The following is excerpted from the year-end commentary by Litman Gregory. To read the full commentary, click here.
Our message has been consistent, even as new information unfolds, that deleveraging will mean slower growth at the same time it raises the risk of another financial crisis. That said, an important part of our investment discipline is to minimize the risk of “confirmation bias.” Confirmation bias refers to the human tendency to seek out and favor information and data that supports one’s beliefs, arguments, etc. Confirmation bias is a powerful trait that all people are prone to, and our industry is not immune. We all want to be right and confirm our beliefs. This can lead to digging in one’s heels, dismissing counter evidence, and ultimately an avoidance of admitting mistakes. In the long run it’s valuable to be able to change one’s mind when we’re presented with new information. John Maynard Keynes famously said, “When the facts change, I change my mind, what do you do?” (Actually there is some controversy as to whether Keynes actually ever said this, but we like the quote anyway.)
Our attempt to avoid confirmation bias in our decision-making involves lots of debate among our team and exposing ourselves to alternative points of view through our reading and working our extensive industry network. Most important, our scenario approach forces us to think through a variety of possible outcomes. With that context, the next part of this commentary lists a variety of bullish factors that, though counter to our base-case view, could drive stocks to strong returns over the next five years.
1. First, the passage of time has led to an improvement in our expected returns for stocks.
This happens as we anticipate a return to more normal earnings growth in the later years of our analysis. As we write this, our five-year expected returns for U.S. stocks in our base-case subpar growth scenario are still low, at about 4.5%. This scenario now assumes a gradual return to trend-level earnings. But in our optimistic scenario, the returns—at close to 14%—are very strong. This scenario assumes that as we put deleveraging-related headwinds behind us, earnings can temporarily overshoot the long-term trend level (we assume by 20%) in five years. Expected returns in this scenario for European stocks (which had suffered large price declines until a market rebound that started in June) and emerging-markets stocks are materially higher than for U.S. stocks.
The passage of time is important in other ways. Let’s remember that an enormous amount of froth has been taken out of stock prices. The stock market, as measured by the S&P 500, is at a level first reached 13 years ago. And even with the rebound from the extreme lows of 2009, the two bear markets since the start of the 2000s have taken back much of the great bull market of the 1980s and 1990s (that started in the summer of 1982). Looking back over 30-plus years, a period that encompasses that great bull market, the annualized return for the stock market is around 12%. That is a good return but it’s not exceptional and, as such, is evidence that the froth of the incredible 17-year bull market has been wiped away. Besides the fact that stock prices were flat over the past 12 years, multiples are much more reasonable than they were.
2. The risk of another financial crisis has declined.
Time has allowed for some healing, some deleveraging has happened, and Europe has made some progress. So the risk of a crisis that leads to deflation is less than it was. Over time, this should have some impact on investor risk-taking, especially if this trend continues.
3. There have also been enormous changes with respect to investor sentiment and fundamentals that drive expectations.
For example, stocks recently comprised 35% of household financial assets compared to over 50% in early 2000. Over that period of time, households withdrew about $1 trillion from stock funds. And almost the same amount has flowed into bond funds since March 2009. U.S. public pension funds have also been selling stocks, with allocations falling from 70% to 52% over the past 10 years, according to the Financial Times.
These shifts reflect huge changes in investor confidence. Confidence about the economy was very high in early 2000, about double today’s level. Today’s low confidence is clearly related to the losses experienced during the financial crisis and its aftermath as we deal with the related problems of debt, lack of demand, and weak job growth. The labor market is particularly important. In early 2000, the unemployment rate was just over half of today’s 7.7%. The takeaway is that bull market peaks are characterized by overconfidence. Back in 2000, when optimism was unrestrained, we recall a consensus forming that the economy would be less volatile with fewer and shallower recessions. There was growing belief that asset valuation didn’t matter. Conversely, bull markets are born from pessimism that makes investors cautious and keeps expectations low. Fears of another financial crisis are a good example of this. When expectations are low and fundamentals have been weak, improving conditions are more likely, i.e., it is easier to have a positive surprise. When expectations are very high, there is greater risk of disappointment. This confidence obviously has an impact on stock prices, with optimism usually leading to overvalued stocks and pessimism leading to undervalued markets. Confidence, while improving, is not high as we head into 2013. As a contrarian indicator, this is a positive.
