After five consecutive monthly declines, equity markets rose in the month of October. Economic data appeared to firm while Euro zone credit market pressures eased as investors regained hope in Europe’s ability to resolve its crisis. The S&P 500 rose 11% while developed international markets rose 10%. Fixed income fared well too; the Barclays U.S. Aggregate rose 0.11%.
Not unexpectedly, our more conservatively positioned domestic equity portfolios underperformed the S&P 500 during the month. Even so, we remain ahead by over 2% for the year.
Underperforming during such a strong up month might cause one to question a more conservatively positioned portfolio. Why, after all, are we more conservatively positioned at this time?
Equity markets are still priced for sub-par long-term returns, even under rosy scenarios. At the end of September, the S&P 500 is expected to have earned $87 per share on estimated revenue of $1,033 per share. That’s an 8.4% net margin, the second highest in the index’s history. By our estimates, the expected average annual total return of the S&P 500–with earnings and dividend growth of 5.5% per year (average nominal GDP growth since 1981) for the next ten years–is 7.6%. However, there is a flaw in the calculation above: it assumes the continuation of record profit margins for an entire decade.
Margins are mean-reverting for many reasons, some of which include inflationary pressures, labor force growth, a market-based economy that competes away outsized returns on capital, diminishing marginal returns, and the occasional recession. These are just some of the reasons that margins have averaged 6% over long periods of time and are likely to bring down current near-record profit margins. Assuming margins steadily decline to the long-term average of 6% from the current 8.4% (and still averaging 7.1% over the next ten years), the expected average annual total return of the S&P 500 is 4.6%. Our calculation isn’t too far off from the calculations of John Hussman (4.5%) of the Hussman Funds and Jeremy Grantham (5.6%) of GMO. Of course, this calculation continues to assume revenue and dividend growth of 5.5% per year, which is well above the last decade’s average nominal GDP growth rate of 3.9%. Put simply, future equity returns are likely to disappoint. Barring another deep recession, bond returns will be even worse.
Broad equity market valuations and expected returns aside–and more specifically–we are more conservatively positioned at this time because value can be found in large, high-quality, dividend-paying, multinational corporations. This is not a subset of the market in which we choose to invest because it provides relative comfort or because we have a bias towards income; we hold these securities now because they trade at discounts to both their intrinsic worth and historical multiples and therefore offer ample return in an otherwise rich investment landscape. Unfortunately, the correlation between stocks is currently close to all-time highs, which has recently made our individual security selection less rewarding.
Markets today are driven by macro events, primarily U.S. economic data and Euro zone developments. Both were viewed well by investors during the month.
During October, economic data improved and leading indicators continued to signal economic growth ahead. Improving data came in spite of declarations–made back in August and September–of an imminent U.S. recession by several prominent firms and economists, including the Economic Cycle Research Institute (ECRI) and David Rosenberg of Gluskin Sheff. The Black Cypress proprietary recession model continues to point to weak, but still positive, economic growth. U.S. consumers are still spending and companies are adding employees, increasing hours worked as well as investing in capital and R&D. While the continuation of the U.S. expansion appears likely for now, the escalation of European debt market troubles into a full-blown credit crisis would likely put the U.S. and world economies back into a recession.
Over the last decade, Euro zone governments increased expenditures as revenues rose rapidly due to strong economic growth, attributable in part to a worldwide housing and asset bubble. The Euro zone periphery countries were able to borrow at lower rates and in larger amounts than otherwise possible due to a common currency and assumed backing of the stronger participants, notably Germany and France. The worldwide recession hit and widening budget deficits increased debt levels further. Now, stagnant GDP, high and still growing debt burdens, and rising borrowing costs are making servicing the debt difficult.
Most countries with currency and central bank sovereignty respond to such a dismal state of affairs with fiscal and monetary stimulus and accompanying currency depreciation. Put simply, the government could act to dampen a weakening economy with government spending, tax cuts, and loose monetary policy. The weak growth coupled with the above often leads to a depreciating currency, which makes the country’s goods and services more competitive internationally. Individual Euro participants do not have the monetary option (the ECB makes monetary policy for all Euro participants) nor can they stimulate their economies without the support of the bond market. In short, the Euro remains strong while investors and both the ECB and IMF are demanding the opposite of stimulus. The situation is further complicated by European banks with weak capital positions that hold the debt and therefore have placed the entire credit market at risk–the crux of the matter. The region needs growth, but even aid from the ECB and IMF are predicated on austerity, which further pressures GDP in the short to medium term.
It is our belief that lessons were learned in the last recession and that worldwide central banks will do whatever it takes to avoid another credit collapse. For now, the ECB hopes to regain confidence with as little money creation as possible. But more sweeping intervention could and will likely be used as a last resort. Failing to act risks regional depression. As such, all eyes are on Europe.