Quarterly Newsletter January 1, 2015
We have had quite a ride over the past 5+ years with the Dow Industrials going from 6,500 to roughly 18,000 today. As you know, we lay no claim to market clairvoyance, but common sense (which we do lay some claim to) would suggest it might be a good time to lighten up a bit. While finding it difficult to bet against common sense, the criteria we believe most relevant stacks up in favor of the market, for the most part, not being overvalued and the chances of a US economic downturn pretty slim.
There are any number of things that influence market moves but there are only two things which literally move the market—Earnings (EPS) and Price/Earnings (P/E) ratios. The sum of these equals the market’s return each year:
The graph above shows three things:
- The annual return of the S&P 500 (red dashed line)
- Annual earnings growth (gray bar)
- Annual change in P/E ratios (blue bar)
To make the numbers a little more discernible, we have put them in table form below, with the net of the EPS and P/E contributions totaling the S&P 500 return for the year.
Contribution to Stock Returns by EPS Growth and change in market P/E multiple
Going forward, a positive scenario would be an earnings increase of 8-10% and a positive P/E change of 3-5% resulting in +11-15% return (approximately our returns for 2014). Today’s Core stock P/E ratio is around 18. An increase of 5% would bring it to 19. The graph on the next page shows the average high and low P/E ratio each year of the Core stocks going back to 1987. P/E ratios in the 20s are not uncommon for these high-quality companies but you must remember the bigger the P/E, the higher the expectations are for the company. Many popular stocks today are priced for perfection; the quarterly sales and earnings had better meet expectations. We attempt to avoid these popular companies. Warren Buffett says he would rather step over a 2-foot fence than try to hurdle over an 8-foot one.
There are some astute market strategists who believe we are in a secular (long-term) bull market which might have another 6-8 years to run. Do we think this is possible? Needless to say, we would like it to be, but there is also some pretty good statistical evidence to suggest it has a reasonable probability. One of our economic advisers, Strategas, has an acronym for the present investment environment—TINA—There Is No Alternative. Stocks are the only stop for decent income, liquidity, appreciation potential, and long-term inflation protection. Selling part of your portfolio in favor of a money market fund would help stabilize your market value, but it would get you 0% yield, while a 5-year treasury bond would lock you in at 1.7%.
Our Core stocks are paying an almost 3% dividend yield. 25 of the 26 Core stocks increased their dividends this year, by an average of 12%. We anticipate the vast majority of our Core stocks will increase earnings, cash flow and dividends in 2015. Market psychology will determine the level of the market P/E ratios. The dollar has been stronger and the Federal Reserve will probably start raising interest rates within the next year or two. Some view these both as negatives, but we believe they are signs of the strengthening U.S. economy. The market is probably building in a little premium in anticipation of the Republicans doing something positive to our budget and tax structure. I would think the market would be willing to pay a higher multiple for less government.
What could go wrong with this rosy scenario? The obvious would be the hotbed of geopolitical situations; i.e. Putin, ISIS, North Korea, Iran, ebola, the oil price crash, or the Federal Reserve bungling the unwinding of its balance sheet. The trio of President Obama, Joe Biden, and Susan Rice vs. Vladimir Putin may be of concern to some. Economic recessions nearly always end bull markets. There do not appear to be any imminent problems yet, but no one rings a bell at the top of an economic cycle.
The market has tolerated a lot of abuse from Washington and continued to climb the wall of worry. If we could get you 5% in a money market fund or 8% on intermediate term treasury bonds, we might conclude “why put up with the volatility of the stock market?” Short-term moves in the market have little to do with common sense or economic fundamentals, but why would you give up a 3% (and growing) dividend yield from the best companies in the world for a 1.7% yield on a 5-year government bond?
—written by David Meyer