February brought with it yet another strong month of equity performance. Since September of last year, the market has moved in a near-vertical fashion to multi-year highs, returning nearly 22% for the 500 largest U.S. stocks. Our domestic equity portfolios have risen an impressive 18% to 22%–depending on the mandate–over that same time frame. Our since-inception equity performance is ahead with less volatility and risk.
The recent ascent in equity markets is welcomed, but investors must remember that today’s price will largely determine the future return. As of today, the S&P 500 is trading for over 16x 2011 earnings, which happened to be the highest on record. The market is also trading for nearly 14x future earnings, as estimates for 2012 are nearly a $100 per share. The typical forward multiple is somewhere between 12 and 14, depending on the dataset used, so even assuming the actual attainment of $100 per share earnings, the market is already paying for them in advance.
Of course, the analyst forecasts that derive the $100 2012 estimate assume further expansion in already-record-high profit margins. This is becoming increasingly unlikely, given improving hiring (falling real labor costs have buoyed profit margins) and rising energy costs, both of which should stymie profit margin expansion. We’ve been here before, as the same individuals that said the market was cheap in 2007 on similar logic are doing so today.
Equity market valuations are not in bubble territory, but they are rich and thus the prospective 10-year return for stocks is lower than average. By our estimates, the S&P 500 will likely deliver average annual returns below 5% over the next decade. The analysis of this is quite simple. Profit margins are already at or near their long-term highs, so profit growth depends on revenue growth, not expanding margins. In fact, the likely reality is that margins will contract over the next decade. The current multiple of 16.1x is already above the long-term average of 15x, so there will likely be no multiple expansion over the next decade either. The S&P 500 is yielding just over 2%, which is comparable to 10-year Treasuries at this time, but is paltry by any long-term standard. Add that all together and you get a sub-5% expected future average annual return. If the world economy, and the U.S. in particular, is in for a “new normal” of slower GDP growth, then returns could be even lower.
A rising market not only changes the future expected return, it also changes the opportunity set available to investors. That is to say, finding securities with a suitable margin of safety is getting more difficult. Financials remain the best value, barring another destabilizing recession, while oil-related energy picks are becoming pricy. Our domestic equity portfolios continue to trade at a reasonable discount to fair value, but the gap is closing, and with it, our comfort-inducing margin of safety.
We think it also bears stating that a market’s ascent makes the investing landscape more risky. This fact, though counter-intuitive to most, is no less true. As equity markets rise, valuations increase and there is less margin of safety for investors. This is as basic as 2 + 2 = 4. Yet, the typical investor draws comfort in a rising market and ultimately becomes complacent. Fear of losing money is replaced by a fear of missing out on further upside. Of course, rich valuations are a staple of equity market tops, and are quickly reversed when the economic landscape changes for the worse.
Economic data continues to indicate a slowly growing economy. Employment is up, real retail sales continue to outstrip inflation, housing investment is growing and manufacturing remains firm. There are a few weak spots, including falling real wages, soft port and rail traffic, and a deceleration in manufacturing hiring. But the Black Cypress proprietary macro model continues to signal expansion and therefore equity market exposure.
We are maintaining our current positioning at this time.
