoulders of giants. - Sir Isaac Newton * * * * * * * I head out to New York on a red eye Sunday night and will spend next week there in client review meetings, in a few specific money manager meetings, in a couple company meetings, and THEN for a weekend with my wife. I always love New York City, and I always love my wife, but I really love being with my wife in New York City. In the meantime it will be about five straight 18-hour days. Next Friday will feature the end of the market month for February and a rather extensive commentary. Have a great weekend, and go USA! With regards, David L. Bahnsen, CFP, CIMA Managing Director, Wealth Advisor The Bahnsen Group at Morgan Stanley Senior Portfolio Manager (1) JP Morgan Asset Management, Q1 2014, Guide to the Markets, p. 4, S&P 500 Index at Inflection Points (2) JP Morgan Asset Management, Q1 2014, Guide to the Markets, p. 8, Corporate Profits and Leverage (3) JP Morgan Asset Management, Q1 2014, Guide to the Markets, p Global Fixed Income (4) JP Morgan Asset Management, Q1 2014, Guide to the Markets, p. 16 Annual Returns and Intra-Year Declines 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.

5 Information contained herein has been obtained from sources considered to be reliable, but we do not guarantee their accuracy or completeness. International investing may not be suitable for every investor and is subject to additional risks, including currency fluctuations, political factors, withholding, lack of liquidity, the absence of adequate financial information, and exchange control restrictions impacting foreign issuers. These risks may be magnified in Emerging Markets. Asset Allocation does not guarantee a profit or protect against a loss in a declining financial market. 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. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio. Asset Allocation does not guarantee a profit or protect against a loss in a declining financial market. 02/14