As we begin the second half of this year, let’s start with an overview of year-to-date performance patterns in the capital markets:
- The corporate bond market has returned around 2.6%
- The emerging-market bond market has returned 2.8%
- The high yield market has returned 2.9%
- The US Large Cap market has returned 7.1%
- The US Small Cap market has returned 3.2%
- The EAFE has returned 4.8%
- The Emerging Market has returned 6.1%
Looking ahead, the pace of GDP around the world is expected to pick up with Asia ex Japan expected to come in around 6.1% for both 2014 & 2015, the U.S. is expected to come in around 2.4% in 2014 and 4.3% in 2015, the UK is expected to come in around 3.2% in 2014 but contract a bit to 2.9% in 2015, Latin America is expected to come in around 1.8% in 2014 and 2.6% in 2015. This expected growth, coupled with low inflation, should keep the door open for the Federal Reserve and their counterparties to remain accommodative.
Here in the U.S. the expectation is that the housing market continues to recover, employment to improve, and that we will continue to see signs of personal consumption growth and business spending. Additionally, we continue to see a positive trend in economic indicators such as the Michigan Consumer Sentiment Index, National Association of Home Builders, and the US Purchasing Manager’s Index (PMI).
What does this all mean?
It appears that the markets currently are fairly or maybe even a bit over valued. However, there still seems to be some room for the market to continue to grind upward. A client recently asked if we see any bubbles out there. Without being facetious, we are always nervous when pondering short term cause and effect. For instance we do see a crowded trade in high yield bank loans which have seen just over 18 months of inflows from investors. We see similar signs in the corporate high yield arena where we feel investors have been reaching too far for yield. Our experience tells us folks are fine with the risk so long as results are positive but when things turn negative the tolerance for risk dissipates quickly and the knee jerk reaction causes the pendulum to swing too far. When it comes to the stock market, in our opinion, the price of stocks always follow earnings plus a premium for dividends. Over time, stock prices reflect how much businesses grow earnings, how much investors are willing to pay for those earnings, with a bit of premium for dividend income that is paid out. Given the well-above normal returns during the last five years, it is reasonable to expect stock returns to be lower going forward. We believe stock prices will be driven by earnings growth and not by expanding multiples (rising P/E ratios). Over the past few years, businesses have driven earnings by finding more and more efficiencies. We believe the growth in earnings going forward will depend on top-line revenue growth. With an expanding GDP in the US, we believe we will see that top-line growth. World-wide stocks appear to be valued at about the median historically as measured by P/E. The notable exception is the US where stocks appear to be in overvalued territory with P/E ratios in the top quartile historically. The reason stocks continue to do well, in our opinion, is that with yields low the hurdle that makes risky assets (stocks) more attractive than non-risky assets (bonds) is so low. This gap will close as bond yields rise but that is not expected until the 2015 – 2016 time periods. Furthermore, if the Fed does start to raise rates that should be interpreted as a sign the economy is healthier. Since 1970 stocks have outperformed their long-term average return in 12 of the 14 rising-rate periods. In short, we expect corporations to have more cash, to put that cash to work through share buy-backs and acquisitions; we expect margins to continue to improve, and cash flow to continue to improve. We think the environment continually favors small and mid-sized companies with good management. We also continue to seek active fund managers with a history of solid performance in markets where fundamental analysis and stock picking talent matters. We have in the past and continue to seek managers that rank high in “Active Share.”
Overall we believe the stock markets still have room to grow, we believe bond investors should proceed with caution especially when reaching for yield, we believe skillful stock pickers will separate themselves from the masses especially in the small and mid-cap areas, and we do believe in managers who manage portfolios that do not mirror their benchmark index. We are expecting some volatility as we approach mid-term elections but view that as short term noise. We continue to hold steady in our asset allocations and while we are always nervous we remain somewhat optimistic.