The FIFA World Cup, NBA Finals and Stanley Cup have all concluded. Football gets going again in a few weeks. Until then, this leaves baseball with its usual summer sports monopoly. Baseball also has a near-monopolistic claim on market metaphors. “Home run,” “batting average,” “singles and doubles” and “bullpen” are just a few of the phrases investors use to describe aspects of their approach to their portfolios. But there is one phrase that beats them all for popularity with investors: “What inning are we in?”
When our analysts and portfolio managers interview CEOs and other corporate executives, “What inning are we in?” is a favorite question. We could be asking about the development of a new product, progress on a restructuring program or the status of a large capital project. Whatever the case, framing the question in terms of a nine-inning game helps to pin down the executive to a somewhat precise answer.
Since the bear market low of March 2009, we have enjoyed a five-year bull market for U.S. equities that has produced a cumulative total return of 221% for the S&P 500 Index (as of 6/30/14). Over the past 18 months alone, the S&P 500 has delivered 42%. It has been 32 months since we last saw a 10% pullback in the broad U.S. equity market. After such a long, steady period of strong returns for equities, it is reasonable for investors to ask what inning we are in.
Identifying the inning we are in depends on the “game” we are playing, as the economic, profit and equity market cycles do not necessarily move in tandem with one another.
The economic cycle
Over the past 100 years, there have been 19 recessions in the U.S., roughly one every 5.3 years. In the past 40 years, there have been six recessions, one every 6.7 years. The current economic expansion has been underway for five years, so on that basis alone, we are already in late or extra innings. The recently revised figure of -2.9% for first-quarter GDP growth would also seem to suggest the recovery may be long in the tooth. (However, that first-quarter weakness was likely aberrational and attributable primarily to poor winter weather.) Our conversations with corporate executives indicate the recovery is intact.
Countering this line of reasoning is the fact that the current recovery has been so anemic. GDP is still below trend and the unemployment rate remains fairly high at 6.3% (as of May 2014). At the current pace, it could be several more years before the economy is back to full potential, suggesting the next recession is still a ways off.
The profit cycle
Although the economic recovery has been sluggish, the recovery of corporate profits from the last recession has been strong. Absolute levels of earnings as well as corporate profit margins have reached all-time peak levels. For those of us who believe in mean reversion, this is a cause for concern and represents a potential risk factor for equities going forward. In our view, it seems unlikely for aggregate profit margins in the U.S. economy to climb meaningfully higher from here.
The equity market cycle
By their nature, equity prices attempt to discount and price the future. Knowing that the economy is strong or that profits are high is often insufficient to judge where we are in the equity market cycle. In other words, the good news may already be reflected in current prices. Certainly, after a more than five-year bull market that has driven the S&P 500 from its intraday low of 666 in March 2009 to its recent flirtation with 2000, a triple off the bottom, it appears that equities are pricing in something.
Volatility in the equity market has also reached a level that is consistent with the later stages of the market cycle. The CBOE Volatility Index (VIX), a widely used measure of volatility for the S&P 500, recently fell below 12, a level last seen in 2007, the final year of the last upcycle for equities.
But another way of thinking about where we are in the cycle is to look at investor sentiment. The American Association of Individual Investors (AAII) conducts a survey of retail investors. When this measure indicates excessive bullishness, it is generally a good idea to be somewhat wary. Recently, only 35% of individual investors identified themselves as bulls, well below the 55% level seen at the end of 2013. This is reassuring.
When we put all of these factors together (a plodding economy, elevated profit margins, a strong five-year rally, low volatility and muted sentiment), the conclusion we draw is that investors should be wary but not fearful. Equity returns are likely to be more modest than in the recent past, perhaps middle single digits over a multiyear period. Given the interest-rate backdrop and dearth of attractive alternatives, we believe equities continue to deserve a place in a well-diversified portfolio.
At this stage of the cycle, it is more important to be selective and to focus on individual companies rather than buying the broad market as a whole. The key is to differentiate those companies that are structurally advantaged from those that have simply had a cyclical bounce. As we study the landscape, we are still finding plenty of good value and opportunities in banks, energy and health care:
- Banks continue to work through their legacy issues and are far better capitalized than they have been in recent years.
- A number of energy companies are entering a period of improving free cash flows as large capital projects are completed.
- The health care sector has seen significant M&A activity, which we think may continue.
Returning to the baseball analogy, perhaps we are approaching the seventh-inning stretch, well into the game, but with time left to score a few more runs.
The S&P 500 Index is an unmanaged index commonly used to measure the performance of the broad U.S. stock market. It is not possible to invest directly in an index. Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. Historical performance of the index illustrates market trends and does not represent the past or future performance of any fund.
Investments in equity securities are sensitive to stock market volatility. Equity investing involves risk, including possible loss of principal. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant.
Past performance is no guarantee of future results.
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