I can remember hiking Tuckerman's Ravine years ago to the summit of Mount Washington in New Hampshire, the highest peak in the Northeastern U.S. It was a crisp winter day as we embarked from Pinkham Notch to start the four-mile journey up about 4,300 feet in elevation. Every step of the way seemed to offer a more beautiful vista. Still, there were moments when I found myself looking down the trail behind me to see how far we had come. I wondered, could I push myself further? Could I keep grinding higher as the path became progressively steeper and the winds picked up speed?
Equity investors today have been on a similar run: a long climb in sometimes difficult conditions that has lifted the S&P 500 up more than 170% from its 2009 low. The benchmark index is up more than 25% year to date, on a path to close out 2013 above 1,700, after a gain of 16% in 2012. This, barring the unforeseen, would be the second year in a row of double-digit gains, a relatively infrequent occurrence for markets.
While it's understandable some investors may be worrying about how far we've come and how much further we can go, they should keep in mind that records are made to be broken. Historical highs are built into trading systems but they're just numbers on the screen that tell us where we've been — not where we are headed. Looking forward into 2014, although there will be ups and downs, we see an environment that will be conducive for equities.
Looking at the "P" and the "E"
Markets are influenced by many factors but they generally rise for two reasons: either earnings are strong, or investors are willing to pay more for earnings (the price-earnings ratio, also known as the multiple). We believe we're in a period where the expanding multiple is likely to drive the markets higher in 2014. A number of factors suggest multiple expansion next year. These include a conducive macroeconomic backdrop, the path of real rates on the long bond and the direction of gold.
The Federal Reserve has indicated it will soon put an end to quantitative easing and taper its purchases of agency mortgage-backed securities (MBS) and long Treasuries. The eventual normalization of interest rates, while engendering challenges for bond investors, will create new areas of strength in the markets within other asset classes. BNY Mellon is forecasting 3% real GDP growth over the next three years which, while not stellar, should provide an acceptable backdrop for equity markets. Stocks tend to like an economy that is growing at a clip that keeps inflation in check; our 3% growth projection would fit that bill.
Keeping it Real
P/Es, and the willingness of markets to pay up for earnings, are determined by many factors. The bond market, for instance, strongly influences equity markets. The real interest rate, which is the interest rate earned on a bond less the impact of inflation, historically has significantly influenced the P/E investors have been willing to pay for $1 of earnings. Rising and high real interest rates are supportive of rising P/Es because markets can reward rising rates, as long as these rates are caused by economic growth. When this growth is combined with low inflation, real rates rise.
Exhibit 1 // Median S&P 500 P/Es vs. Real 10-Year Treasury Yields
Source: BCA Research. S&P 500 P/E based on trailing four-quarter earnings.
Data shown is from 1872 through 2011. Real bond yields are on the 10-year U.S. Treasury.
Exhibit 1 demonstrates that P/Es are positively correlated with real bond yields. While this data goes back some time, the interest rate rise in 2013 serves as an excellent microcosm of this historical behavior. Rates have risen in 2013, but have done so not because of higher inflation, but due to rising real rates.
If rates continue to rise slowly over the next few years, as we expect, then equity markets should be able to take this trend in stride. In fact, they could move even higher, if supported by higher earnings, higher P/Es or both.
The Gold Touch
Another lesser known, but by no means less powerful, influencer of P/Es is the secular direction in gold prices. P/Es have shown a tendency to move in the opposite direction of the long-term price change of gold. This is best illustrated by looking at gold in recent decades. As outlined in Exhibit 2, during the 1970s, gold rose while stocks — and P/Es — struggled. Gold peaked at about 850 in 1980. Stocks went on a two-decade tear after this peak. Half of that gain was from earnings growth, the other half from P/E expansion.
Gold bottomed in 2001 and then went on an 11-year run, topping in 2013 at $1,900 per ounce. Stocks experienced their lost decade during this time, with two bear markets in 2001-2002 and in 2008-2009. Gold has since fallen over 30%, to less than $1,300 per ounce, as equities have continued their positive trajectory. No one knows if gold has peaked during this longer cycle but, given the recent decline, we must at least consider that the bull market in gold is over for now. If that is the case, then a falling or stable gold price should be very supportive of rising or stable P/Es. This bodes well for equity markets as we move into 2014.
Exhibit 2 // Since the 1970s, gold has been inversely related to P/Es
Source: As of 9/30/13. Source: Bloomberg.
Investors in any environment should be mindful of potential market risks. At the same time, there is no need for excessive worry, given the equity levels today. We have for some time advocated an overweighting to equities and do not feel a change is warranted, given current conditions. We are deep into the bull market in equities yet still believe there is room to run. Looking ahead to 2014, we see potential for growth stocks to outperform value, and for large caps to start leading smaller capitalization stocks. This period could last anywhere from one to five years, by our analysis.
Of course, there will always be pullbacks as markets move higher and readjust to new levels. This is a normal part of any economic cycle. Think back to 1997 when the S&P 500 was at 1,000. At the time, many thought it could go no higher, but it did.
When I reached the summit at Mount Washington all those years ago, I was so glad that I made the journey. I could see for miles and the sky was a million shades of blue. The wind made it bitter cold but I wouldn't have wanted to miss out on the experience. In a solid investment environment such as what we have today, we believe the message is clear. If you stop moving forward, you just might miss out on that new high.
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