Some pundits suggest a 55 month long bull market that began on March 10th 2009 has taken equity valuations to unsupportable levels. These assertions are headline worthy but are they of merit? My view is that proponents of a major stock market top are narrowly focused upon absolute valuations. They appear to minimize relative measures. Secondly, those who predict long term doom for equity prices unduly discount the very substantial growth in the global economy since 2007. Finally, bears fail to acknowledge the absence of certain important irrational behaviors of investors which traditionally accompany cyclical market tops.
The focus of most is on just one headline grabbing point; a 1000+ point increase in the S&P 500 index value, off the bottom. Of late, virtually all of the credit for this return has been placed at the altar of quantitative easing. By implication, a goodly number assume that an end to easing will end the bull market. I consider this to be a false dilemma. Growth in the global economy, growth in corporate profitability and changes in investor behavior since 2009 may greatly extend the duration of this bull cycle.
Let’s explore one of the three components of my bullish case in further depth; absolute valuations vs. relative valuations. The S&P 500 has moved from the October 10th, 2007 high of 1562.47 to the current price of 1703.20. This unimpressive gain of 9% is barely newsworthy. However, few choose to appraise current equity levels against the prior cyclical peak. Instead, most focus on the index move from the cyclical bottom touched on March 9th, 2009. Factor in today’s value of 1703.20 against the backdrop of a 676.53 value and the 150% gain, within the last 55 months, certainly looks robust.
There is your headline. Any broadly based index that has increased by more than 150% over six years must be at a peak, correct?
Perhaps naysayers are correct, perhaps they are not. An apples-to-apples appraisal of corporate earnings since 2009, based upon the consensus forecast for 2014, indicates a 101% potential increase in S&P earnings. On 2014 anticipated earnings, the S&P 500 is presently selling for 13.7X forward multiples. After factoring in the current ten year bond yield (2.59%) and contrasting that to yields received at both the previous cyclical market top (4.68%) and equity market bottom (2.88%), it becomes difficult to make a credible case for a significant drop in major indexes.
Secondly, those who look at American equity indexes and pronounce markets to be toppy and overvalued may not fully comprehend the magnitude of the global economic advance since 2007. In 2007, global GDP, on a PPP basis, was determined to be $65.6 trillion US. For 2013, global GDP is estimated to be $88 trillion. Preliminary 2014 estimates suggest global GDP should easily surpass $90.5 trillion. Plainly put, the global economy is now a full 34% larger than at the previous stock market top. A growing global economy permits large companies to increase output and profits. Based upon the returns earned by my large cap global fund, it appears that the 2009-2013 global improvement was of greatest benefit to large companies. I presently see benefits now trickling down to smaller firms at the margins.
Finally, many forecasters fail to anticipate longstanding behavioral patterns associated at market tops and bottoms. Equity prices traditionally overshoot reasonable estimates of fair market values at both peaks and troughs. During periods of exuberance, investors buy based upon a widely publicized opportunity cost of not owning equities. In periods of abdication or troughs, investors sell because they fear total loss of capital.
The present market advance lacks wide-spread participation by individual investors. It has recently been reported that individual American equity ownership is at an all-time low. In October 2007, approximately 65% of Americans participated in the equities market. Currently, fewer than 52% of Americans hold equity investments.
I’ve read other surveys that indicate American participation in equity investment has fallen below 50%. Such limited participation, against the backdrop of 2009-2013 index gains, assuredly produces a measure of regret and envy from bystanders. To make matters worse, anecdotal conversations with many investors further imply an inordinate number were swept up, far too late, into the fear trade that is precious metals ownership and precious metals stock investment. Ironically, the term “fear trade” turned out to be exceedingly accurate, but not for the reason intended. Losses from exposure to hard hit metals markets and metals related equities have kept many of the investing public frozen with fear, or at the minimum, wary.
Those who have done exceedingly well in this bull market have been uncharacteristically silent. Perhaps they fear being classified as part of the much maligned “1%”. I don’t begrudge such reserve. During prior equity advances, steadfastness and investment acumen were deemed to be praiseworthy characteristics. Such traits are now considered unseemly. This five plus year bull market remains one of the more sullen and skeptical beasts that I have personally experienced. And, that is a good thing. Irrational exuberance has yet to rear its ugly head.
As I look at the potential for positive equity moves from here, my good cheer remains intact. The current backdrop of restrained commodity prices and record food harvests in key producing nations should provide tailwinds for the global consumer in 2014. Previously moribund economies such as Britain and Japan are finally returning to economic growth. The almost perpetual bank write-downs, which have served to depress index earnings for years, are tailing off. At the end of 2014, the global economy may be 37% larger than at the time of the 2007 stock market peak. To follow my thread to a logical conclusion, if the global economy will be 37% larger in 2014 than 2007, is it completely unrealistic to assume that equity prices may track such growth?
We should not discount potential market movements based upon investor behavior. There are three components to rising equity values that have been largely absent from the present bull market. The first, and most important, is the wealth effect based on strong equity markets in the United States. While participants may not be talking about gains, those with skin in the game have generated some impressive returns since 2009. As was customary, based upon evidence gathered in prior bull markets, a percentage of these gains do get converted to cash and provide a discretionary consumer spending stimulus. This impacts retail sales for luxury and upmarket goods with commensurate trickle down effects. I anticipate that such stimulus will become evident early in 2014.
Secondly, rising equity markets generate additional government tax revenues, in jurisdictions where capital gains taxes apply. Above average stock market returns may result in lower than forecast budget deficit reports for fiscal 2014. This will further blunt the thesis of doomsayers and simultaneously bolster the mood, or animal spirits, of the public. There is a component of perception to any economic cycle. A positive perception is self-reinforcing.
Finally, providing that a modest percentage of the sidelined American public resumes ownership of equities (the retail public tends to arrive at a good party rather late), the S&P 500 may continue to advance strongly in the coming twenty four months. Current, albeit preliminary, data from several large banks indicates increasing public interest in equities. Should the party crashers return, en masse, market indexes have the potential to greatly overshoot my upside target. I predict data to support my thesis will make headlines no later than Q1, 2014.
Few warning bells presently ring in my head. I have not been privy to stories of the irrational exuberances that typically accompany cyclical market tops. Until such time as those cautionary nuggets cross my desk, I remain as before, fully invested.