The equity market rally that began in 2009 showed no signs of abating as the calendar turned from 2012 to 2013. However, the merits and sustainability of this rally remain debated. The bullish view is that equities were undervalued following the sell-off that occurred in 2008-09 and recent performance is a correction to more fairly price securities based on their underlying earnings capacity. The bearish view, on the other hand, is that equity markets are being artificially supported by government stimulus programs and will correct once these programs run their course. Both positions have some logical statistical support.
For example, both the level and quality of corporate profits have been significant. Certainly, the last few years have forced companies to become leaner while they have opted to raise significant levels of cash. This has allowed many companies to pursue stock repurchase plans, support dividend payouts, and in some cases acquire competitors. Furthermore, the current low interest rate environment gives corporations access to capital at very favorable rates while a weak labor market constrains employment costs. The degree to which any tightening of fiscal and monetary policies may curtail these benefits and have an impact on earnings is yet to be seen.
From a valuation perspective, despite having more than doubled over the last four years, companies in the S&P 500 remain close to historical averages based on current price-to-earnings ratios. Whether this ratio may expand or contract is an open issue; however, the risk aversion seen since the depths of the recession would indicate that wide or rapid expansion is less likely. Additionally, the Federal Reserve's bond-buying measures and record low interest rates have driven down yields on fixed income investments leaving many yield-hungry investors with little choice but to buy stocks. Persistent low inflation could enable the Fed to maintain its easy-money policies for the near future, but thereafter, a rise in interest rates would have to be seen as the most fundamental risk confronting equity investment.
Consumers continue to relax their cautionary spending habits and drive some GDP growth, but pressures are mounting. The expiration of the payroll tax resulted in an immediate 2% reduction to consumers' take-home pay. Given the size of the federal budget deficit and looming sequester cuts, it is likely that there will be continued upward pressure on income tax rates in the future. Stagnant wages and rising gas prices remain a burden for many consumers as well. One bright spot is the housing market where prices continue to recover despite a bevy of distressed sales. Other positive indicators include low inventories and affordability, the latter of which is a direct result of the Fed's easy-money policy and has resulted in average monthly mortgage payments remaining below average monthly rents.
Globally, Japanese stocks continued to soar in turn with aggressive easy-money policies and a devalued currency that has boosted exports. Critics contend that Japan has intentionally reduced the price of the yen in this regard and several countries, including the United States, have issued warnings against this type of currency manipulation. Nevertheless, after decades of deflation others are encouraged to see such aggressive inflationary policies. To this point, the stock market rally is purely speculative, as Japan's economy has contracted for three straight quarters as of the end of 2012, so it remains to be seen if equity gains will be sustained.
Across the Atlantic, Europe's biggest economies continue to contract and unemployment continues to rise. Political uncertainty in Italy, a near run-on-banks in Cyprus that led to another European Central Bank bailout and the continuing austerity vs. growth debate renewed concerns about the future of the European Union and the long-term viability of the Euro. Ultimately cooler heads prevailed as borrowing rates remained reasonable for the more troubled Eurozone countries and equity market returns were positive.
After considering just some of these issues, it is no surprise that short, and eve intermediate, term predictions of equity market direction are most likely to be incorrect. But we do believe individuals, companies and governmental institutions, generally react in ways to positively deal with these myriad and uncertain conditions. Given sufficient time, this often results in profitable investment and economic growth. This supports our suggested investment policy which is based upon statistics that show, over longer periods of time, equity investors have realized a return premium of about 150% over low risk investments. We see no reason that this trend should not continue in the future and remain confident that long-term investors will be rewarded for the risk inherent in their equity investments.
Urban Financial Advisory Corporation