4. Relative valuations driven by the Fed’s low interest-rate policies could continue to play a big role in equity returns going forward.
Valuations are in a fair-value range (not cheap) on many absolute measures. If one assumes that macro forces will result in below-average earnings growth (as we do in our base-case scenario), stocks look around 20% overvalued. However, if economic growth gradually improves, tail-risk fears subside, and as time further distances investors from the financial crisis, investors could find stocks far more appealing than bonds or cash. Cash yields nothing (and has a negative return after inflation) and is likely to continue to be the case for some time given Fed policy. Bond yields are also painfully low and everyone knows that at some point there will be a rise in interest rates that will result in lower bond prices. This point may be far down the road, but, in the meantime, investors are increasingly aware of the longer-term risk in holding bonds, and they are paid very little to take that risk. In terms of the relative yield, stocks have not looked this attractive compared to bonds for decades. If time continues to pass without a crisis, and moderate economic gains allow earnings to make steady progress, stocks could benefit from the mountain of cash allocated to bonds in recent years starting to be reallocated back into the stock market.
5. Uncertainty about policy decisions and debt-related risks continue to drive investor concerns.
However, these risks are the subject of great focus and real progress could be made in 2013. As we mentioned at the outset of this commentary, Congress’s last-minute compromise on the fiscal cliff on January 1, 2013, allayed the worst fears of tax increases combined with abrupt spending cuts. However, President Obama and Congress will still need to address the spending cuts, which were delayed for two months and it remains to be seen if politicians can agree upon a credible plan for long-term deficit reduction. If they do, that could go a long way toward mitigating concerns about future debt build-up and related policy errors. In the United States, this could unleash corporate animal spirits as the fear of tail risk subsides. The corporate sector is sitting on a lot of cash that could be used for capital investment and hiring as some of the uncertainty recedes. (Corporate sector cash is a positive no matter what—companies are buying back large amounts of their shares. This improves earnings per share over time. If uncertainty declines and businesses instead invest for growth, this will be good for the overall economy.) In Europe there is also fear of policy errors and though this fear is certainly justified, it is also possible that 2013 could see progress toward banking and fiscal union and a return to growth later in the year. If that happens, fear of a disorderly breakup of the monetary union could decline. Less uncertainty would be bullish for stocks.
6. The global economy has experienced some encouraging macro developments.
In the United States, the housing market may be in a sustainable upturn. Home values are increasing and are cheap relative to replacement costs, and interest rates are exceptionally low for those who can get a loan. Housing starts are moving up from of a very low level. Housing is now a driver of growth rather than a drag on growth. Credit markets also continue to improve with easier lending standards. And the labor market is slowly healing, though it remains historically weak. The number of unemployed per job opening remains high, but is steadily declining and virtually every labor market measure is getting better, though there is a long way to go before the patient is fully healed. And as mentioned, there is a possibility of the economy gaining more traction if corporations loosen their purse strings and begin to invest and hire. Overall, there is no robust growth story, but the recovery is broadening out and the participation of the housing sector is important. Outside the United States, the growth slowdown in the emerging markets may have ended and there are numerous signs that China’s economy is picking up (though not to previous growth levels). Even Europe, currently in recession, could start growing again in the second half of 2013.
How Probable is the Bullish Case?
The odds of the bullish case playing out may be increasing, but in our view they are still not high. There is no easy road out of our debt bind and there are consequences to that reality. The only easy road would be robust growth, but this is close to a mutually exclusive condition with a deleveraging global economy. So despite somewhat improved odds of the bullish scenario, it is more likely that we see a slow-growth environment with a continuation of some aversion to risk. In this environment, corporate earnings will be challenged as growth through cost cutting has largely played out. Revenue growth will need to be a driver and ultimately that will depend on demand. Partly due to very high (and potentially unsustainable) profit margins, our estimate of normalized earnings is materially below the current level.
