2013 was a stellar year for stocks — the S&P 500 reached new highs and finished with a gain of 30%. Other developed markets performed well too — the MSCI All Country World Index (ACWI) rose 23% — but the MSCI Emerging Markets index fell 3%. As for 2014, we started the year with a dip begging the question of whether a material correction might be in store, as some observers have predicted.
If the global economy continues to grow moderately, profits can still grind higher. From a valuation perspective, equities do not seem terribly expensive by traditional metrics e.g., the trailing P/E of the S&P 500 is 17.3x, as compared to a twenty-year average of 19.2x. This combination of continued earnings growth and reasonable valuations should be supportive of stock prices.
Global Growth Seems Set to Continue
Despite recent concerns about the global economy in general and emerging markets in particular, underlying fundamentals seem sound. Economic growth is still positive in the U.S. and in most emerging markets — including China — while previously troubled peripheral European economies seem to be stabilizing.
As for the big European economies, with many banks still in deleveraging mode lending may be too weak to fund strong economic growth. Europe is a particularly important region for U.S. corporations; something like 15% of S&P profits are derived from Europe. So, while European growth is not likely to be particularly robust in 2014, it is still a significant positive that most of the region’s economies are now expanding.
Due for a Market Correction?
As referenced above, many observers have been predicting that a market correction will indeed occur at some point in 2014. By historical standards, it would seem that stocks are due for a downturn. We have gone 21 months without a year-to-year decline in the S&P 500, calculated on a monthly basis.
Among the factors that might contribute to a correction:
- It’s arguable that U.S. stocks are vulnerable to “bad news” because many investors are holding large profits.
- Bullishness is widespread –a Barron’s survey of 10 Wall Street strategists in December 2013 revealed that all 10 strategists expected the S&P 500 to advance in 2014, with a mean anticipated gain of about 10%.
- There are signs of complacency in the market — the S&P 500 Volatility Index (aka “the VIX fear index”) was 14 at the start of 2014, down from 18 at the start of 2013.
A Sharp Decline in Stock Prices Seems Unlikely
That said, none of the classic causes of a sharp decline in stock prices – rising interest rates, financial panic and war—seem likely to occur in 2014.
- Rising interest rates: Short-term rates are unlikely to rise meaningfully before 2016, so that investors will continue to earn virtually nothing on CDs and money market funds, and very little from bonds (on top of the possible price risk for long-dated fixed income instruments).
- Financial panic: We are unlikely to experience a financial panic similar to that of 2008 anytime soon, because regulators (and investors) are alert to the warning signs of speculative excesses, and Wall Street managements have neither the appetite nor the approval to dabble in risky “financial innovations.” All the same, as discussed below, there is a risk—albeit a small one—of an imported financial panic that spreads from emerging markets.
- War: It seems to many observers that President Obama prefers to retreat from international confrontations instead of pursuing more aggressive options (e.g., Syria, Iran).
There is a (Small) Risk of an Imported Financial Panic
The Federal Reserve’s announced tapering of its bond purchases exposed the economic and financial fragility of certain emerging economies, a number of which have also been experiencing political turmoil (e.g., Argentina, Egypt, Thailand, Turkey, Ukraine). In comparison to developed economies, many emerging markets are far less diversified, have less robust capitalist institutions and face greater financial risk because many must borrow abroad. The Fed taper talk pressured the currencies of some of these emerging economies, and forced a number of central banks to raise interest rates.
Today there is a risk – albeit small –of an imported financial panic that spreads from emerging markets and ultimately triggers a sharp decline in stock prices. Recall that the 1997-98 Asian financial crisis raised the specter of global deflation and caused a financial panic in the autumn of 1998.
In the late 1990s, Asia’s fundamental problem was an overemphasis on saving and production. Booms supported by excessive bank lending and inflows of foreign capital collapsed in several industrializing Asian nations, which led to a wave of bankruptcies, most notably in South Korea, Indonesia and Thailand. Collapsing currencies plunged much of Asia into recession, while weakening demand in developed markets caused global commodity prices to collapse. Battered by weak oil prices and a capital flight out of emerging markets, Russia was thrown into economic turmoil and defaulted on its international debts. The Russian debt default caused the U.S. bond market to freeze up, which proved calamitous to Long Term Capital Management. The prospect of this large hedge fund’s collapse sparked a financial panic in the autumn of 1998.
Today the risk of an imported financial panic that spreads from emerging markets seems low. For a start, it’s important to distinguish between China and other emerging markets.
- As noted above, the Federal Reserve’s announced tapering of its bond purchases exposed the economic and financial fragility of certain emerging economies. A review of the trade and government budget balances of emerging markets suggests that a number of countries have significant trade and/or budget deficits, which are often accompanied by relatively low levels of foreign exchange reserves. This group includes countries such as Argentina and Turkey.
- China is among those emerging economies that have fewer imbalances and that look relatively healthy. This is significant because China has been responsible for around 40% of the growth rate of global GDP, given that its economy has continued to expand by 7+% a year while developed world economies struggle to grow at 2-3%.
Profits and Stock Prices Look Set to Grind Higher
If the global economy continues to grow moderately, profits and stock prices can still grind higher. The sectors that are likely to experience profit growth in 2014 are those with broad cyclical exposure, including Consumer Discretionary and Industrials. However, moderate global economic growth will likely mean that commodity prices languish.
Of course, for investors, valuations are just as important as earnings. In the current very low interest rate environment, many investors have been “reaching for yield” so that some “bond substitutes” — including Consumer Staples and Utilities – have relatively high valuations.
For further context in reviewing the U.S. market and considering relative value by sector, below we briefly summarize the profitability (i.e., operating margins) and valuations (2014 estimated operating P/E) of the ten key sectors in the S&P 500:
- Consumer Discretionary: An improving U.S. consumer is undoubtedly a positive for margins, which have been flattish; however the sector is currently the most expensive (17.7x) of all.
- Consumer Staples: While margins have expanded in recent years, this “bond substitute” isn’t cheap (16.5x) relative to other sectors.
- Energy: Margins have been declining, so the relatively low P/E (12.6x) likely reflects an outlook for limited growth opportunities.
- Financials: The second least expensive sector (13.2x) after Energy, likely reflecting uncertainty about revenue growth and regulatory reform.
- Health Care: The second most expensive sector (17.1x); “Obamacare” is a wildcard for margins.
- Industrials: A steadily growing global economy is a positive for margins (which have been expanding and are significantly higher than those of the Energy and Materials sectors), while valuations don’t seem stretched (15.9x versus 15.1 for the S&P 500). Continued capex growth is a critical factor.
- Information Technology: Even cheaper than Industrials (14.7x), although margins have been flattish. Continued capex growth is critical here too.
- Materials: The P/E is roughly the same as Industrials (15.6x) but pricing power seems questionable in an environment of just moderate global economic growth.
- Telecommunication Services: A relatively cheap sector (13.5x) although, as with Energy, the low P/E likely reflects an outlook for limited growth opportunities.
- Utilities: This “bond substitute” is even more expensive (14.9x) than Information Technology, although catalysts for margin expansion are unclear in this regulated sector.
Michael Geraghty is the founder Informed Investor, LLC a consultancy specializing in thought leadership that produces bespoke research reports for institutional investors. Michael has over three decades of experience in the financial services industry. He has worked as an investment strategist at a number of leading firms.