Market Perspectives - January 2013
2013 outlook: Love risk by managing it
EquitiesBy John Manley, CFA, Chief Equity Strategist
Hero: “For us, there will never be happiness.”
We believe it is particularly hard to be an investor these days. The rash of forces that buffet the capital markets are potent and give little respect to logic and none to patience. Yet, in our opinion, both of these qualities—logic and patience—are essential requirements of successful investing. Those of us without clairvoyance must have a gimlet eye to draw the correct inferences from widely known facts and then patiently wait until the consensus arrives at our conclusion. We must be like a willful child who shouts: “I'm right and the rest of the world is wrong. Just you wait and see.”
At the end of 2012, most eyes were firmly fixed on Washington as politicians tried to avoid or avert the implementation of a series of tax hikes and spending cuts required by prior legislation. The U.S. is spending far more than it is taking in, and at some point this must stop. Government revenues must rise, government expenditure growth will need to ease, or some combination of the two must occur. The capital markets will force the issue if something is not done by our elected officials.
The topic of the fiscal cliff had a wide following but—like most things—a short shelf life. After the fiscal cliff, on what shall we focus next? The fixation and fascination with the fiscal cliff has highlighted one important issue but obscured a number of generally positive developments.
The dark consensusIn our opinion, there has been a lingering consensus haunting Wall Street since the end of the last major bear market four years ago: Sooner or later, we are going to have to pay for the excesses of the past 25 years. After two enormous bear markets, a world financial crisis, the U.S. housing crisis, the European peripheral sovereign debt crisis, and the rapid contraction of emerging markets growth expectations, investors have become cautious. There is an expectation of unpleasant surprises yet to come. As was the case in the last stages of the inflation-driven secular bear market of the 1970s, we perceive and understand the problems; we just don't know their solutions. Investors believe that valuations should be low compared with risk-free instruments because they do not see a clear path to growth. The equity market may rise and fall with our changing perception of the timing of the next problem, but a problem is always somewhere on the horizon, waiting for a catchy name.
Thus, expectations remain low and buyers continue to be skeptical. Bad news was expected in some form and, therefore, seems to have less of a negative effect on stock prices. Thus, the fiscal cliff is merely the latest in a series of unpleasant oddities anticipated by our anxiety.
The good things we are missingWe had expected a range-bound market in 2012 as the equity vigilantes forced their way on reluctant politicians around the world. Further, we had hoped that stocks would end the year near the upper end of a trading band as progress was made in dealing with an economy struggling to grow. However, the markets performed better than expected because real progress occurred on many fronts. Some of the progress can be attributed to the activism of the capital markets while some can be attributed to their normal functioning. For whatever reason, a number of improvements occurred in 2012 that should continue into 2013.
1. The Fed: In our opinion, one of the most important (but not the only) drivers of stock market performance is the stance and actions of the Fed. When the Fed is creating liquidity, or pushing it into the economy, that liquidity tends to drive up asset prices. Equities are not the only potential beneficiary of central bank largesse, but they do tend to be high on the list unless counteracted by a strong negative shift in fundamentals or expectations. Given our perception of already low and cynical expectations, and given our observation that earnings are not under inordinate downward pressure, we would expect the Fed 's actions to be a plus for equity prices in the year ahead. Of course, Chairman Bernanke is not targeting stock prices directly. Still, if the various easings that the Fed has engineered are to have a positive effect on the economy, we suspect they will have done so because they increased our perception of the amount of our wealth or our confidence in the safety of that wealth.
2. Europe: The old world seems to be dealing with its problems. Perhaps driven by the impatience of the capital markets, the actions of the European Central Bank and the statements of its president seem to have tightened the bands that hold the eurozone together. Progress may be slow and halting, but there is progress. In addition, we suspect that, just as the effects of fiscal austerity further cut into European economic growth prospects, the political landscape may allow that austerity to become less austere or, at least, to be spread out over a longer period of time. We believe that Europe's fundamentals may be bottoming and that its capital markets may be following suit. As is typical, markets may move ahead of the fundamentals (markets are supposed to be forward-looking, after all).
