2015 Economic and Stock Market Outlook

As of this time that this report was written (November 23), the S&P 500 had risen by 13.71% on a total return basis year-to-date and had more than tripled from its March 2009 lows. Is the stock market overvalued?

On December 5, 1996, Federal Reserve Chairman Alan Greenspan gave his now famous speech to the American Enterprise Institute in which he pondered how the Fed could respond if “irrational exuberance” had escalated asset prices to the point in which the overall economy could falter if asset prices collapsed.[i] Despite posing the statement as a question, this remark on “irrational exuberance” – in a speech largely focused on the changing role of monetary policy in American history – was interpreted to mean that the Fed thought that the stock market, especially the technology sector, was in a bubble as the Dow had soared by 33 percent in 1995 and another 24 percent in 1996.[ii] Despite a sell-off in stocks following that speech, from the date of the speech through the year 2000, the Dow climbed 81 percent and the NASDAQ rose 200 percent (as the chart below shows, the S&P 500 also experienced large gains).[iii] 2015-1[iv]

In a similar manner, on July 15 of this year, Fed Chairman Janet Yellen appeared before the Senate Banking Committee. Although she stated that the “prices of real estate, equities and corporate bonds…remain generally in line with historic norms,” she also said that the “equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched.”[v] Stocks sold off on her

statement but have rallied back and as of the time of this writing sit at record highs. Similar to the mid-90s, stocks have lately risen sharply: in 2012 the total return of the S&P 500 was 15.84 percent, in 2013 it was 32.21 percent and year-to-date it is 13.71 percent.[vi] Therefore, this data pose two questions: is the stock market overvalued, and even if the stock market is overvalued can it continue to grow by double-digits annually?

When attempting to determine the value of the stock market as a whole, analysts typically look at relative statistics, such as the Price-to-Earnings (P/E) ratio. As I explained in this year’s preview, for the S&P 500, the P/E ratio is calculated by dividing the index’s price by the sum of the earnings per share of the individual companies in the index. Based on the last twelve months of earnings, the P/E of the S&P 500 is currently 18.25x. The historical average for the P/E ratio of the U.S. stock market is around 15x. In December 1996, the P/E ratio stood at 28x.[vii] Therefore, while the P/E ratio is higher than the historical average, it is much lower than it was during the late 1990s. Furthermore, in many instances the stock market has tended to become more overvalued before a correction brings prices back to normal (or below normal). Fundamentally, is there a justification for the stock market to have an above average earnings multiple? Over the first nine months of this year, U.S. GDP has only expanded at an average 2.0 percent growth rate. From 1947 until 2014, U.S. GDP growth averaged 3.27 percent, hitting an all-time high of 16.90 percent in the first quarter of 1950 and a low of -10.00 percent in the first quarter of 1958.[viii] However, investors care more about the earnings of the individual companies than about the GDP growth of the U.S. While there is a high correlation between corporate earnings and GDP growth, corporate earnings could become a larger percentage of GDP and thus grow faster than the overall U.S. economy. This is indeed what is happening.



Recently, after-tax corporate profits as a percent of GDP rose above 11 percent for the first time in history. One of the main reasons for this increase is because U.S. GDP includes income earned abroad by U.S. corporations and excludes income earned in the U.S. by foreigners. For companies in the S&P 500, approximately 45 percent of income is earned abroad.[x] Moreover, an analysis by the Wall Street Journal in 2013 of 60 of the largest U.S. companies found that they parked a total of $166 billion offshore in 2012 – thus shielding over 40 percent of their earnings from U.S. taxes. Since the size of the U.S. economy in 2012 was $16.2 trillion, roughly 1 percent ($166 billion) of growth in corporate profits can be explained by the increase in earnings abroad that escaped U.S. taxation.[xi] Helped by globalization and the increase in stock repurchases, the increase in corporate earnings over the past 12 months for companies in the S&P 500 has been 7.3 percent – far outpacing growth in GDP.[xii]

Even though the S&P 500 has tripled from its March 2009 lows, are there still many investment opportunities in the U.S. stock market?

