By Rome Mostert
As of the end June 2014 the S&P 500 Index had increased 189.75% since the inflection point in the spot index in early March 2009. Thus, the annualized return over this period was 22.17%. Take these returns and the age of this bull (5 years and 3 months) and throw in steadily rising PE multiples, and a number of bearish calls start surfacing across financial media space.
A quick scroll through MarketWatch, Bloomberg and Seeking Alpha produces a heavily bearish view on global equity markets:
- Industrial Production Surge Looks Like 2007 Just Before Economy Collapsed
- The Implosion Is Near: Signs Of The Bubble’s Last Days
- Bubble Paranoia Setting In as S&P 500 Surge Stirs Angst
- We’re in the third biggest stock bubble in U.S. history
If there is one thing that financial markets repeatedly teaches us, it is the fact that the conventional wisdom of the consensus view are more frequently than not, completely wrong. As such, investment strategies, such as value investing, were developed around the principle of contrarian investing, seeking to shy away from convention and consensus opinion.
With a typically contrarian take, IJG continues to be of the view that 2013 saw the global economy making the transition from the early expansion phase to the late expansion. This view is backed across the spectrum of economic indicators and evident in the pricing of assets across the global financial markets.
The US Economy
After the winter thaw, from an economic perspective the US economy has started to show some momentum with 2015 and 2016 forecasts ahead of the long term trend at 3.0% plus. Inflation figures are also starting to tick upwards, but more importantly inflation forecast numbers have signaled a trough. This is viewed positively by the FOMC, who are actively targeting higher prices across the consumer basket and personal consumption expenditure. Business confidence has also been strong, with the volume of M&A deals at US$1.27 trillion, the highest since mid-2007. Tightening monetary policies are also synonymous with the late expansion theme, with economic momentum and corporate profitability expected to spur growth in aggregate demand, offsetting the declines resulting from the tapering of QE and rising interest rates.
Equity performance
Returns across the equity market spectrum have in a large part been attributed to increases in the PE multiples, a classical late expansion characteristic. A relative comparison to long-run histories suggest that multiples are rich, but considering the macro climate and the probable impact on forward earnings, it seems likely that the current valuations are in fact more reasonable than perceived at first sight. In our view the relative attractiveness of equities to other asset classes remains key, underpinning the strong demand, and thus increasing price for such.
Fixed income performance
US bonds have seen a bottoming out in yields, with yields likely to trend higher in the foreseeable future. Alongside higher yields we expect to see a flattening yield curve both of which further cement our view of a late expansion play.
Volatility
Volatility tends to be declining throughout the initial economic recovery, low during the early expansion while starting to rise during the late expansion. We await the confirmation from volatility that late expansion has commenced.
Riding the secular bull…
With these comments made, we investigate the idea that the current cyclical bull (and consensus view soon to be new bear) witnessed in the S&P 500 index, is in fact the first phase of a secular bull market which can rally into the late teens or twenties of the 2000s.
As is illustrated in the graph below, the S&P 500 has only now emerged from the highs set 15 years ago and has consequently been in a secular bear market since the year 2000.
Secular bull and bear trends are also evident in the 10 year returns of the S&P 500. The index is currently 77.0% up on its level 10 years ago, an annualised rate of 5.9%. This is marginally lower than the long run average return of 6.3%.
What stand out in the graph below are the long term trends in 10 year returns. The market returns tends to trend in a direction for multi decades, overshooting to both ends. The highest 10 year return in the graph below is 16.7% versus the lowest 10 year return of -8.8%. Considering that the S&P 500 is still less than 5 years into the longer run uptrend, history suggests that there are still a number of years to come.
In our view the secular bull case is supported by the low and rising global inflation numbers, the emergence of economic momentum, reasonable valuations (S&P 500 trading 16.6x and 14.9x earnings 6 and 18 months out relative to the long run average of 16.3x) and the great rotation from fixed income to equities.
Cheaper energy (as a result of fracking and other drilling technologies) together with the transition from Boomers to the Millennial Generation could further justify the secular bull.
…just don’t fall off!
A secular bull does not mean no bear market at all. Cyclical bears and declines of 20% to 25% will be part of the secular bull. The risk also remains that equities remain in the secular bear market. Thus while riding the current bull (be it cyclical or secular) we advise to keep a close eye on the following indicators in order to appropriately take risk off the table when needed:
i. Economic growth
a. Downward revisions
ii. Inflation
a. Downward revisions
iii. Corporate earnings surprises
a. Negative surprises
b. Rising PE multiple as a result of earnings declines
iv. Market breadth and sentiment
a. A broad based loss in momentum
v. The US yield curve
a. Flat or inverted yield curve