Market Comment Q2 2014


Following last year’s stellar gains, stock markets so far this year are subdued. In the U.S., the S&P 500 stock market average is up 1%, having overcome a 5% correction in January. Economic activity is widely expected to strengthen this year, and corporate earnings are expected to advance by 8-10%. Business and consumer confidence, having grown substantially last year, remain strong.

Somewhat worryingly, the first estimate of first quarter GDP growth of 0.1% was well below the consensus of 1.2%. A decline in gross private domestic investment restrained growth by a full 1%. About half of this decline had to do with fixed investment and the other half was the result of a reduction in private inventories. Residential investment has recently fallen quite sharply, contributing to the disappointment. Existing home sales in March were 7.5% below last year’s pace. Given that home prices are up nearly 13% nationally from last year, the decline seems a normal and healthy response to higher home prices and mortgage rates. For its part, while inventory de-stocking restrains growth, it often augurs higher rates of production in ensuing quarters.


Seen in this light, first quarter growth does not portend broader weakness in the economy. In all likelihood, growth will accelerate in coming quarters, employment will continue to rise gradually, and the impact of stock market gains and higher confidence will foster a virtuous cycle of higher demand, higher investment and higher earnings. While it is not reasonable to expect a repeat of last year’s rise in equity prices, earnings this year are likely to advance and solidify last year’s gains.


But there are worries. In the Ukraine, Russia’s bid to counter the installation of a pro-Western government has introduced further geopolitical uncertainty into a world already dealing with substantial problems in the Middle East. Russia’s exercise of power in Crimea and Eastern Ukraine has provoked the imposition of economic sanctions on individuals and companies in Russia. The trouble is that, unlike the environment during the Cold War, economic integration of Russia into the West has proceeded so far and so rapidly that the impact of sanctions and any retaliatory reaction is likely to affect both sides of the impasse, perhaps in unpredictable ways. Though the situation is potentially volatile, there does not appear to be any inherently intractable conflict of interest. Russia would prefer that NATO not include Ukraine; the U.S. and Europe would prefer no further military activity. The best outcome would be some sort of negotiated decrease in tension that permits economic ties to continue.


In recent weeks, a number of high-flying technology stocks have come under intense selling pressure. Twitter has lost 46% of its value; SolarCity, 40%, LinkedIn, 36% and Facebook, 20%. The common denominator of these stocks was excessively high valuation and, as a result, we have little or no investment in these companies. These stocks and others in the internet and biotech sectors were among last year’s star performers. In a “momentum” market—one at least partially built on the belief that what goes up will continue to go up—investors had simply piled into strong-performing “story stocks” until, well, until they stopped doing so. Something sparked portfolio managers to sell. Perhaps it was an increasingly supply of such companies coming to market via initial public offerings; perhaps it was the expiration of lock-ups that prevented managements and venture capitalists from selling their holdings. Perhaps it was simply the realization that many other companies are poised to grow earnings in a broadening economic recovery. So far, the declines in these stocks have not undermined the broader market. In fact, while these stocks were declining, many of last year’s underperformers have been catching up. If there has been an outbreak of rationality among investors, it is all to the good.


By many measures, stock valuations remain reasonable, despite the increase in stock prices last year that was well in excess of earnings gains. Though stock prices now are at or near record highs, valuations are only slightly above the long-term average when judged by the ratio of stock prices to earnings.

Other measures, however, suggest caution. Commentators who fret about a stock market bubble usually cite either the afore-mentioned high-flying tech stocks or valuation measures different from the standard price/earnings ratio. One such measure, the cyclically-adjusted price/earnings ratio (“CAPE”), developed by Professor Robert Shiller of Yale, suggests that current valuations are indeed at elevated levels (though Shiller himself has suggested this is not a reason to sell stocks). Other analysts suggest that corporate profit margins, which are currently well above historical levels, exaggerate corporate earnings power over the long term. If profit margins were to return to their historical average, then current valuations would prove to have been extreme.

While there is little risk of a sudden drop in corporate profitability, a regression to the mean would provide a substantial headwind for equities. Given the signals from these alternative measures of valuation, it is wise to consider rebalancing accounts in which equities have grown above the targeted weight as a percent of total portfolios. We do not recommend market timing, but we are firmly committed to hewing to an appropriate asset allocation, which rebalancing will help to maintain.


As Yogi Berra has said, it is never easy to make predictions, especially about the future. The consensus view—and the one embedded in current stock market valuations—is that the global economy will continue to strengthen, earnings continue to rise, a shooting war in Ukraine will be avoided, and central banks will successfully navigate the shoals of “too hot” or “too cold” monetary policy. While this is the expectation, we are fully aware of the risks to this outlook. In an uncertain world, it is mandatory to be mindful of both risks and opportunities and maintain an investment posture that offers the benefits of upside but that can be withstood on the downside. When we work with our clients, this is our clear objective.

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