How good could it possibly get? That’s what some people are asking. After the equity markets’ incredible run-up this year, both the S&P 500 and Dow Jones indexes tripped over new milestones—the former ripping past 1800 while the latter broke the tape at 16,000.
“There hasn’t been much earnings growth yet the market is up,” says Ben Inker, co-head of the asset allocation team at GMO, noting the S&P 500’s 22% rise from the beginning of the year to the end of November. A lot of that has to do with the fact that equities seem like the only game in town. Investors in bonds are not only getting bupkes for returns, but they are threatened with a plunge in bond value during the coming, inexorable rise in interest rates.
So is it time for stock lovers to be awash in champagne? Or is it time for a cold shower?
The exuberance has been like honey for the bears, as a matter of fact. Many fund managers are now saying they see no deals anywhere, that stocks are perfectly priced and ready for a sell-off. They point to the end of quantitative easing, to the way it has put equities on speed, giving investors an artificial high that will leave them with nasty, withdrawal symptoms once the true fundamentals are exposed.
Oaktree’s Chairman Howard Marks, among others, acknowledges that it is hard to find compelling values in today’s equity market, but it’s not in bubble territory. Still, he recently told Bloomberg Television that he isn’t ready to blow a whistle and say “everybody out of the pool.” Equity prices have been driven up by the flight from low-interest-rate bonds as part of quantitative easing’s nudge forward. The search for return from investments has led everyone to riskier assets, he said, but many institutions and individuals remain underweighted in equities.
Inker put it pungently enough in GMO’s November 2013 quarterly letter: “Breaking News! U.S. Equity Market Overvalued!” was the name of his article. “The U.S. stock market is trading at levels that do not seem capable of supporting the type of returns that investors have gotten used to receiving from equities,” Inker writes. Pondering the idea that the firm’s forecasts could be wrong, he continues:
“The pleasant way we could be wrong is if the U.S. is about to embark on a golden age of corporate investment and economic growth that will gradually compete down the current return on capital such that overall profits manage to grow decently as the P/E of the stock market wafts slowly down. This would solve lots of problems, including the federal deficit and unemployment and, quite possibly, health care costs as well, but there is sadly no evidence whatsoever that it is occurring.”
Stocks “could go up next year, but they don’t really deserve to,” Inker says to Financial Advisor. “Most of the people who are saying that the market looks fine on a P/E basis are comparing it to next year’s forecast for earnings, which are forecast to be up quite a bit. This year’s earnings last year were forecast to be up quite a bit. They wound up 3 and a half, year on year.”
Inker doesn’t think that the economy is going to do worse next year but that profit margins are at all-time highs with nowhere to go but down, and if the economy does better next year it’s probably because we’re getting income growth per household. Yet if income goes up, it will also squeeze the corporate sector, which will have to pay higher wages, he says. And if those profit margins narrow, revenue growth goosed forward by more confident consumers is not going to be enough to make up for it. He thinks revenue growth could be only 3% or 4% with current inflation. Revenue growth amid falling profit margins are nothing to be overjoyed at, he argues.
He agrees that the promise of lower energy prices might help household spending but won’t necessarily translate to corporate profit. “Corporate profits have been able to do well when energy prices were high because they passed those costs along,” he says. “It’s not clear to us why falling energy prices accrue only to the corporate bottom line.”
Small-cap stocks in particular have been doing very well and have nosebleed high P/E margins that Inker calls dangerous. “If anything goes wrong, there is a long way that they could go down.”
Overseas growth favors big-cap companies over small-cap firms. “It’s unlikely to be a huge deal because economic growth outside the U.S. … Nobody is forecasting great things,” he says. “So it’s unlikely that foreign earnings will really zoom higher unless the dollar is weak. The dollar hasn’t been particularly weak.”
Inker says, however, that there’s a group of companies with strong balance sheets and lots of cash that haven’t been beneficiaries of the Fed’s easing strategies but at the same time won’t be as exposed if debt costs rise. He mentions big, stable companies like Wal-Mart, Apple, McDonald’s, Coca-Cola. “They don’t look brilliant, but they look a lot more stable than the overall market.”
Financials, he says, look cheap next to the overall market but Inker says his group at GMO have a hard time getting excited about financial stocks because of all the uncertainty about future regulation and capital requirements. And he thinks energy prices, though they are going to fall, aren’t going to fall a lot.
“Those companies look OK.” Otherwise, he says he likes defensive sectors like consumer staples, health care and some of the big tech companies “with strong moats around them.” “We are more nervous about the more cyclical end of the market and certainly the more levered end of the market. That’s places that either have pretty stretched valuations or a lot of downside vulnerability should [interest] rates increase.”
Charles de Vaulx, a portfolio manager at IVA Funds, says that around the world most stocks seem fully priced, not overpriced. He says that the middling earnings growth amid a 25% S&P 500 growth “is another way of saying the market has only gone up based on a re-rating, in other words a multiple expansion. That multiple expansion was warranted in the sense that the alternatives—cash or high-quality bonds—are not appealing.”
