Saturday, March 23, 2013

The Bull Case for US Equities in 2013

There are so many unique things going on in today's market that it is easy to come up with arguments for and against almost every investment (maybe that's not so unique after all!).  I am putting together the various pieces of my analysis & thinking in this post.

My analysis leads me to be bullish for equities going forward - that doesn't mean stocks will continue rising in the short term (nobody can predict that!), but US stocks seem to be the best source of real returns over the long run.

(1) Surverying the alternatives

First, let's look at the alternatives.  The only alternatives I consider are cash, bonds, and equities - other things like gold, fine art, etc are beyond my knowledge or interest as they aren't productive assets.

  • Inflation is running about 2% in the US.
  • Cash is yielding 0.2%, for a large negative real yield.
  • Long treasury bonds are yielding 1.9% for 10yr, 3.1% for 30yr, so basically you are making very little on inflation that is likely to be at least the same if not higher over those long periods.
  • The S&P500 yields profit of 6.3% (ttm profits), 5.5% (3yr average profits), or 4.5% (10yr average profits, used in Shiller's CAPE).

S&P profit premiums to inflation are close to average (using the CAPE data), whereas cash and bond premiums are 2-3% lower than average (1.5 standard deviations lower for cash, 0.5 standard deviations for 10yr treasuries).

Just looking at this instantaneous data, equities are clearly the best choice.  However, there are many who correctly argue that the low rates which make equities look attractive are artificial and so shouldn't be used for valuing equities (due to the US government's intervention through Operation Twist, Quantitative Easing, etc).

I completely agree that a significant rise in rates would change the equation, but I can't predict whether this will happen, or more importantly when it will happen.  I'm also not convinced anybody else can predict this, since there have been plenty of incorrect macro calls made by the best of the best, even legends like Ben Graham and Warren Buffett!  In the end, Buffett's advice of ignoring macro issues and focusing on buying good business cheaply seems like the only reasonable approach to me unless an alternative investment is a better risk-reward based on data today (no predictions!).

Given all this, the first piece of my analysis says to invest in the best choice I have today, which is in US equities.

(2) Macro Economic Thoughts

While I just said that ignoring macro factors is best, it is interesting to think about the environment to see if that thought process yields at least some reason to support the investments I am making today.

(2a) Government intervention & rising rates - The Impossible Trinity

One way I think about the environment today is by considering the Impossible Trinity (  It says a government can only have 2 of these things:  control of monetary policy (interest rates), free capital mobility, and fixed exchange rates.  The US is holding rates low (control of monetary policy), and has free capital mobility, which implies a floating exchange rate.  If the action of keeping rates low were beyond what the market would support, the US dollar should be dropping and inflation should be rising, neither of which have been happening.

Now consider China, which I believe is an important part of this equation.  China has control of monetary policy and a fixed (pegged) exchange rate to the dollar.  Therefore China cannot have free capital mobility.

I am no expert in how macroeconomics work, but the pegged exchange rate seems to be allowing the US to borrow at low rates from a China forced to buy US dollars (in order to keep their peg working).  The exchange rate peg allows the US to print money without paying the cost (inflation, loss of currency's purchasing power), in fact exporting the inflation to China and other countries that manage their exchange rates.

What if China decided to stop their peg?  To me that seems unlikely for an economy that is reliant on exports to the US - allowing the Yuan to appreciate would devastate their export-driven economy dramatically more than it is already being hurt today.  The level of social unrest such a policy change would cause in China is against the incentives of all the leadership, who like any politicians would single-mindedly avoid losing power.

(2b) The Commodity Cycle

Countries like Canada have been isolated from the US economic weakness of late because of a strong commodity cycle.  I have written about this in the past in terms of the Canadian stock market relative to the US market (link).  With recent US energy production surging and the inherent cyclicality of commodities, the commodity cycle should continue to unwind in my view, giving further tailwinds to the US consumer especially.

(3) Profit Margins

Many people point to the historically high profit margins and say that this indicates over-inflated profits that must be discounted when valuing stocks.  Certainly, the level of corporate profits as a % of GDP (based on Federal Reserve data at FRED) is at record highs of 11% vs an average of 6% over the past 50 years or so.

Looking at the S&P500, the total after-tax profit margin is 8.6% on a trailing 12 months basis.  I don't have historical data for this, but Warren Buffett's 1977 article (link) mentions that margins were 8% to 8.6% pre-tax in the 1955-1975 time period.  So margins are higher because the latter numbers are pre-tax, but not as dramatically as the 11%-vs-6% the FRED data implies.

If you are reading this far, you will no doubt have heard the famous saying that 'This time is different' is the most dangerous phrase in investing (I believe originally said by John Templeton).  So are margins certain to revert back to the 8% pre-tax level?  Perhaps.  But on the other hand, there's also some reason to think higher margins are supported by fundamentals.

On one hand, an article I linked to earlier (link) shows a graph that I've pasted below showing how productivity has increased far faster than wages since the mid-70s.

The graph below shows this another way by graphing the 5-year growth in real salaries & wages from Federal Reserve data at FRED.  Only in the early 80s was the wage growth so poor (if you track markets, you will know that the early 80s were one of the best times to invest!).  All of this lines up with what I see as much lower power for labor than has been the case in past decades, which when combined with increases in outsourcing & a relatively high unemployment rate, supports higher profit margins from cheaper labor costs.

In addition to the above, there are so many companies out there that are issuing long bonds for close-to-inflation interest rates, using proceeds to buy back stock aggressively.  Many big companies have been doing this, and you can see an older article about this here.  All of this borrowing & stock buyback results in higher ROE for the same ROA.  While this doesn't affect margins directly, it explains why ROE of the S&P500 is 14% today vs more normal levels of 12% (see again the Buffett article mentioned above).  So from a return on capital perspective, the higher level of 14% makes intuitive sense and doesn't seem ripe for falling apart in the short term.

(4) Sentiment & Historical Factors

There are several historical ways to look at things that further encourage my bullishness.  The graph below shows the real value of the S&P500 if dividends were re-invested.  Note that the Y-axis is logarithmic, which is required for any long time period like the one here going back to 1928.  You can see that real returns were:

  • near-zero from 1928 to 1942 (14 years)
  • strong from 1942 to 1962 (20 years)
  • near-zero from 1962 to 1982 (20 years)
  • strong from 1982 to 2000 (18 years)
  • near-zero from 2000 to 2012 (12 years)

Can you take a couple samples like this to the bank?  Of course not, but it is interesting that there have been pretty consistent cycles that last ~35 years.  I also find it interesting that 35 years is not too different than what the investing lifetime of an average investor must be.
The graph below shows a picture of the previous 5-year growth in real earnings (measured as the average of the last 3 years) and of dividends.  A cycle is again visible, with good times to buy generally being when the lines are low, and with no cases where the line doesn't rise up a peak much higher than where we are today.

Next, this graph is from the Horan Capital Advisors blog, which shows that fund flows have only recently started to turn around for equities, but far from adequate considering how bad a bond investment is today (Warren Buffett has said bonds should come with a warning label!).

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