In the context of financial market history, we are clearly not experiencing “normal” times. What will the balance of 2013 hold in store? In the comments that follow, analysts and portfolio managers across several equity disciplines share their thoughts.
By Ty Nutt
We believe we’re in the latter stages of a cyclical bull market that began in early March 2009. Despite a subdued economic recovery and only modest employment growth, stocks have enjoyed an extended run. The broad-market S&P 500® Index has produced a cumulative total return of 160% since its March 2009 (through May 31, 2013) low (data: Standard & Poor's Corp.), which works out to an annualized return of approximately 25%. The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the U.S. stock market.
How much further the market can rise is anyone’s guess. Investors have responded positively to the Federal Reserve’s ongoing stimulus (that is, near-zero short-term interest rates and monthly purchases of Treasury and agency securities), and it appears that these measures may continue for a while. Sentiment indices have been elevated and there is evidence that retail investors are increasing their equity allocations.
While all of this could provide further support for stock prices, we wouldn’t be surprised to see a pull-back during the second half of this year. This could be driven by seasonal patterns (summer and fall months have historically been sub-par), or fundamental challenges such as disappointing earnings, weaker economic data, or escalating geopolitical tensions.
As long-term investors, our investment horizon is always at least three to five years. Our longer-term view remains that we are partway through a secular bear market that started in March 2000 when the S&P 500 Index’s price-to-earnings ratio (based on 10-year normalized earnings) peaked at 43 (Data: Bloomberg; Ned Davis Research). Secular bear markets are characterized by declining valuations and annualized returns that are below the market’s long-term historical average.
Large cyclical price swings are also a defining trait of secular bear markets, as illustrated in the chart below. Since the inception of this secular downturn, the S&P 500 Index’s annualized total return has been 2.6% (through May 31, 2013). We think the current secular bear could last another five years or so, ending when the market price-to-earnings ratio gets to somewhere around 10 (it was 15.69 as of Aug 1, 2013).
S&P 500 Index: Price return only (March 2000 – May 2013)
(Data: Standard & Poor’s via U.S. Federal Reserve, accessed on June 1, 2013)
Chart above is for illustrative purposes only and is not representative of the performance of any specific investment. Past performance does not guarantee future results.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the U.S. stock market.
Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.
Given our concerns about stock market valuation and economic fundamentals, we think a more-defensive positioning continues to be the best course of action. We expect to accomplish this through a combination of overweighting less-cyclical sectors, maintaining relatively low valuation multiples across the portfolio, and targeting companies that, in our view, represent above-average quality and have solid balance sheet fundamentals.
By Christopher S. Beck
Small-cap equities: Signs of life despite a lumbering economy
Listen as Christoper S. Beck takes you through his views on recent developments in the small-cap market that provide for investor confidence. [Runtime 5:20]
We believe the main drivers of the recent equity gains are still relevant as we look to the back half of the year; the Federal Reserve continues to hold rates low, and the housing market is showing signs of revival, to such an extent that it has become a positive contributor to overall U.S. gross domestic product (GDP), the total market value of all goods and services produced within a nation's economy. (See the table below for one indicator of housing growth: construction of new housing during the month of May, compared to one year ago.)
With these factors in mind, we think the economy is on pace to maintain a growth rate of 2-3% for the balance of 2013. We do not believe stocks will see a significant pullback during this period — though it would not surprise us to see a pause given the strong performance of the first half.
New residential construction increase, May 2012 – 2013 (year over year)
||Est. % change
Data: U.S. Census Bureau. Most recent data available. Estimates are based on sample surveys and are subject to variability related to the sampling method. Each measurement shown in the table was calculated with a corresponding standard error. Those standard errors are: ± 1.3, building permits; ± 14.4, housing starts; ± 13.7, housing completions.
We see several constructive trends for small-cap companies, and small-cap stocks, remaining in place in the coming quarters, including:
- initiating new dividends or increasing payouts on existing dividend streams
- increasing the amount of share buybacks
- paying down debt and/or refinancing at very low rates
There is no guarantee that dividend-paying stocks will continue to pay dividends.
Our biggest uncertainty at this time has to do with market expectations. Earnings expectations, for example, could prove overly optimistic if GDP growth proves to be much lower than currently expected.
In light of our modestly optimistic outlook, we are maintaining overweight positions in the more cyclical areas of the market, including consumer services, basic industries, and capital spending. At the same time, we continue to hold reasonably underweight allocations to traditionally defensive sectors such as real estate investment trusts (REITs) and utilities.
A closing word about the possibility of rising interest rates
Given their current low levels, we fully expect interest rates to increase over the next few years, as rate volatility already has been significant in recent months. The magnitude of the increases (as well as the reasons why) will determine whether rising rates are a positive or negative for the equity market.
We do not believe the Fed will raise interest rates in a sharp or hastened manner, which would more than likely have negative implications for the market. It is more probable in our opinion that rates will rise gradually, implying a stronger economic outlook and investors’ willingness to shift into riskier assets. This scenario would be more constructive for increasing earnings and stock prices.
