Permanent Value

Week in Review 8/5/13

Bruce Doole
August 5th, 2013

Second Quarter 2013 Market Review & Outlook

Whenever an especially strong consensus emerges among money managers and the media, look for the economy and markets to move the other way. Near the end of the Great Recession and associated global bear market, it was near-universally believed the U.S. economic recovery would be a sluggish one characterized by newfound frugality among consumers.

Domestic stock market returns—according to this “New Normal” script—would be locked in the single-digit range, with the most attractive prospects for equities and economic growth residing with emerging world economic powers like China and Brazil.

Students of contrarian opinion theory know that the more widely such storylines are embraced, the less likely they are to occur. While the “New Normal” hypothesis hasn’t been entirely off-base from an economic perspective (i.e., a sluggish U.S. recovery, compared with solid growth in emerging economies), its investment implications were way off the mark. Far from the single-digit prospects projected near the 2009 lows, U.S. stocks have gained about 150% in a market surge that has now lasted longer (52 months) than three quarters of all cyclical bull markets since 1900. The MSCI Emerging Markets Index, in comparison, has gained 99% from its low, while the rest of the developed world is up only 71%. China’s Shanghai Composite has recently flirted with its late-2008 bear market lows.

The superiority of U.S. stocks during the current bull market hasn’t gone unnoticed, and we’ve begun to wonder whether a new and potentially dangerous consensus has been building surrounding U.S. economic and stock market resilience. Although U.S. stock market valuations aren’t yet in “bubble”, they have climbed to levels seen at many important bull market highs. And, our long-term return estimates for U.S. stocks (which have proven of limited value in the short run, but extremely accurate over periods of seven to ten years) have dropped to the 5-6% range.

Even though U.S. stocks look mildly to moderately overvalued on most of our measures, the environment is shaping up as one in which stocks could become even more overvalued before finally topping out for this business cycle. Enthusiasm for stocks, however, remains constrained, particularly considering the huge four-year gains already on the books and the near-daily occurrence of new highs during much of 2013. Net inflows into domestic equity mutual funds remain depressed, and we suspect there could be a phase of great public participation ahead before the bull market is over.

We’d sum up the U.S. stock market, then, by describing it as: (1) moderately overvalued; yet, (2) so healthy from an “internal” perspective that a final bull market top is probably not imminent. Neither of these applies, though, to foreign equities, which have badly lagged U.S. equities since early 2011, after largely keeping pace during the first two years of the bull market. Developed country stock market valuations are about 30-40% lower than those in the U.S., and Emerging Market readings have dropped to their “undervaluation” zone. We expect that our global industry analysis will increasingly lead us to these cheap locales, ultimately providing us with higher expected returns than we currently estimate for U.S. equities over the next several years.

A few market strategists began writing the epitaph for the post-1981 secular bull market in U.S. bonds more than a decade ago, when yields on 10-year U.S. Treasury bonds fell below 4% for the first time since the 1960s. Instead, bond yields managed to confound nearly everyone by remaining in an irregularly downward path through last summer, when the 10-year bond yield hit a record low of 1.43%. Yields looked on their way to challenging that low as recently as May, before jumping more than a full percentage point in two months. We view this spike in yields as an important warning sign that the trend in yields for the next few years will be up. We continue to target maturities in our fixed income holdings that are below those of the relevant benchmarks.

 

Source: Leuthold Weeden