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Rockefeller & Co. Perspectives Matthew Gelfand

Paul Veith

T h i s p a p e r i s f o r i n f o r m a t i o n a l p u r p o s e s o n ly. C e r t a i n i n f o r m a t i o n m ay c o n s t i t u t e “ f o r w a r d - l o o k i n g s t a t e m e n t s . ” N o r e p r e s e n t a t i o n s o r w a r r a n t i e s a r e m a d e a s t o t h e a cc u r a c y o r c o m p l e t e n e s s o f s u c h s t a t e m e n t s , a n d a ct u a l e v e n t s o r r e s u l t s m ay d i f f e r m a t e r i a l ly f r o m t h o s e r e f l e ct e d o r c o n t e m p l a t e d . Co py r i g h t 2 01 3 © R o c k e f e l l e r & Co. , I n c . A l l R i g h ts R e s e rv e d.


he U.S. stock market repeatedly setting record highs this winter and spring calls to mind the old adage, “is the class half empty or half full?” Recall the 1999-2000 Technology Bubble bursting in 2000-2002 and the aftermath of market highs in October 2007 as the Great Recession began. Should investors worry again that equity markets are ahead of themselves given the challenges facing the global economy? Headlines about stock market records sound better than the reality. Actually, the Dow Jones Index and the S&P 500 Index are short of record levels when adjusted for inflation or viewed relative to corporate earnings. Of greater concern is the bond market where yields to maturity are near record lows, whether measured nominally or after adjusting for inflation. Low interest rates are important in assessing today’s stock market levels and in thinking about asset allocation. Are equity markets overvalued today given the substantial recovery in share prices since 2009? Stock prices still appear moderate relative to stock fundamentals despite double digit market gains during the last 18 months. For example, prices average about 14 times 2013 projected earnings (“the P/E ratio”). Historic norms for the P/E ratio are approximately 15x. P/E ratios entering 2012 were approximately 12.5x. The expansion in P/E ratios from 12.5x to the recent 14.1x at the end of April 2013 has accounted for slightly more than half of the 27 percentage point price gain in the S&P 500 Index between December 31, 2012 and April 30, 2013. Thus, earnings expansion also accounted for nearly half of the price gain. Additionally, compare stocks to yields on high yield (or “junk”) bonds.Today, the earnings yield on the S&P 500 Index of 7 percemt (the reciprocal of the market multiple of 14x) for the first time exceeds the yield on a basket of junk bonds since the junk bond market was established




Broken Records: Stock Markets and Sovereign Debt in the mid-1980s. Thus, the “broken record” of greater concern is not the new high of the Dow Jones Industrials Index or the S&P 500 Index. Bonds seem fully priced across the risk spectrum, from U.S. Treasuries, which have negative yields after adjusting for inflation, to junk bonds where nominal yields are barely above 5 percent versus historic norms of 10 percent. Low bond yields are in large part due to the Federal Reserve’s loose monetary policy, but also reflect expectations for modest economic growth over the next several years. Debt levels are very high in the United States at all government

“Nonetheless, the U.S. economy’s resilience is pleasantly surprising.” levels, in Europe and especially in Japan. The consequent need for deleveraging has weighed on growth prospects. For example, the International Monetary Fund forecasts a modest recession in Europe in 2013, and slow growth for 2014. Although some key measures suggest Europe has been stabilizing, the controversial bank “bail-in” in Cyprus illustrates Europe’s tenuous position. The bail-in is particularly troubling because it shook the notion of bank deposit safety (even though, in the end, only the large depositors suffered losses). The Eurozone probably will continue to battle significant political and social challenges as its disparate nations attempt to coordinate fiscal policies. Japan’s new Prime Minister, Shinzo Abe, entered office with great momentum. Abe and the new Bank of Japan Governor, Haruhiko Kuroda, seem committed to pushing the levers on their economy, expanding quantitative easing in part to weaken the yen. A weaker yen would boost prospects for export-focused Japanese


companies. The corollary to the weak yen, however, is a stronger U.S. dollar, which has the potential for further gains founded on increased domestic energy production. Greater domestic production should help the U.S. current account deficit as crude oil imports decline. The U.S. housing market also has strengthened. Having peaked in 2006, this sector has endured a long process of clearing excess inventory from prior overbuilding, “underwater” houses, which are worth less than what homeowners owe on their mortgages, and foreclosed, vacant homes. Construction activity and home prices appear to be rebounding. Double-digit, year-to-date equity market returns already exceed historic average annual returns in the mid- to high-single digits. Nonetheless, the U.S. economy’s resilience is pleasantly surprising. Current forecasts for 2013 U.S. GDP growth range between 1-1/2 percent and 2-1/2 percent despite increased payroll taxes, higher income taxes and the fiscal sequester, which combined probably have shaved 1.5 percent from growth. A grand bargain in the nation’s capital that trims the deficit at a measured pace, we believe, would be constructive. Meanwhile, recent elections in Italy and elsewhere suggest that European austerity programs have been too severe for voters’ tastes and going forward likely will be spread out over longer periods, leaving investors – and European citizens – with ongoing uncertainty. In short, equity markets could set new nominal highs.The major risk to equity markets might be if the tepid economic recovery were to lose steam, in which case bond market yields could set new lows. Matthew Gelfand and Paul Veith are managing directors in the Washington, D.C. office of Rockefeller & Co., the investment advisory firm.


Washington Life - June 2013 - Rockefeller