By Ned Gray
We appear to live in a policy-driven world. Since the depths of the global financial crisis, one could be pardoned for thinking the world’s equity markets have responded more to policy initiatives than to changes in the underlying economy. From the early stimulus efforts by the U.S. Federal Reserve (and other central banks and fiscal authorities), through to the recent sharp reaction to Fed Chairman Ben Bernanke’s comments regarding the prospect of “tapering” of quantitative easing, markets have moved in reaction to policy statements.
Just as importantly, markets have reacted to a lack of aggressive action, particularly on occasions when observers believed such action was called for. Several developments can be seen in this light:
- the euro crisis and its follow-on effects;
- the sharp devaluation of the Japanese yen (and the accompanying spike in that country’s equity valuations); and
- the sharp recovery and then gradual erosion of the fortunes of the emerging stock markets over the past five years.
In today’s environment, a key challenge to forecasting market performance lies in anticipating the interaction of economic activity, policy action, and market participants’ perceptions of both. Though the Fed and others may be seen as trying to respond in predictable ways to unpredictable events — thereby playing a stabilizing role — the sheer magnitude of policy intervention appears to be creating a significant new dynamic of its own.
Under a normal business cycle, for example, an increase in long-term interest rates and steepening of the yield curve (such as that seen recently) could be a healthy sign of robust growth in demand for credit in an expanding economy, supportive of equity valuations. However, the market’s recent negative responses may suggest, rather more ominously, that there is significant support for the notion that it is monetary stimulus itself, rather than the real economy, that is supporting those valuations.
As global equity managers taking a contrarian approach to bottom-up (stock-by-stock) stock selection (meaning that we carefully seek to go against the prevailing market psychology when identifying mispriced stocks), we believe that we have some distinct advantages in navigating this thicket of economic volatility and policy uncertainty.
The first of these is that our investable universe represents a broad variety of distinct regional economies and asynchronous valuation cycles from which to choose. The second is our conviction that cyclical volatility will always what we view as create opportunities for those who understand and are prepared for it. Finally, we are confident that the identification of what we view as strong, competitive companies with solid managements and compelling valuations will continue to provide the most reliable way to seize the opportunities that unpredictable market volatility will send our way.
By Francis X. Morris
June 28, 2013
As the first half of 2013 comes to a close, performance of U.S. equities, and in particular small-capitalization stocks, have provided investors with a substantial gain year-to-date. As of this writing, the Russell 2000® index, which measures the performance of the small-cap segment of the U.S. equity universe and is a subset of the Russell 3000® Index, has advanced slightly in excess of 16%. In our minds, the rationale for the gain can be traced to several factors, including:
- An accommodative Federal Reserve, whose $85 billion-a-month bond-buying program has provided the necessary liquidity to bolster the U.S. economy, and hence rally consumer confidence.
- A generally improving — albeit gradually — U.S. economy. This is a critical factor for small-cap stocks, because the majority of their sales and income are generated domestically.
- A valuation structure that, broadly speaking, was supportive to incremental money flows into smaller stocks.
Events in recent weeks have, at a minimum, increased the volatility associated with equity investing (or as some have indicated, altered the landscape in a downward trajectory for equity prices). While the pullback has been sharp on a daily basis, it is important to note that the overall effect has been a 3-4% decline from what started out as an elevated level. Significant yes, but still short of what has been traditionally considered a correction (down 10%).
We believe the key for investors in smaller-cap equities going forward will be to focus on the strength, or lack thereof, of the U.S. economy. If, as many analysts are forecasting, economic activity continues to improve, then so too should corporate earnings, potentially leading to valuation expansion during the latter half of 2013.
If events unfold as we have just put forth, the environment for investing in smaller-cap equities has the potential to increasingly move to a greater emphasis on stock-by-stock analysis and away from what has been a more macro-driven market as of late. We believe we are uniquely positioned to benefit from this shift, given our fundamental approach that focuses on:
- detailed analysis of financial statements
- interviews with company managements
- thorough analysis of competitive positioning
- evaluation of the catalysts that have the potential to unlock value
- identification of opportunities across the entire small-cap equity spectrum
With that said, examples of our current positioning include a current focus on possible opportunities in the technology sector, especially within companies that help their customers reduce costs. We are also optimistic about consumer stocks, which have been comparatively strong in recent years and, in our opinion, remain a solid story.
Concurrently, we have eased on utilities and REITs, primarily due to our view that valuations in both sectors recently got ahead of themselves. (Indeed, they've subsequently lost momentum in the wake of the Fed’s pronouncements that it may pursue future reductions in its bond-buying program.)
As a closing note, we reiterate that the environment for investing in smaller-cap equities has been favorable year-to-date, and we believe it has the potential to continue to be so for the remainder of the year. We believe disciplined approach, focused on company-level research, has positioned the portfolios we manage with an eye toward capitalizing on the current market environment.
Investing involves risk, including the possible loss of principal.
Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.
International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.
Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.
An index is unmanaged and one cannot invest directly in an index.