House of Sand
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I strolled Botany Bay today. You don't see it happen with the naked eye, but the ocean finely divides and grinds rock and minerals into what we know as sand. For now, the tide is out. The sun is shining. There is a cool breeze. Two little children build an impressive sandcastle. There was so much to be thankful for during this Memorial Day weekend, but as an asset manager, I can't help but think about investing.
Equity markets rose again in April, the tenth time in eleven months. Economic data remains soft, but positive, equity valuations are stretched but currently supported by record profit margins, and interest rates plumb historical lows with declining credit spreads. Black Cypress portfolios have risen an average of nearly 19% per year since inception.
Mathematically, the future set of returns available to us does not look as bright. Equity valuations imply low single digit returns over the next decade while fixed income securities are priced to lose money after inflation. Though, expected returns have looked low for a couple of years and that has not stopped the prolific rise in risk assets.
If valuations look stretched by both historical standards and reasonable estimates of value, why then are equity markets rising so productively? We think there are at least six reasons.
- Earnings have rebounded sharply. Negative real wage growth, low corporate tax rates, and record low interest rates, coupled with a recovering economy, have buoyed earnings per share sharply since 2009. Analysts expect reported earnings to hit $92 per share in June of this year, a new nominal record. As rising tides lift all boats, so too do rising earnings lift all stocks.
- Analysts are extremely positive on future earnings prospects. Earnings are projected to climb over 13% and nearly 12.5% in 2013 and 2014, respectively.
- The market appears reasonably valued to most investors based on these forward projections. If the S&P 500 actually earns $113 over the next year as analysts expect, the S&P 500 is trading for 14.6x forward earnings. According to David Kostin at Goldman Sachs, forward P/Es have had a median value of 12.9x since 1976 and 14.3x over the last ten years. Today's figure is elevated, but not excessively so.
- Slow economic growth and subdued inflation, coupled with an accommodative Fed, have driven risk-free interest rates to historical lows. Credit spreads have also tightened and pushed the prices of interest-rate-sensitive securities to record highs. This has made stocks relatively attractive compared to equity-alternatives.
- Housing–most individual's largest asset–is recovering. Rising house prices have historically had the greatest economic effect on an individual's feeling of wealth.
- The Federal Reserve blatantly stated it intends to prop up asset markets until a sustainable economic recovery is reached. This has eliminated much investor risk aversion.
The above has made for a pretty convincing case for equity markets to reach and exceed all-time highs. But while each point builds upon the other into what seems to be a credible case, the overall argument is specious.
- Over the course of a complete economic cycle, S&P 500 profit margins vary between 4% and 8%, historically averaging 6%. $92 per share will represent a profit margin of 8.4%, the second highest on record.
- Since 1957, nominal earnings have grown an average 6% per year. What is the likelihood that earnings will grow more than twice the average rate off of peak profit margins and peak earnings, while revenue growth slowed to 2.5% year-over-year in March 2013?
- Forward P/Es are a relatively new phenomenon. Historically, markets traded for an average 15x trailing earnings. If the S&P 500 does in fact earn $92 per share, the market is already trading for 18x trailing earnings on the highest earnings ever.
- Fixed income securities are priced to lose money in real terms and may experience nominal losses if sold before maturity. However, such poor valuations in fixed income do not eliminate the risk of loss in stocks. Historically, equities have lost value in one out of three years. Stocks lost over 50% in value during the last two bear markets. Overpriced fixed income securities will not save overpriced stocks.
- Housing's resurgence is unabashedly bullish. Record-low interest rates and tight inventories coupled with real house prices at early 2000s levels have greatly enhanced affordability. Though, price gains will likely slow over the next two years as inventory returns to the market.
- The Fed has embarked with an unprecedented policy response with little negative side effects to date. The real economy impact has been muted, while investor exuberance in credit and stock markets is apparent. There is significant risk in both the Fed overstaying their welcome and the Fed failing to effectively exit accommodation without reverberating impact.
The bull case for ever-higher stock prices is always built on logical fallacies. Like those kids constructing their fortress of sand, good times have a way of building overconfidence.
As I finish my stroll I return to find the tide coming back in and the same kids fighting a gallant battle with the ocean. As hard as they try, they will not be able to keep the ocean at bay. Steadily and without emotion, the ocean will swallow their hard work.
We do not yet see the tide shifting in the economic landscape. For now, the bull case will likely stand firm. But the tide will shift, the economy will sputter, and when it does, so too will that house of sand.
(c) Alan Hartley, CFA
Black Cypress Capital Management