(This is a lightly modified version of a letter sent to clients of Brooks, Hughes & Jones December 18, 2009.)
As we move into 2010 on the shoulders of a giant stock market rally, a phrase from the final episode of Seinfeld comes to mind – “restrained jubilation.”
This describes the current sentiment well. The rise of global stocks over the past nine months would cause pure, unrestrained jubilation if it weren’t for the fact that less than a year ago the possibility of a Depression was real.
As it turns out, anxiety peaked and stock markets bottomed on March 9. From the market’s bottom through Dec. 15, the Russell Global Index, measuring 98% of all the stocks in the world, rose 78% (with dividends reinvested). Nonetheless, the index needs to climb another 35% to return to the pre-bear market high of October 11, 2007.
The rally has not featured equal participation across all market segments, however. Among stocks, growth stocks have nearly quadrupled the return of value stocks and small/mid-sized companies have easily outpaced large companies. Emerging markets stocks have been the overall returns leader with indexes for some single countries posting 100+% gains. In the bond markets, the lower the credit rating the higher the return has been.
Thus, 2009 was a sharp reminder that it’s impossible to predict short-term market movements.
So we won’t. Instead, we focus on answering two key questions:
- What do the prospects for economic growth and company profits look like in 2010?
- To what extent are these prospects for growth accurately reflected in today’s stock and bond prices?
Prospects for growth in 2010
Much of the sentiment that has restrained confidence is driven by concerns about the U.S. economy. Some question whether it is still the engine of global growth. Others call this an artificial rally built on cost cutting, not earnings growth, and accelerated by stimulus money that didn’t exist before governments around the world turned their currency printers up to maximum capacity.
The short-term challenges are real. But it’s important not to lose sight of some important underlying positives.
Recessions have a way of cleansing the marketplace. Coming out of a recession, companies are likely to be more profitable due to the cost cutting they have done to survive. Innovation also increases coming out of a recession. We are on the cutting edge with new thinking in many industries that could change everything from the energy that powers our world to the efficiency of our communications and business operations.
Bright people and competitive companies will continue to advance their products and services creating attractive investment opportunities. We may not see rapid growth but we expect to see solid growth. If the majority of that growth is driven by companies outside of the U.S., we will not be surprised.
Today’s valuation levels
The market is overvalued, it’s undervalued and it’s fairly valued. It just depends on which segment you’re looking at. Regardless, we need to focus our investment decisions on buying stocks and bonds at attractive prices.
For instance, the S&P 500 Index, representing large U.S. companies, has hovered around the 1,100 mark for the past month. This puts the average price/earnings ratio of the S&P 500 at between 19 and 20 times earnings. Before 2008, you have to go back to 1992 to find the last time we saw this multiple consistently below 20 times average 10-year earnings. Throughout the period from 1997 to 2001, this multiple was in the 30s and 40s. When the multiple was in the 40s, you paid twice as much for a dollar of earnings as you do today. It should be noted that even at 19 or 20 times earnings, P/E ratios today remain higher than very long term averages.
Unless company earnings begin to demonstrate growth across industries, we think that the S&P 500 can rise to about 1,200 before the legs of this rally weaken and the broad U.S. market reaches overvalued territory. Fortunately, there are opportunities outside of the S&P 500 that we expect will present attractive investments that fit well into a globally balanced portfolio.
The consensus of many analysts we follow points to stock market appreciation that could easily add 8-to-10% to today’s values. That level of gain could come in six weeks. It could take a whole year. Along the way, we will be mindful of opportunities to capture profits and rebalance portfolios.
The right approach for your portfolio
We maintain our conviction for many investments that have served our clients well through the market extremes of the past two years. We will continue to design investment portfolios that are very diverse at the core. We will also continue to complete our asset allocation recommendations with choices meant to enhance overall returns without introducing more risk than is comfortable for any given client.
Today, points of emphasis in our investment strategy are high-quality, large-cap U.S. stocks that remain undervalued, Treasury Inflation Protected Securities (TIPs), and emerging international stocks and bonds.
We are cautiously optimistic that the balance of risk vs. return will tilt in the favor of investors who put their money to work outside of risk-free assets. Given the alternative of money market assets earning nothing and Treasuries that may wind up with negative real returns, we prefer putting money to work where it can grow.
Best wishes for an enjoyable new year and a prosperous new decade!