JPMorgan cautious in U.S. equities for 2014
JPMorgan Chase & Co. (NYSE:JPM)’s US market strategy team issued its quarterly “Guide to the Markets” slide guide this January. Regarding equities, they note that the S&P 500 has risen 173% since its 2009 trough and that the index hit a record at the end of 2013. Even though the index is not as expensive relative to its 13 year history with its 15.4 forward price/earnings (P/E) ratio, caution should be the word for 2014 as the measure is close to the 15.2 forward P/E seen at the last peak in 2007. The S&P 500 could experience some correction this year as positive earnings and high margins may be already priced in. Without further revenue upside or margin expansion, earnings per share (EPS) and stock price growth rates may slow. For the fourth quarter of 2013, 8% of EPS growth was driven by margin while 3.3% was driven by revenues.
The Shiller cyclically adjusted P/E for the S&P 500 is at 25.3, 33% above its historical average. This measure suggests equities are expensive and that slower or negative growth rates are possible. Such P/Es may not be sustainable.
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Source: Standard & Poor’s, Factset, Robert Shiller Data, JP Morgan Asset Management
Source: Standard & Poor’s, IBES, Moody’s, FactSet, JP Morgan Asset Management
However, relative to bonds, equities are cheaper as the S&P 500 earnings yield is 6.5% versus the 5.3% Moody’s Baa yield. JPMorgan analysts highlight that when 10 year U.S. Treasury yields are below 5%, rising rates have a positive relationship with stock prices. Given that current 10 year U.S. Treasury yields are around 3%, stock prices have more potential for growth. In a diversified portfolio, equities should still be overweight relative to bonds.
There may be some investment opportunities within the large and midcap segments of the U.S. equity market. Large cap growth and mid cap growth segments are 14.3% and 10.6% cheaper than their 20 year historical average suggesting growth potential.
Source: Russell Investment Group, Standard & Poor’s, FactSet, JP Morgan Asset Management
Faster GDP growth may support U.S. stocks
The economy will need to recover jobs and disposable income at a faster pace to help companies increase revenues to grow margins. Efficiency initiatives have worked so far, but for further earnings and cash flow upside faster revenue growth is needed. As consumption is about 68% of the U.S. economy, faster job creation and disposable income growth rates could further bolster consumption and in turn firm revenues. During the 2008 crisis 8.8 million jobs were lost and since 2010 8.1 million jobs have been recovered. Only when jobs recovered exceed jobs lost during the crisis and when the labor participation rate recovers, can consumption improve enough to support faster GDP and revenue growth. Trends supporting consumption growth currently are improving household net worth and declining household debt service ratios. The recovery in home prices likely supported the improved household finance picture. An improving economy in 2014 may bolster stock prices if it translates to higher equity cash flows and margins.
Source: BEA, FRB, JP Morgan Asset Management
Value in international stocks
Given that U.S. equities outperformed international markets last year, asset managers should consider rebalancing to place more funds in international equities. The goal is to ensure exposure to U.S. equities does not get to drive the majority of portfolio returns. It is well documented that asset classes that perform well in a given year may not perform as well in future years.
From the chart below, emerging market stocks were the worst performers for last year returning only 3.8% in local terms versus -2.3% in USD. Emerging market currencies depreciated against the U.S. dollar due to tapering fears and increasing inflation in emerging markets.
Source: Standard & Poor’s, MSCI, FactSet, JP Morgan Asset Management
Regarding valuations, the U.S. is the most expensive country relative to the world. Also, the U.S. market is the only one that has recovered beyond its 2007 peak price suggesting that upside is limited. On the other hand, the MSCI EAFE, France, the U.K. and Germany are inexpensive relative to the world. These markets have not recovered to 2007 levels, hence they have appreciation potential.
Source: MSCI, FactSet, JP Morgan Asset Management
Russia, China, and Brazil are undervalued relative to the world
The BRIC countries, Brazil, Russia, India and China have been the worst performers of 2013, with returns ranging from -15.8% for Brazil to only 4% for China. Out of these three countries, only Russia, China, and Brazil are undervalued relative to the world. The outlook may be promising for Russia and China despite slower real GDP growth rates as their low gross debt to GDP ratios give these countries flexibility to stimulate the economy if needed. Russia comes in as one of the most inexpensive countries with a forward P/E of 4.8, below its 10 year average of 7.9 and the world’s 10 year average of 13.1.
Source: MSCI, FactSet, JP Morgan Asset Management