The Positive Case for the U.S. Stock Market Revisited

We remain optimistic regarding prospects for the U.S. market, but with a more elevated level of caution.

Coming into the year, we forecasted 2014 U.S. GDP growth of about 3%, which we expected to result in Standard and Poor's 500 (S&P 500) corporate profit growth of 7-9%. In a fairly valued but not overvalued market, we projected further that this profit growth would result in a corresponding 7-9% gain for the S&P 500 Index in 2014 (see Marietta's Jan. 3 Outlook).

Since the beginning of the year:

• The U.S. economy suffered from a weather-impacted -1.0% first quarter GDP setback, which has reduced the consensus (and our) 2014 GDP growth estimate to 2.4% ("The Economist" June 14, 2014).
• The underperformance of the U.S. economy year-to-date has lowered corporate profit estimates for 2014.
• Despite reduced 2014 economic growth and profit expectations, the S&P 500 Index has advanced 7.1% through June 23.
• The fully-valued stock market is stretched further with corporate profit estimates coming down and the market moving up. Howard Silverblatt, S&P 500 Senior Index Analyst, reports that the consensus of Wall Street analysts estimate the forward P/E ratio of S&P 500 operating earnings to be 16.1x versus a 10-year historic average of 14.8x. Bloomberg (June 12) adds that 70% of S&P 500 stocks currently sport forward year P/E's above this 10-year average, raising concerns for the market's valuation.

We emphasize that there are many other factors influencing the market in addition to corporate profit gains and valuation. Among the offsetting positives are:

•  The economy is rebounding from the first quarter downturn, as reflected in strong employment gains and healthy Purchasing Manager Indexes (PMI) for both manufacturing and services. The result could be a surprising boost in corporate earnings.
• The Federal Reserve remains highly accommodative, further supporting the economy and financial markets.
• Although 2014 profit estimates have been coming down, first quarter earnings were not as bad as the negative economic growth would suggest, and research analysts remain highly optimistic for the year as a whole. Deutsche Bank reports that although first quarter GDP was negative, S&P profits actually gained 5% (June 6 "U.S. Equity Insights"). During this difficult first quarter, 335 (67.3%) of S&P 500 companies beat Wall Street expectations. For all of 2014, Silverblatt notes that "bottom-up" consensus analyst profit growth estimates for the S&P 500 Index remains a lofty +11.5%. We remain comfortable that our +7-9% projections for both profit gains and market gains will be matched or exceeded.
• With regard to valuation, we observe that the market's P/E ratio historically has been higher in periods of low inflation and interest rates. Strategas research informs us that since 1950, the average P/E ratio in periods with 0-2% inflation is 17.9x, whereas 4-6% inflation is associated with an average P/E of 14.7x. This diminishes the concern that the market is currently unsustainably overvalued. Indeed, there is also the distinct possibility that there could be more market multiple expansion reflecting a continuation of 2013 trends.
• Corporations are still sitting on a mountain of cash, which is being used to fund M&A activity, dividend increases, and stock buybacks, all of which elevate the overall market.
• Stocks remain highly attractive relative to low- or zero-yielding money market and bond competitors. The Investment Company Institute (ICI) report for April shows $2.573 trillion on the sideline in money market funds that could help fuel a further stock market advance.

Our conclusion is that the positive case for stocks is still intact, but the rising valuation of the market increases its vulnerability to an economic or geopolitical surprise. Investors will need to be cautious and flexible.

Bond Fund Buyers Beware

Proposed Bond Fund Fee Highlights the Unappreciated Risk in Bond Mutual Funds

Readers of the Financial Times were confronted yesterday with a front-page article headlined, "Fed Fears Over Bond Fund Run." According to the article, the Federal Reserve, increasingly concerned about the vulnerability of the bond market, particularly bond mutual funds, is considering an unprecedented move to impose exit fees on bond fund owners looking to redeem their shares.

The Financial Times highlights the problem facing the Federal Reserve:
 

“Officials fear that bond funds are becoming ‘shadow banks’, because investors can withdraw their money on demand, even though the assets held by the funds can be hard to sell in a crisis.”

“. . . U.S. retail investors have pumped more than $1 trillion into bond funds since early 2009. This has created a boom for fixed-income money managers, but raises the prospect of a massive disorganized flight of money should interest rates rise sharply.”

The goal of the proposed fees is to discourage this mass exodus from the bond market and prevent a bursting of the bond bubble. This is an important acknowledgement of the significant risk that should have been apparent to investors who parked assets in bond funds for their perceived safety. We think the Fed's fears regarding bond mutual funds, a favorite investment of many wealth management firms looking to safeguard clients' "sleep-at-night money," are warranted.

It is important to note the distinction between bond mutual funds and actual individual bonds. Mutual funds that invest in bonds, even the safest bonds, carry a risk that owners of individual bonds avoid. Under normal circumstances, if an investor in the bond fund wants to sell, the manager can use the money from a new investor to pay to seller without selling the underlying bond. However, when there are more sellers than buyers, the fund is forced to sell the bonds to make up the difference. Bond investors are accustomed to the two main risks in this sector: the bond may default and the value may decline if interest rates rise. But a run on bond funds is a particularly acute problem for those invested in them. The bond fund market has ballooned to over $10 trillion with an increasing proportion of those assets from retail investors. A sharp rise in interest rates, which many economists and financial commentators consider a matter of when rather than if, could trigger a panic and a rush of bond fund investors looking to sell. If this run on bond funds happens, fund managers will have to sell, potentially at steep losses, and fund investors will find that the value of their investments was far less secure than they thought. Unlike bond funds though, limiting fixed-income investments to individual bonds, which Marietta advises for clients, gives investors the option to hold the bond to maturity and receive the bond's par value. Bond mutual funds never mature and during a run its investors are left to the mercy of the market.

While the Fed is concerned about the effect such a sharp rate rise will have on the broader economy, its targeting of bond mutual funds should serve as a warning to bond fund investors. Bond mutual funds carry unique risk in a time of historic, artificially inflated bond prices. Wealth managers who view these investments as secure based on the quality of the bonds in the fund ignore, to the detriment of their clients, the market risk inherent in these investments. Marietta aims to protect clients against the traditional risks of bonds by holding short maturity, high-quality bonds, and we have consistently advised against holding bond funds rather than actual bonds because of the potential illiquidity of the fund shares. That the central bank is even considering such an extraordinary control over the bond fund market reinforces our conviction that bond mutual funds expose investors to heightened and inappropriate risks, especially those investors looking to reduce risk by investing in bonds.