While our primary task is to be “bottom-up” owners of terrific businesses, rather than the less predictable, less profitable and certainly less satisfying task of economic or stock market forecasting, we would like to offer our views on the current investing environment. In short, we expect much of 2014 to be the opposite of 2013. Further, we expect Main Street to outperform Wall Street. We expect better than expected economic growth, better employment – and correspondingly higher than expected inflation and interest rates. Even a cursory dive into the latest employment figures shows that the college-plus segment is near full employment. Leading economic indicators have currently crept back up to 3-year highs. Relatedly, what may be better for the economy, may very well likely challenge current exuberant financial markets – particularly the stock market. Higher interest rates and higher inflation could cause a deflation-obsessed Fed to “taper” much sooner than their official policy statements.
As such, any surprises in interest rates and inflation could well be to the upside and prove to be, in our opinion, a considerable headwind for the stock market. 2013 was a year of P/E multiple expansion. 2014 may well be the opposite. We also expect more volatility (read: downside) throughout 2014. Our more specific evolving views on the broad stock market echo our thoughts from our last couple of Client Letters. As much as pessimism and fear ruled the day back in late 2008 and early 2009, we are of the current view that we are in the midst of a bull market in optimism. In short, we expect evolving Risk-avoidance to trump Reward-chasing in 2014.
Continuing our recent quarterly discussions on corporate profits, we believe that corporate profit margins could surprise to the downside in 2014. Thanks to generational low interest rates, corporate interest expense is also at generational lows. Said another way, the best refinancing/borrowing in a generation ended in July 2012 (and May 2013). In addition, wage and compensation expenses are also near multi-decade lows. Furthermore, the constant and increasingly vocal drumbeat of corporate managers unable to find enough skilled labor to fill growing job openings is no doubt good news for the skilled employed – but bad news for corporate profit margins. Wage pressures (plus healthcare expenses) are certainly on the rise. Here are a few more of our thoughts on corporate profit margins from last July:
According to BCA Research, compensation expenses, adjusted for consumer prices, are still at year-end 2008 levels. In addition, while measures of productivity remain steady at elevated levels, previous margin tailwinds such as falling interest rates, and declining depreciation charges (largely from 2008 through late 2012) are likely to become headwinds. Corporate tax burden is volatile (and linked to economic activity), yet remains quite low by historical standards. Even the juice from low tax-regime overseas profits seem to be as good as it can get. The combination of these factors leaves revenue growth as the likely key driver of future profit growth. Furthermore, if margins do recede even a bit, it would take double-digit growth in revenues just to maintain single-digit earnings growth.
Lastly, we cannot help but be minimally observant at the stretched valuations of many stocks and the broader stock market indices too. According to Standard & Poor’s, since the 1930’s the current Great Bull Market ranks third out of eighteen measured bull markets in terms of gains and fourth (currently 254 weeks) in terms of duration. In fact, if the current mighty Bull makes it to it’s official 5-year anniversary in early March, it will become the second longest bull market since the early 1930’s.
The Wall Street Journal reports that the trailing P/E multiple of 18.6X on the S&P 500 Index is now higher than 24 of the past 35 bull market peaks since 1900. The Shiller CAPE (cyclically-adjusted P/E) multiple of nearly 26X is higher too than 29 of the prior bull market highs since 1900. In addition, the S&P 500 Index’s Price/Book ratio of 2.7X is higher than all five of the past 28 bull market peaks over the past 90 years and the Price/Sales ratio of 1.6X is now higher than all but two of the 18 bull market tops since 1995. (See Supplement at the end of this Letter for more historic bull market comparisons.)
On this score, three of our favorite stock market valuation measures (Shiller P/E, Wilshire 5000/GDP (Warren Buffett (Trades, Portfolio)’s favorite measure) and the Value Line 3-5 Year Market Appreciation Potential – VLMAP) are all at multi-decade bearish extremes. In addition, GMO’s 7-Year Asset Forecast is flashing red as well. It is important to note, we list such measures and forecasts not in any attempt on our part to “time the market.” That important caveat aside, all three measures, plus GMO’s forecast, depict the current investing environment as one that will deliver, at best, low single digit returns over the next five to seven years and, more critically, negative compounded returns, at worst. Thank goodness our task (difficult still in circa- 2014) is to populate our portfolio with just 20 stocks…
In summary, as the 5th year of the Great Bull Market of 2009-2013(4) rolls along, we are no doubt finding the current investing environment limiting and challenging. The most favorable investment opportunities that we can find largely, if not exclusively, reside in your current portfolio. Again, our task of building a +20 stock portfolio of best-of-breed companies - that additionally must sport attractive valuations - can be accomplished in the current ebullient environment. That said, we believe there is mounting evidence that the stock market has advanced so far, so fast over the past year as to render future returns quite poor on a risk-adjusted basis.
See Full PDF here: wedgewood partners fourth quarter 2013 client letter