With the S&P 500 having tripled from its March 2009 low, we are having trouble finding individual stocks that we like at current prices. When looking for new stocks to add to our portfolios – or to replace stocks that we believe have risen above their intrinsic values – we tend to favor high quality companies with solid management and stable normalized cash flows. What do I mean by normalized cash flows? As I previously mentioned, analysts project future cash flows and then discount them back to the present to determine the fair value for a stock. Implicit within these projections are assumptions on future revenue growth, operating expenses, tax rates, etc. While analyzing a company for sustainable competitive advantages can help ascertain approximate long-term sales and expenses for a company, no estimates are going to be exactly precise. Therefore, a stock needs to be trading at a discount (a margin of safety) to its calculated fair value in order to increase the probability that the investment in the stock will be profitable. For companies in which we look favorably on their long-term competitive advantages, we find that the best time to invest is when the company has missed quarterly estimates because of what we believe are temporary circumstances. Over a long-term time horizon, the temporary circumstances will fade and the company will be back to making normal cash flows. This form of investment is correctly named value investing as we look for companies that trade at below average multiples because of the market’s shortsightedness. On many occasions these are best-of-breed companies that have historically had stable cash flows or that now belong to out-of-favor sectors. Can we be certain that our projections are accurate and that the current environment for that company might be more than temporary? No, but that is why we attempt to be conservative by only investing in stocks with a margin of safety below our calculated fair values. Although companies in the energy sector or those that derive their earnings from Europe have not performed well lately, we have increased our research in those areas as we are looking for situations in which the baby has been thrown out with the bath water. 

The yield on the 10-year Treasury has declined from 3.0% at the start of the year to 2.3% currently despite an almost universal belief that bonds could be overpriced. Has the rally in bond prices (prices move inversely to yields) changed your outlook for the asset class?

While we are not bullish on U.S. stocks, we do not believe that they are wildly overvalued either. The same cannot be said regarding our view of U.S. government and corporate bonds. Across the world bond yields are at or near historic lows. Bond yields encapsulate both a nominal return and a premium for inflation. If growth is low (or negative), the nominal return demanded by investors is lower. If inflation is low (or negative), the premium for inflation is lower. When both are low – and are expected to remain low – the result is the current low yield environment. An analysis of global median inflation rates over the past few hundred years shows that volatility in annual inflation rates has decreased significantly and inflation in the modern world has tended to be positive as monetary systems became less tied to precious metals (since the U.S. went off the gold standard in 1933 there have only been 4 years of deflation and only one, 2009, in the past 50 years).[xiii]


In a world of positive inflation bias, we view bonds at their current prices – with both low inflation and low growth for the foreseeable future most likely priced in – with more caution than is historically warranted for the asset class. U.S. government bonds are said to offer risk-free return. We will stand by Warren Buffett in our belief that they instead offer “return-free risk.” Despite the asset class’ good performance over the past few years in spite of projections that interest rates were going to rise imminently, we remain mainly invested in bonds with low durations and have not been swayed by the outperformance in past years of high duration bonds.

With the price of a barrel of WTI crude oil having declined to around $75, many companies in the energy sector that focus on the exploration and production of oil and natural gas have seen their share prices decline precipitously over the past few months. Have the fundamentals of the industry changed that much during that period of time?

Over the short term, the independent exploration and production (E&P) companies really have no choice to do anything but drill because of the capital structures of the majority of them.  Since many are partially financed by secured floating rate debt (secured by the value of the wells), when the price of oil goes down the companies are going to generate less in operating cash flow and are going to have pay higher interest rates on their debt as the value of the securitized asset declines.  As an individual company, the E&P will decide that it needs to continue to drill – even if unprofitable – because it now owes more in debt payments and cannot afford to see operating cash flows fall any further.  As an industry, it would be beneficial to see some of the companies fail in order to ensure consolidation occurs and that the price of WTI crude oil does not fall below the cost to produce it.  In the short term however, this is exactly like game theory and each will most likely think of its own prospects rather than rationalizing as to what is best for the industry.  In the long term, some companies will fail and the surviving companies will be stronger with higher cash flows.  Because of the many variables that affect the price of oil (shale gas drilling in North America, OPEC, global demand, export terminal, viable substitutes, wars in the Middle East, etc.), it is impossible to predict the price of oil and therefore determine what the price at which crude oil will bottom.  The path to this price and the duration that it lasts will almost certainly determine when the E&P industry will actually consolidate, and thus the time at which the economics for the stronger companies will improve.  Therefore, we believe that it is prudent to remain invested in the energy sector as the long term prospects of the industry have not changed.