But don’t count equities out yet, say bulls. A number of portfolio managers think that the earnings outlook is promising enough that 2014 will continue to see an equities upturn. The combination of a mildly growing economy, lower energy costs and the abject state of bonds will be enough to allow equities to keep flying. What’s more, companies have been buying back their shares, say bulls, which means a shrinking equity market overall in a state of more giddy demand—in other words, another thermal updraft helping equities float upward.
“I don’t think we’re in for a correction anytime soon,” says Lew Piantedosi, lead manager at Eaton Vance’s large-cap growth fund. “I think the market has the support of quality underlying earnings. If you look at multiples on those earnings I’d say we’re at reasonable levels.”
There are some pockets of overvaluation, but that’s because we’re in an environment where it’s difficult to find good growth, he notes. Moreover, many companies have been diligent about their cost controls, and have been aggressively buying back shares. Companies’ more aggressive cost-cutting and balance sheet discipline, he says, means that they are in a better stead to take advantage of even mild economic growth.
“Even modest topline growth in that environment can move the bottom line quite a bit,” Piantedosi says. “We are getting that modest topline growth and the leverage to the bottom line has been pretty powerful.”
Industries set to grow next year include health care, which is particularly attractive to him as a growth manager—“particularly biotech,” Piantedosi says. “A lot of those biotech names have been great performers in 2013 and I think it continues into 2014 and beyond. We’re seeing huge new drug discoveries in a lot of these biotech companies. These are going to be blockbuster drugs that help move the needle on the top and bottom lines.”
He mentions Gilead, and its new pill for hepatitis C (one with reportedly high cure rates called sofosbuvir), and Biogen, which has come up with a drug for multiple sclerosis, Tecfidera, which he says will poise the company for big top and bottom line growth.
“The run-up has been justified by the fundamentals,” he says. He also likes areas that have lagged the economic recovery but are starting to show signs of life. Armstrong World Industries, for example, is a play on commercial real estate recovery, “which really has yet to participate in the economic recovery, but all leading indicators are pointing toward a recovery in that area. Armstrong is a leader in ceiling tiles and floors for commercial real estate.”
He says that GDP growth will probably continue to be sluggish at 2% to 3%, but that the government interference should be less of a drag in 2014 and that lending should pick up in the banks. “Commercial and industrial loan growth has started to materialize, so that’s positive. Also, the wealth effect from the stock market with lower gas prices should buoy consumer spending as well. I think things should get a little better, not a whole heck of a lot better.”
Another bull, Dan Veru, chief investment officer at Palisade Capital Management, thinks that the U.S. economy is picking up strength. “It’s like a freight train slowly picking up momentum,” he says. “Where you see it expressed is in small-cap stocks. The Russell 2000 has so far so widely outperformed the S&P 500 this year. Because small-cap stocks are an excellent proxy for U.S. demand, I think what you’re seeing is that the pricing mechanisms of the market are telling you that business is good and it’s improving.”
Veru says that while Washington has not helped the growth situation (he blames both sides of the aisle), the Fed’s accommodative liquidity policy has served as a helpful counterweight. Small caps have led the way out of the slow growth environment, he says. When GDP growth is under 3.5%, historically, he says, “you typically have small caps leading. Why is that? Big cap companies struggle to grow organically. What do they do? They go and buy the growth. They make acquisitions. What do they buy? Medium-size down to small-cap stocks. What I think has been grossly underreported is the amount of merger and acquisition activity that’s occurred in the market from ’09 to the present. There’s been a lot of companies that have been bought.”
He says his firm has observed “50 companies get acquired over the last two and three-quarter years and the average premium was just under 40%” from the previous day’s close. “So it’s just a unique environment right now.” Despite the slow growth, you can borrow money and fund acquisitions, Veru says.
He’s not as worried by the high P/E ratios. “It’s a little more complicated than, look at price and valuation. You have to look at the strategic value.” Take a cloud company that’s bought by a larger tech firm. The product is pushed by the sales force and gets an instant return, he says.
Jay Wong, manager at the Payden Equity Income Fund, says that you can’t forget the income factor as well—that dividends are going to be the reason people are attracted to the equity markets as their coupons get cut in bonds. “In this universe, where it seems that people are stretching for income and sources of income, equities could be quite attractive in this environment because you’re getting many sectors with bond-like yields; particularly you’re getting growth in those yields and capital price appreciation through earnings growth, and that’s not something you’re going to get in the bond market,” he says.
Thus Wong thinks high-dividend growth stocks are the place to be in 2014. “I’m bullish on the equity market because the fundamentals support moderate equity growth, but when you factor in the opportunity cost of where investors can put their money, I think there is still an attractiveness to the equity market vis a vis other asset classes—cash, bonds and alternative investments.”
Doug Cote, the chief market strategist at ING Investment Management, is also in the bullish camp and has been since he arrived at ING four years ago. “The mistake has been waiting for the pullback that never happened,” he says. “I think the whole market has been unacceptably defensive for the past four years and [those out of the market have] really missed out on some extraordinary returns.”
Next year, he says, will be a year of global economic expansion. “Everybody thinks we were in a worldwide depression in 2008,” Cote says. In reality, global growth is likely to accelerate. Cote likes energy, industrials and consumer products for 2014. He is not as enthusiastic about financials or health care, which are subject to the whims of Congressmen and their pens. “There is so much regulation coming down the pike [for financials], their whole business model is about to change.”