I think most investors would agree that as the year began they did not expect the Standard & Poor's 500 to have risen 27% by Thanksgiving. Stocks have continually worked their way higher with the only meaningful corrections occurring in June, August and October when the talk of reducing the $85 billion a month monetary easing program picked up (June, August) and the government shut down (October). All of this has taken place without the help of especially strong earnings or declining interest rates. The U.S. economy has struggled to grow at 2% and the much-anticipated year-end acceleration has failed to materialize. The individual investor has become less enchanted with bonds and has been buying stocks, but it has not yet become a tumultuous shift. Corporations have been purchasing their own stock back, but nothing much beyond normal levels. Washington continues to be dysfunctional so nothing has happened there to increase confidence. Geopolitical issues have improved, but we are not yet at a point where we can feel comfortable about the Middle East, Europe or the South China Sea.
I continue to believe that the monetary expansion of the Federal Reserve was a major factor in the appreciation of equities this year. In my view, about three-quarters of the $85 billion a month of the bond-buying program flows into financial assets rather than the real economy, so the program is a very inefficient form of economic stimulation. The main effect of the expansion is to move stock prices higher and keep interest rates low. If you assume that of the $85 billion, 75% goes into financial assets, that's about $63 billion. If 75% of that goes into equities that's $47 billion. The average daily dollar volume for the New York Stock Exchange and the Nasdaq is about $34 billion. Assuming 22 trading days a month that's $748 billion. The $47 billion seems like a minor factor influencing the stock market, so it must be the confidence the monetary easing engenders that propels the market higher. We saw a hint of that when Ben Bernanke said he was thinking of tapering and confidence declined.
"Renewed confidence has been reflected in mutual fund flows. Up until this year investors have been more favorable toward bond funds, but the strong performance of equities in 2012 and so far this year has changed the mood. As a result, through October flows into U.S.-oriented equity mutual funds have been $20.2 billion and international equity funds have gotten $113 billion, while bond funds have experienced withdrawals of $39 billion. Institutional investors also have been more willing to take the cash they have had in reserves and put it into equities. The prevailing view seems to be that as long as monetary policy is accommodative, stocks will keep rising. In the view of most investors, valuation is not yet a problem. The S&P 500 is selling at less than sixteen times earnings, a long way from the excessive multiple levels of 2007 and 1999. Fifteen times is the long-term average.
The bear market of 2008-9 was caused by the sub-prime mortgage crisis and the recession it produced. Interest rates were low when the decline started and they stayed low throughout the rise in the market. In this cycle, which has lasted 56 months, the S&P 500 has risen 166% with 106 points coming from earnings improvement and only 59 points from multiple expansion. Based on history, the current bull market is already aging and with most observers expecting interest rates to rise, there is not much chance for further multiple expansion. These factors would argue for limited upside.
While the U.S. economy has continued to plod along at a growth rate of 2%, and earnings and revenues for the S&P 500 had been increasing at 2% and 2.5% respectively, there has been some improvement since October. Earnings and revenues are now increasing at 5% and 4%, respectively. While this does not yet confirm the acceleration that many were expecting for the second half, it does reflect a more positive business environment. Earnings for the S&P 500 for 2013 are running at a rate of about $105. The consensus estimate for 2014 is about $120. I have been skeptical about an increase of that magnitude with profit margins at a high and revenues increasing modestly, but if the present favorable trend continues, earnings may turn out to be stronger than I had thought.
I was originally planning to write about the emerging markets this month. Equities for these countries have been doing better since the summer, but overall, the performance in 2013 has been disappointing. The economies are still growing, but their rate of growth has slowed down substantially and this has cooled off investor enthusiasm. Their GDP is expanding faster than their developed country counterparts. China is expected to grow at 7.4% in 2014, India at 4.5%, Brazil at 2.3% and Mexico at 3.5%. Emerging markets are 45% of world GDP, however, and, in my view, they are going to increase their importance going forward. The standard of living in these countries is rising in contrast to the developed world and that should provide numerous investment opportunities in the future. It is just hard to know when these markets will start to perform again.
There is reason to think important changes are taking place in China. The November Third Plenum proposed a number of reforms. The country is shifting toward market-driven pricing for fuel and pharmaceuticals rather than state control. Eventually even the currency could float. The one-child policy will be relaxed over time. The hukou system, which deprived migrant workers of the ability to transfer social welfare benefits from their home town to their new place of employment, is in the process of change. State-owned enterprises will set aside 30% of their profits for programs like social security and healthcare. The result of these initiatives will be a shift in the balance of the economy from an export orientation to internal consumption. Instead of providing favorably priced goods to the United States and buying our Treasury securities, China may become the most important customer for our manufactured products. Xi Jinping, China's President, has the power and political base to make this happen. Let's see how long it takes.
After an initial surge of enthusiasm about the effects of Shinzo Abe's first two "arrows" of fiscal and monetary stimulus, investors have become skeptical about the third arrow which is a growth strategy based on deregulation, increased competitiveness and innovation. The major impediment to the success of the growth plan is Japan's aging population and declining workforce. Abe has already accomplished more than his critics thought he could, so perhaps further favorable surprises are ahead.
This is the time in the year where everyone is speculating about the prospects for equities in the year ahead. As usual the consensus is that the market will be up 10% in 2014. I have been an observer of strategists' estimates for half a century and I can tell you that as a group they always think the market will be up 10% in the following year whether stocks were up 20% or down 20% in the previous year. What nobody seems to be talking about is the possibility of a "fat tail." With the uncertainties surrounding Obama's Affordable Care Act, and the risks of the initiatives in Syria and Iran taking a turn for the worse, profit margins peaking and earnings falling short, the downside is certainly not out of the question.
As for the positives, the tone of economies around the world is improving, individuals are coming back into the equity market, share buy-backs continue, merger and acquisition activity is picking up, growth in Europe is getting better, the decline in oil prices increasing consumer purchasing power and interest rates are likely to stay low because of a reduction in bond offerings. This could produce another year of strong stock market gains. At this point I don't know which of the "fat tails" is more likely. While investor optimism is approaching extreme levels on the positive side, which is a warning signal, stocks don't appear to be melting up yet. I just have a feeling that 10% appreciation won't be the number at year-end 2014"'.
Source: Caijing.com Reflections at Year End, by Byron Wien
