Federal Reserve Supports Marietta's Positive Outlook for U.S. Economy and Stock Market

On March 21, the Federal Reserve Open Market Committee reiterated its positive year-end forecast for U.S. economic growth in 2014 and 2015. In a subsequent press conference, Fed Chair Janet Yellen stated that weak U.S. economic data in January and February was due primarily to bad weather and would pick up in coming months. She emphasized that "the Committee's views are largely unchanged" since December and confirmed the Fed's prior prediction of 2.8-3.0% GDP growth and 1.5-1.6% inflation in 2014. With this promising outlook, the Fed expects to continue its tapering policy to completion in September. It will proceed to raise its base short-term interest rate after a pause if inflation and employment data continue favorably.

Marietta's January 3 Outlook emphasized the importance of economic acceleration and corporate profit growth in extending the 5-year bull market through 2014. The 29.6% surge in the S&P 500 index in 2013 was driven in part by a 10.8% increase in S&P 500 corporate earnings but even more by an increase in the market's P/E valuation. This "multiple expansion" has resulted in a rise in the Index's current P/E ratio on trailing 12-month earnings to 16.5, which is above the last 10-year average of 14.7 We consider the market to be fully valued rather than overvalued, but we think a further advance should be fueled by earnings growth rather than multiple expansion. Hence, our bullish view relies on our favorable 2014 forecast of 3.0% GDP growth and a rise of 7-9% in corporate earnings.

We are encouraged by the 4th quarter corporate earnings reports released during the 1st quarter. According to Howard Silverblatt at Standard & Poor's, 64% of S&P 500 companies reported earnings above Wall Street estimates and an additional 11% met expectations. He also indicates that company research analysts are currently estimating an increase of 12.1% in aggregate operating profits for all of 2014. Assuming the S&P 500's P/E valuation remains constant through 2014, this increase in profits would reward investors with another year of double-digit returns. We think this scenario is reasonable because the market's valuation multiple is unlikely to contract as long as the expected return on money-market funds and bond alternatives remain unattractive.

A concern for some investors is that the Fed's statement is actually negative for the stock market because it hastens the date of an increase in historically low 0-0.25% short-term interest rates. We are not persuaded. The Fed has clearly indicated that it will not raise rates until it is convinced that economic growth has achieved healthy, sustainable growth, which in turn will increase investor confidence in further profit growth. Our view is that investors will not become excessively alarmed as long as inflation and interest rates remain below long-term norms of 2% and 4% respectively.

What is the Problem with Hedge Funds?

2013 was a miserable year for hedge fund relative performance. Bloomberg reports that only 16 large funds (those with assets over $1 billion) surpassed the Standard & Poor’s 500 Index as of October 31. Among the more popular approaches (asset backed, credit arbitrage, distressed, long/short equity, long-biased equity, merger arbitrage, equity statistical arbitrage), none provided an average return through October 31 of more than 11% (the S&P 500 had already surged 23.2% by this point).      

For the entire year, hedge funds on average reported a modest 7.4%, which paled in comparison to the 32.4% total return of the S&P 500 Index. These results are surprising. Despite vast intellectual resources, cutting edge technological capabilities, and headline-grabbing media exposure, hedge fund managers have saddled clients with mediocre or worse returns. 2012 was also a dismal year for hedge funds: an average return of 6.2% trailed a 15.9% gain by the S&P 500. The last time hedge funds outperformed the Index as a group was 2008. 

The persistent underperformance of hedge funds is in stark contrast to their continued popularity. Hedge fund clients poured in a net $71 billion as of the end of November, and, by the end of 2013 assets under management had risen to $2.01 trillion.

So, there are two perplexing issues. In addition to the relative underperformance surprise, there is the question of why investors still think hedge funds are such a promising investment. Compounding the paradox is that hedge fund clients pay hefty annual fees typically 2% to 3% of assets under management plus 20% of any returns. On the other hand, most investment advisory firms charge annual fees of roughly 1% of assets under management with no performance fees.