*The opinions and forecasts expressed are for informational purposes only and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions.

The S&P 500 Index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. An investor cannot invest directly in an index. Past performance does not guarantee future results.

Bond investments involve the risks of price fluctuation and the issuer’s credit quality. Treasury bonds are backed by the full faith and credit of the U.S. government.

Investments in large companies generally involves the risks of price fluctuation and market cycles.

International stocks entail the special risks of international investing, including currency exchange fluctuation, government regulations, and the potential for political and economic instability.

An investment in a specific market sector is subject to the risks inherent to the sector. The investment’s performance will depend, at least in part, on the condition of the overall sector.

[i] Greenspan, Alan. Remarks by Chairman Alan Greenspan. 5 Dec 1996. The Federal Reserve Board. 3 Nov 2014. <http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm.>

[ii] Schlesinger, Jacob M. How Alan Greenspan Finally Came to Terms with the Market. 8 May 2000. The Wall Street Journal. 3 Nov 2014. <http://online.wsj.com/articles/SB95774078783030219.>

[iii] Wile, Rob. Chart of the Day: Here’s What Stocks Did After Alan Greenspan Warned About ‘Irrational Exuberance.’ 15 July 2014. Business Insider. 3 Nov 2014. <http://www.businessinsider.com/stocks-after-the-irrational-exuberance-speech-2014-7.>

[iv] SPX Index. 23 Dec 2013. Bloomberg Terminal. 23 Dec 2013.

[v] Capitol Report: Recap of Janet Yellen’s Appearance Before Senate. 15 July 2014. Market Watch. 3 Nov 2014. <http://blogs.marketwatch.com/capitolreport/2014/07/15/live-blog-and-video-of-janet-yellens-appearance-before-senate/.>

[vi] SPDR S&P 500. 23 Nov 2013. Morningstar. 23 Nov 2013. <http://performance.morningstar.com/funds/etf/total-returns.action?t=SPY.>

[vii] Peterson, Richard L. Inside the Investor’s Brain: The Power of Mind Over Money. 2007. Page 254. 3 Nov 2014.

[viii] National Income and Product Accounts: Gross Domestic Product. 30 Oct 2014. Bureau of Economic Analysis. 3 Nov 2014. <http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm.>

[ix] Worstall, Tim. Why Have Corporate Profits Been Rising as a Percentage of GDP? Globalization. 7 May 2013. Forbes. 23 Nov 2014. <http://www.forbes.com/sites/timworstall/2013/05/07/why-have-corporate-profits-been-rising-as-a-percentage-of-gdp-globalisation/.>

[x] Colombo, Jesse. Why Stocks Are Undoubtedly Experiencing a Massive Bubble. 8 Oct 2013. Forbes. 3 Nov 2014. <http://www.forbes.com/sites/jessecolombo/2013/10/08/why-stocks-are-undoubtedly-experiencing-a-massive-bubble/.>

[xi] Worstall, Tim. Why Have Corporate Profits Been Rising as a Percentage of GDP? Globalization. 7 May 2013. Forbes. 3 Nov 2014. <http://www.forbes.com/sites/timworstall/2013/05/07/why-have-corporate-profits-been-rising-as-a-percentage-of-gdp-globalisation/.>

[xii] Butters, John. Earnings Insight. 31 Oct 2014. FactSet. 3 Nov 2014. <http://www.factset.com/websitefiles/PDFs/earningsinsight/earningsinsight_10.31.14.>

[xiii] Historical Inflation Rates 1914-2014. US Inflation Calculator. 3 Nov 2014. <http://www.usinflationcalculator.com/inflation/historical-inflation-rates/.>

[xiv] Chart of the Day: 803 Years of Global Inflation. 4 Sept 2012. Zero Hedge. 23 Nov 2014. <http://www.zerohedge.com/news/chart-day-803-years-global-inflation.>


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