03-14-2014 11:07 AM
By John Toohey,
Vice President, Equity Investments
On March 10, 2009, the Standard & Poor’s 500 index climbed 43 points from the previous day. Nothing special on an absolute basis, but every one of those 43 points is worth remembering in a historical context. They marked the end of one of the most severe U.S. market corrections ever and the beginning of one of the longest and most powerful stock recoveries.
Five years and a few days later, the S&P 500 is getting ever closer to triple its trough level, leaving exhilarated but edgy investors with the question they’ve asked every March since the brutal bottom: How much can possibly be left in the tank?
The answer to that question is — who knows? Stocks have been marking a succession of all-time highs. This week’s slippage aside, the S&P 500 has seen a half-dozen record closes so far in 2014. But stocks can certainly keep climbing. Volatility is very low, indicating a general lack of worry among investors, and the economy is showing signs of improvement.
The Wall Street Journal pointed out this week that only three of the 11 post-World War II bull markets lasted at least six years, but those three averaged double-digit gains in their sixth years. So come next March, it’s not outside the realm of possibility that we could find ourselves at new heights asking, “Are we there yet?”
While we don’t feel ready to proclaim that the bull is living on borrowed time, we do think equity investors in the U.S. are paying Cadillac prices for Chevrolet earnings. This comparison is in no way intended to slight Chevy, but the analogy is apt. Investors in U.S. stocks have been getting solid, reliable earnings, but the price of those earnings has risen to luxury levels that no longer represent good value.
This viewpoint is evident in price-earnings ratios. The S&P 500’s trailing 12-month P/E is around 18x, which is roughly 20% above its long-term average. The 10-year P/E average, as measured by the Shiller CAPE ratio, looks even more overvalued at around 25x, and the Russell 2000 Index of small-cap stocks is lofty at more than 30x.
Because of this significant overvaluation, we have maintained underweight positions to U.S. large-cap and small-cap stocks. In recent weeks, we have further reduced our exposure to small caps in our managed portfolios on a tactical basis due to the stretched valuations. We also believe that we are now late in the current economic cycle, and historically small caps have not done well at this stage. We continue to see better opportunities overseas in both developed and emerging markets.
Going forward, earnings may get less reliable because they’re being generated mostly via cost-cutting and share buybacks rather than as a result of rising revenue. The numbers tell a compelling story: While share prices have shot up more than 170% in the past five years, profit margins per share have gained 43% during that period and revenue per share has increased a meager 12.5%, or roughly 2% per year.
In the fourth quarter of 2013, the S&P 500 saw earnings grow more than 12% compared to the same three months of 2012. Balance-sheet write-downs lowered profits in the fourth quarter of 2012, which helped the fourth quarter of 2013 look better than it may have otherwise. In any case, the relative improvement didn’t come from the top line: Revenue growth in the fourth quarter of 2013 was barely half a percentage point.
Companies can only cut their operating costs so far, and they can only repurchase so many shares. At some point, the sustainability of their cash flows and their profits (and, ultimately, their share prices) demands that they bring in more revenue.
USAA Investments Managed Portfolio Outlook
Our view of caution toward U.S. equities remains unchanged. We are underweight U.S. large caps and small caps. We are also tactically underweight fixed income. We remain slightly overweight cash in our diversified managed portfolios.
We also are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund also provides potential protection against the risks of long-term inflation.
Emerging markets represent another opportunity. Though they have been hit especially hard recently, we believe that emerging markets remain attractive. They offer both an interesting long-term prospect for growth and compelling valuations. The USAA Emerging Markets Fund offers exposure to stocks in less-developed countries.
As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for you based on your individual goals, objectives, risk tolerance and time horizon.
This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.
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Past performance is no guarantee of future results.
Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability. Emerging market countries are most volatile. Emerging market countries are less diverse and mature than other countries and tend to be politically less stable.
The S&P 500 Index is a well-known stock market index that includes common stocks of 500 companies from several industrial sectors representing a significant portion of the market value of all stocks publicly traded in the United States. Most of these stocks are listed on the New York Stock Exchange.
Standard & Poor’s 500 Index and S&P are registered trademarks. The S&P 500 Index is an unmanaged index of 500 stocks. The S&P 500 focuses on the large cap segment of the market, covering 75% of the U.S. equities market. S&P 500 is a trademark of the McGraw-Hill Companies, Inc.
The Russell 2000® Index is an unmanaged index which consists of the 2,000 smallest companies in the Russell 3,000 Index, and is a widely recognized small cap index.
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High double digit returns are attributable, in part, to unusually favorable market conditions and may not be repeated or consistently achieved in the future.
Financial planning services and financial advice provided by USAA Financial Planning Services Insurance Agency, Inc. (known as USAA Financial Insurance Agency in California, License #0E36312), a registered investment adviser and insurance agency and its wholly owned subsidiary, USAA Financial Advisors, Inc., a registered broker dealer.
Investments provided by USAA Investment Management Company and USAA Financial Advisors Inc., both registered broker dealers.
The Real Return Fund may be subject to stock market risk and is non-diversified which means that it may invest a greater percentage of its assets in a single issuer. Individual stocks will fluctuate in response to the activities of individual companies, general market, and economic conditions domestically and abroad. When redeemed or sold, may be worth more or less than the original cost.
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Diversification does not guarantee a profit or prevent a loss.