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On The Lookout

James Swanson, Chief Investment Strategist, helps readers make sense of the markets by sharing what he learns along the way.

January 31, 2014

US equity market: Bubble or opportunity?

MFS Institutional Portfolio Manager Rob Almeida and I share our views on the current state of the US equity market...

Before the recent period of turbulence, the US stock market had been performing exceptionally well, buoyed by strong fundamentals including gains in earnings and revenues across all sectors, record-breaking cash flows and historically robust returns on equity. Yet as the S&P 500 Index stretched for one all-time high after another, investors ranging from sophisticated institutions to the general public continued to talk about a bubble.

We all recognize this provocative term as a metaphor for market excess — one that conjures up the image of hot air, or lack of substance, inflating and eventually bursting when market participants become disillusioned with overcapacity. After two major downturns during the past 13 years, it is understandable for equity investors to be wary of another bubble.

Yet it is important to bear in mind that in the case of liquid stocks, which can be easily bought and sold, there are only two sources of excess, either valuations or earnings. In terms of the price-to-earnings ratio, or P/E, the excess must be in the “P” or the “E.”

In 1999, for example, the technology bubble was based on excessive valuations, with some stocks trading at more than 100 times earnings and others with no earnings at all. In 2007, by contrast, the bubble was based on earnings, which topped $100 per share for the S&P 500 Index. When the global financial crisis hit the following year, earnings collapsed by 50%, and equity prices plunged along with them.

We argue that rising stock prices have been based on excesses in neither valuation nor earnings this time around. Rather, investor enthusiasm about the outlook for US equities, which is evident when the market is at such high levels, has reflected what we believe to be a compelling opportunity.

Equity risk premium is reverting to the mean

As evidence to help us rule out that the US stock market is a bubble built on excessive valuation, consider the equity risk premium, or ERP, which is calculated by subtracting the yield on the 10-year Treasury from the inverse of the P/E ratio, or earnings yield on the S&P 500 (see Exhibit 1). This measure of the compensation for owning stocks rather than bonds has averaged 32 basis points over the past 50 years.

When the ERP is significantly below average, stocks can be said to be overvalued. As we have discussed, the last valuation bubble was in the late 1990s, when cash flowed into stocks and the ERP declined to −300 basis points — nearly 10 times below the 50-year average, a 1.5-standard-deviation low.

Over the past five years, the dynamic has been different. While stock prices have been rising more on steady earnings growth than on valuation, cash flows have gone into bonds instead, helped along by the US Federal Reserve’s purchases of fixed income securities. As investors demanded greater compensation for holding equities, the ERP peaked in 2011 at close to 600 basis points — about a 2.5-standard-deviation high.

More recently, the ERP has been retreating rapidly back toward the 50-year average. We expect this mean reversion to continue through 2014, as stocks are likely to outperform bonds against the backdrop of enduring economic growth.

Other valuation ratios — for example, price-to-sales, price-to-book and price-to-cyclically adjusted earnings — point to a market that is no longer cheap but may have better earnings prospects ahead. All told, the collection of typical valuation metrics used by many equity analysts and portfolio managers suggests that this period does not resemble previous bubble peaks.

US cyclical expansion may be sustainable

Since the end of the recession in June 2009, the US economy has been growing at 2.4% per year, compared with the 4% to 5% growth rates experienced during recoveries in the 1980s and 1990s. However, the corporate sector is what matters to stock investors, and that has been growing at a 3.3% real rate during the cycle. This growth has been achieved while companies have spent conservatively, relying on natural demand rather than debt to expand their businesses.

At MFS, we believe that this kind of slow but steady cycle is likely to be more sustainable, durable and organic than earlier cycles — and a better environment for US equities. The robust profits, high margins and healthy balance sheets of US companies have supported strong gains in the stock market. This may turn out to be a longer cycle — one that pushes off the arrival of the next recession and allows jobs, housing and manufacturing to carry on with the recovery’s measured pace of healing.

We expect that the following factors can extend the cycle of growth and sustain the attractiveness of US equities:

Low cost of capital. Thanks to the accommodative monetary policies of the Fed and other central banks, the cost of borrowed capital has remained low in both real and nominal terms. This has played a key role in boosting corporate profits.

Manufacturing competitiveness. Relative to other major economies, the United States has minimal labor interference from the government, so the price of labor can be reset after recessions. With cost of labor increases subdued, productivity has risen, enabling the country to gain a share of world exports and to witness a revival of manufacturing.

Abundant energy sources. New technologies to extract domestic oil and natural gas have lowered electric and ethylene costs in the United States, giving a competitive edge in global markets to US-made products such as plastics.

Low debt, high cash. Companies have been deleveraging since the financial crisis of 2008 – 2009 and now hold ample amounts of cash on their balance sheets. With debt service payments so low, large US corporations should have the wherewithal to expand their operations to meet growing domestic and international demand.

Pent-up demand for capital expenditures. The reluctance of companies and consumers to spend on high-cost items has resulted in aging buildings, computers, software, motor vehicles and other durable goods. With a replacement cycle at hand, spending on new infrastructure should generate growth.

Demographic trends. Unlike Europe or Japan, the United States is benefiting from a combination of higher birth rates as well as positive immigration trends, which can also add to natural economic growth.

Asset correlations have been falling

During the slow recovery after the financial crisis, markets have oscillated between greed and fear. In this persistent risk-on/risk-off environment, we have seen investment dollars seesaw between risky assets like stocks in the pursuit of performance and relatively riskless assets like US Treasuries in the search for safety.

When markets move together in this way, correlations rise regardless of the real differences between stocks and the businesses that underlie them. Fundamental factors that active managers normally consider — such as the strength and quality of company balance sheets or the growth in sales, earnings and dividends — have little bearing on the day-to-day movement of individual stock prices. In such markets, the effectiveness of investing on fundamentals fades.

More recently, however, we have watched the 252-day rolling correlation of the median S&P 500 stock to the overall index fall from a plateau around 0.77 in mid-2012 to levels much closer to the average of 0.56 since 2000 (see Exhibit 2). As the equity market transitions from a risk-on/risk-off mentality to a focus on fundamentals, we believe there will be greater rewards to active management and individual stock selection.

Return dispersion is wider over longer horizons

We view return dispersion between the best performing and worst performing stocks in the equity market as a durable opportunity for an investment manager to add value. Wider dispersion increases the impact of investment decisions, and in such an environment, demonstrating skill in security selection can make a larger contribution to performance than forecasting systematic factors in the broad market.

Looking at stock return dispersion across various time periods ranging from one day to five years, we see that there is greater return dispersion between the 10th and 90th percentiles as the holding period gets longer, which means that there are more opportunities for differentiated performance when securities are held over longer horizons (see Exhibit 3).

The implications for investment strategy are clear. For a portfolio manager who turns over holdings on a daily or weekly basis, the ability to add value after trading costs is limited because stocks tend to move in tandem in the short term. Over a longer horizon of five years, with much greater return dispersion in the market, there are more opportunities for portfolio managers to focus on meaningful investment signals that point to sustainable earnings growth and to express views that translate into positive returns relative to the benchmark. We consider this time-horizon arbitrage opportunity to be a significant factor in generating long-term performance.

For these reasons, we believe that investment managers with a longer-term view and a focus on stock selection can find abundant opportunities in US equities.

No forecasts can be guaranteed.

The views expressed are those of James Swanson and Robert Almeida and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.