News & Insights
Finding Direction Amid the Cross Currents
As we enter the last quarter of 2014, there is a lot to be happy about, most particularly the stock rally that has continued after a sparkling rise in 2013. As the market has surged ahead, the economy is showing signs of strength and earnings of companies have continued to improve. With the economy on a surer path and corporations in good shape, it is not unreasonable to have a sunny outlook.
Our position embraces the optimism prevailing in the wake of this good bull market, but remains conscious of embedded and developing risks that may affect our client's holdings. There are three chief factors which serve to keep our optimism in perspective. They are in order: the stock market's relatively rich valuation, pending shifts in central bank policy and the unusual and subdued nature of the economic recovery since 2009.
Readers of our commentary are well aware of our position on the market's valuation. We use traditional metrics such as Schiller' s P/E, price to book, and stock market capitalization to GDP to begin such an analysis, and all of these indicate a richly priced stock market. By some other measures the market does not seem as stretched, but by all but the least stringent measurements, the market is fully priced. This alone is not a great cause for concern since the market can remain at an elevated level for years.
A more timely concern is the announced policy by the Federal Reserve Bank to end extraordinary bond purchases (QE) this quarter. It is undeniable that this policy has been a factor in boosting stock prices and so it is logical to consider the consequences of its end.
Finally, the economic recovery since 2009 has been modest by historical standards. Many of the causes are well understood. The recession's catalyst in the housing debt market was unique in the post war era. Unprecedented levels of government debt and dysfunctional politics limited the flexibility of policy makers to respond to the collapse with stimulative measures as consumers attempted to repair their debt-swollen balance sheets. The result has been an economy growing at a weak 2% annually. We think this anemic recovery is likely to continue even amid recent signs of acceleration.
The performance of solid American businesses as reflected in our clients’ holdings has been good. Earnings on the S&P will increase around 7% this year. So while the economic environment has been puny, well run corporations are in decent shape. With stocks at elevated levels and the economy just so-so, earnings growth will have to come from good management.
In the aggregate we believe the U.S. stock market will produce less sparkling returns over the next five years than it has produced over the last, and that chances for a significant pull back in prices are increased, justifying a slightly cautious stance. Opportunity exists in markets under pressure, such as those in the emerging economies, Japan & Europe. Navigating these cross-currents means taking some profits in U.S. shares and redeploying some of those funds in markets overseas.
The Altavista Investment Team - Fall 2014