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.

Emerging Economy Stocks Rebounding

12 months iShares MSCI Emerging Markets (EEM) vs. S&P 500 Index. Source: Yahoo! Finance, May 29, 2014.

Emerging economy stocks as a group are booming. In the week of May 21, emerging market stocks attracted another $1 billion of inflows even as U.S. equity funds saw withdrawals of $10.9 billion. This data comes from EPFR, a company that tracks the flow of money into and out of world stock markets. The firm adds that this weekly addition marks the seventh week of net inflows in the past two months. From February 3 through May 23, the iShares MSCI ETF for emerging markets (EEM) has soared 16.2% whereas the Standard & Poor's 500 Index has risen 9.1%. Leading the emerging markets higher has been India, where the expectation of favorable national elections propelled its market to a gain of 32.2% during this period. The popular ETF for Brazil (EWZ) rocketed 25.8%. The question for investors is whether these emerging markets will continue to advance and to also outpace U.S. stocks.

This surge in emerging markets has surprised many investors due to the widespread assumption that the Federal Reserve's "tapering" policy, now in its sixth month, would damage emerging markets. This view goes back to the announcement on May 22, 2013 by then Chairman Bernanke that an expected pickup in the U.S. economy would permit the Fed to wind down its policy of purchasing $85 billion of bonds per month, which had been designed to put downward pressure on long-term rates and support the mortgage market.

Bernanke's statement had an immediate and dramatic impact: U.S. bond yields rose and the dollar strengthened against many emerging currencies. This in turn led to fears that currency, inflation, and interest rates would rise, economic growth would slow, capital outflows would increase, and equity markets would decline in some key emerging countries. In the month following Bernanke's remarks the EEM plunged 14% whereas the S&P 5900 Index declined only 4.7%. Conditions continued to deteriorate during the summer, which in late August prompted Christine Lagarde, Managing Director of the International Monetary Fund (IMF), to warn the Fed to be highly sensitive when initiating its tapering policy to a possible adverse reaction within emerging countries.

At this point, the EEM has managed to recoup all of the losses incurred since Bernanke's speech a year ago, yet the EEM's gain of 1.2% trails the 15.1% advance of the S&P 500 Index over the last twelve months. It seems obvious that the Fed's tapering policy, on its own, is no longer sufficient to cripple emerging markets. On the other hand, it appears that it is when tapering combines with other developments to drive the yield on the benchmark 10-year U.S. Treasury notes and the dollar up, as was the case in mid-2013, that there is a negative causal impact on emerging markets. Since February 3, the opposite has happened. The yield on the 10-year Treasuries has fallen slightly from 2.58% to 2.53%. Also, the net asset value of the PIMCO Emerging Markets Currency Fund (PLMIX) has risen from 9.87 to 10.37, a gain of 5.1%.

The Marietta economic outlook includes a probable rise in the 10-year Treasury yield as the U.S. economy continues to strengthen in the second half of the year. If this occurs, and is accompanied by a rise in the dollar vs. emerging currencies, there will likely be a sterner test for emerging stock markets. This would especially apply to those countries with a recent history of inflation and currency woes (India, Brazil, Indonesia, South Africa, Turkey, et al.). On the other hand, from a fundamental perspective, a stronger U.S. economy and rising U.S. stock market may well be viewed as a positive for emerging markets in that it will increase investor confidence in the global economic growth scenario and boost their willingness to invest in the perceived higher risk associated with emerging markets. This is what happened in the booming markets from 2003 through 2007.

Our conclusion is that it is appropriate for investors to increase modestly their exposure to emerging country stocks in the currently more favorable conditions. If the U.S. economy strengthens and longer term interest rates rise, as we expect, and key emerging market stocks continue to rise, then a larger commitment is justified. An important caveat: not all emerging economies will react similarly to propitious conditions. China, for example, has a unique set of conditions such that Federal Reserve policy changes and interest rate fluctuations will likely have a reduced impact on its more insulated economy and markets. We recommend countries which are expected to experience an improved mix of accelerating GDP, stable or rising currencies, stable and preferably declining inflation and interest rates, and a growth-oriented government and central bank.