As the first quarter of 2013 comes to an end the S&P 500 currently sits at a record high. Since hitting an intraday low of 666.79 in March 2009, the S&P 500 has rallied 135 percent. This performance, however, has been accompanied by a lackluster recovery in the overall economy.
This recent market rally can be attributed to aggressive monetary policy by the Fed and record profits from US companies. Despite some apprehension among several Fed members, the Central Bank recently agreed to maintain their accommodative monetary stance of purchasing $85 billion in monthly bond purchases. This accommodative stance is designed to suppress interest rates and boost housing and equity values in an effort to elevate US employment. Globally, central banks are flooding markets with cash, but we are still not yet seeing a big rotation out of bonds. Companies have proved they can produce the earnings and they are finally beginning to get paid for those profits in the form of higher stock prices. As investors gain more confidence in the broader market we expect to see the rotation out of bonds into equities, pushing financial markets even higher.
In 2007, the S&P 500 had earnings of $83.99 while the average forecast for this year is $111.17. Additionally, in 2007, the S&P was relatively expensive compared to today’s valuation as the market was trading at 15.7 times earnings relative to the current 14.2 times earnings. Considering the current earnings yield of 7 percent (anticipated earnings per share divided by stock price) and the current yield on a 10-year Treasury bond of 2 percent, equities appear even more attractive. In 2007, the earnings yield was 5.3%.
In contrast to the circumstances surrounding the last market peak in 2007, the banking sector is better capitalized, housing seems to have stabilized, corporate profits continue to improve and profit margins remain solid. We are also starting to see a revival in the commercial real estate sector, which could add another leg to the economic recovery.
The third revision of US economic growth in the last quarter of 2012 showed the US economy grew at an annualized rate of 0.4%, higher than the initial estimate of 0.1%. Most of the improvement in this latest revision is attributable to a much higher estimate in business investment in buildings.
Despite a hit to disposable income (payroll tax hike) and fiscal tightening, consumer spending appears to have remained relatively robust thus far in 2013. The consensus is that the private sector should be able to push US growth higher even with government spending cuts.
Globally, emerging stocks continue to underperform and have experienced their biggest first quarter slump since 2008. Renewed fears of a Chinese slowdown have spurred concern about the outlook for the nation’s economy. The MSCI Emerging Markets Index slipped 2.2% this year, trailing the S&P 500 and the MSCI World Index of developed-country stocks. Valuations on emerging market stocks appear cheap as the measure trades at just 10.9 times forward earnings, compared to the MSCI World Index and S&P 500 which both trade at 14.2 times forward earnings. Although emerging markets have recently underperformed the broader market, we still like the growth prospects of these countries and are confident that valuations will eventually normalize.
Although emerging markets, bonds and commodities have underperformed the S&P 500 and have subsequently mired the performance of our portfolios, we are encouraged to see these asset classes moving back towards traditional correlations. This development should bode well for well-disciplined investors with well diversified portfolios.