3. China: Skeptics have been predicting the Chinese bubble has been about to burst for years. While there are many clear examples of excess, there is also still a great deal of unrequited demand. It appears that the central government's focus on improving the lot of its less-fortunate citizens is beginning to have an impact. China's industrial production seems to be accelerating along with retail sales. We expect China to add to world growth in 2013 and would be open to investment in Chinese equities, especially those exposed to the industrials and consumer sectors (the banks are a bit too opaque in their accounting for nonperforming loans for our tastes).
4. Earnings: We believe many investors are aware of the high levels of profitability currently enjoyed by S&P 500 Index companies and are skeptical of future earnings growth. Profit margins may eventually revert to the mean, but that can take some time, and the mean can change in the interim. We find it hard to believe that corporate earnings are permanently peaking with the world's economies in such a depressed state. Once corporate managers get a sense of what the rules will be, we think that corporate cash can be put to work. We believe that profits can continue to positively surprise in 2013 and beyond. At some point, the lesson will be learned and investors will apply a more normal multiple to earnings as the fear of their imminent decline abates.
5. Valuation: The S&P 500 Index's price/earnings (P/E) multiple at the end of 2012 was a little over 12.5 times consensus forward earnings. That equates to an earnings yield of about 7.9% versus the 10-year U.S. Treasury note yield of slightly more than 1.7%. While not extreme, this valuation is well below the normal 14 times to 18 times valuation band of the past 50 years. In our opinion, it reflects the anxiety of impending economic contraction and the fear of future earnings decline. It also implies the potential for multiple expansion (if only to normal levels), should earnings continue to rise and the world begin to lift out of its economic torpor.
The bad things that could happenMassive amounts of debt still overhang the developed world. Europe is gradually convalescing, but the process will be a slow and unsteady one. Over the course of 2013, we will have to deal with elections, bond auctions, and intergovernmental negotiations. Expect frightening headlines from Europe and you will not be disappointed. The U.S. federal government will try to raise revenues and cut expenditures. This has to be done, but it will surely impede domestic growth for some period. Legislative gridlock on a number of matters seems likely. Expect greater regulation to affect the financials, energy, and health care sectors. The debt ceiling may cause concern about our credit rating. In short, the issues already being felt may brew up again and give us headline risk.
Equity conclusionsWe continue to favor growth over value and large over small. We believe that the demographic necessity for yield and predictable growth will continue to impel investors into high-quality stocks with 2%–4% yields that have good cash positions, strong cash flow, and visible growth prospects. Yield is a precious commodity these days, and growth has become even rarer. High-quality bonds no longer offer the yields they once did. Eventually stocks could fill that void.
For the time being, our favorite sectors remain unchanged from our 2012 mid-year outlook. Health care is no longer a great value, but the sector currently offers noncyclical visibility and strong cash flow. Technology has been hurt by the European exposure of many of its companies, but the sector now trades at a P/E discount to the S&P 500 Index. Europe may be experiencing its worst weakness now, and the corporate technology upgrade cycle does not appear complete. Energy is our value play. We believe the development of natural gas resources in the U.S. will be complicated but ultimately successful. Outside the U.S., we expect that high exploration and production costs for additional oil will support the price of the commodity. We also like the financial characteristics of the large integrated oil companies.
With Europe in a recession, and likely to stay that way throughout 2013, investors may be a bit too glum on European and emerging markets equities. We think Europe could be host to—and the source of—volatility, but with austerity becoming less austere, investor confidence could improve. Emerging markets declined in sympathy with Europe as the developed world tends to be big buyers of emerging markets goods and services. Some emerging markets have slightly shifted away from export-dependent growth and their economies—and markets—could advance nicely. We don't encourage an overweight to either Europe or emerging markets, but we do like a selective normal weight to both areas.
Chart 1: Consensus estimate of next 12 months, earnings per share of the S&P 500 Index