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High Anxiety

Covering your assets

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With the US equity market recently at all-time highs, a fear of heights seems justified. After all, we’ve just experienced the sharpest recovery in post-WWII market history while being recently reminded about the eventual removal of the Federal Reserve’s asset purchase program. Europe seems to be mired in recession and credit-tightening in China adds to the general sense of unease. With the sting of the 2008 financial crisis still fresh in investors’ minds, these concerns are rational and likely explain at least some of the recent higher volatility.

So why stick around?

The US economy appears to be entering a period of renewed growth. Also, you have probably heard something about the very healthy condition of corporate fundamentals, which we do not think are going to change anytime soon. Keep in mind we also expect monetary policy to remain unusually accommodative for the next few years. In our view, these are clear and durable positives for equity valuations and provide meaningful incentives for long-term investors.

What a ride.

After the most devastating bear market since the Great Depression, the S&P 500 Index has recovered all the ground lost from 2007 through early 2009. While this recovery has been similar to prior recoveries in terms of duration, we’ve had much wider swings in market value which has made for one of the most intense full market cycles in history.

Buoyed by strong corporate earnings and three rounds of bond purchases from the Fed, the US bull market is now entering its fifth year, reaching record highs in early May 2013. Of course, market setbacks have occurred along the way, ranging from fears of a Eurozone collapse to downgrades of US credit to fears of another global recession. However, investors who bore the risk and stayed invested have been handsomely rewarded as the S&P 500 has risen 141% from March 2009 through May 2013 (see Figure 1).

Figure 1: Standard & Poor's 500 Index

Source: Bloomberg, Standard & Poor’s Corporation, as of May 2013. Past perfomance is not necessarily indicative of future performance. All investments may lose value over time. These returns do not reflect the deduction of Aspiriant fees nor fund manager fees and may or may not contain the deduction for the reinvestment of dividends and other earnings. Indices are unmanaged and have no fees. An investment may not be made directly in an index.

The US keeps improving.

The world’s largest economy is proving its uniqueness and resiliency. Despite some growth challenges around the world, the persistent structural advantages of the US economy are key differentiators: flexible labor markets, less complicated capital formation, leadership in technological innovation and a consumption-oriented culture. Additionally, the recent boom in energy production is likely to develop into another durable benefit. Combining those advantages with the relatively fair, but very far from perfect, mix of fiscal, monetary and legislative policies has created the most fertile conditions for fostering sustainable growth.

More recently, the US economy appears to be gaining traction. We expect increased growth, albeit historically sub-par, to be led by housing and consumer spending. However, there will be challenges, as we anticipate the US economy will be restrained by reduced federal and state spending, higher taxes and lower trade due to struggling overseas economies.

Consumers are in a much better position today to increase spending than just a few years ago. As illustrated in Figure 2, the deleveraging cycle is nearly complete and nominal household net-worth has been fully restored to pre-crisis levels. This should support a 2.0% to 3.0% annual rise in consumer spending relative to an average 1.5% increase during 2005-20121. Additionally, recent data regarding consumer confidence (see Figure 3) and sentiment have been very encouraging, indicating a sense of optimism we have not seen since July 2007.

Figure 2: Household Debt & Net Worth

Source: US Federal Reserve, as of December 2012.

Figure 3: Michigan Consumer Sentiment Index

Source: Michigan Consumer Sentiment Index, as of May 2013.

Housing activity continues to improve from low levels. A combination of higher demand, driven by near-record affordability (see Figure 4), and low supply has been positive for home prices. Over the last year the S&P Case-Shiller National House Price Index rose 10.2% through the second quarter. Price gains were also broadly distributed, as over 80% of zip codes experienced home price increases2, including regions that had seen disproportionate levels of sub-prime lending. Moving forward, housing fundamentals point to further price gains, but gains will be moderated by increasing mortgage rates, increasing inventory and continued tight lending standards.

Figure 4: Housing affordability index remains high; price-to-rent ratio is near 2001 levels

Source: CoreLogic, BLS, NAR, GS Global ECS Research, as of May 2013.

As the US economy goes, so eventually goes the rest of the world economy. With consumption and housing on firmer ground and the drag from reduced government spending declining later this year, we see the sequential growth story for the US economy rising over the next several quarters. Additionally, with an anticipated bottoming out in Europe early next year and Japan embarking on an aggressive central bank balance sheet expansion, prospects for global growth are set to improve in 2014.

We belong here.

Business fundamentals have rarely looked better. With operating earnings near all-time highs, the most attractive profit margins we have ever seen (see Figure 5) and de-leveraged balance sheets flush with excess cash, is it unreasonable for equity markets to be near all-time highs?

Some analysts counter that, moving forward, profit margins should eventually slip back to historical levels, leaving stocks vulnerable to downward earnings revisions. In our view, the arguments are far from compelling that the margin trend should mean-revert anytime soon.

Figure 5: After-Tax Profit Margins

Source: Department of Commerce, as of March 2013.

According to the 2012/13 Global Wage Report by the International Labour Organization (ILO), a majority of countries have experienced a downward trend in the labor income share of corporate earnings (i.e., wages), which means a lower percentage of GDP has gone into labor compensation and a higher share into profits. In short, it suggests that most of the gains in productivity growth have accumulated to shareholders instead of workers.

Figure 6: Adjusted labor income shares in developed economies, Germany, the USA and Japan 1970-2010

Note: ADV = unweighted average of 16 high-income OECD countries (Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, the Netherlands, Spain, Sweden, the United Kingdom and the United States. The Republic of Korea is excluded.)

Source: International Labour Organization, Stockhammer from AMECO database, as of December 2010.

Figure 6 illustrates the decline in labor’s share income since the 1980s. Observe the trend for the OECD countries (ADV), which is almost a mirror image of the profitability trend in Figure 5 since the early 1980s. The effects have been so persistent and pervasive across countries and industries it implies larger structural forces are involved. The ILO report proposes a variety of potential causes including technological progress, trade and labor market globalization and the expansion of financial markets, all of which have eroded the bargaining power of labor.3

In our view, absent increasing wage pressures (unlikely, given the slack in the global labor markets), we expect corporate profit margins to mostly resist any roll-back tendencies. Maintaining current margins is an important component of the future earning power of global businesses and, in turn, the valuations of those enterprises.

Equity valuations are reasonable.

Intelligent investors would agree that valuations play an important role in explaining long-term stock market returns. However, assessing valuations is complicated due to the wide range of techniques used to measure value. For simplicity and clarity, we will focus on one of the more commonly used metrics.

Figure 7: Cyclically-Adjusted PE Ratio S&P 500

Source: Yale University/Shiller data, Aspiriant LLC, as of March 2013. Ratio of company’s current share price compared to its per-share earnings.

A popular ratio is the cyclically-adjusted price-to-earnings (CAPE) ratio, also referred to as the “Shiller P/E.” Instead of using one-year trailing earnings as the denominator, this metric uses an average of the prior ten years’ earnings and adjusts them for inflation. The average smooths-out the earnings variability arising from business cycle fluctuations to help arrive at a more stable and long-term understanding of valuations. The fair value range indicated in Figure 7 is defined by a one standard-deviation adjustment to the historical average, excluding outliers. We notice that US equities are within a fair value range, albeit not the bargain they were a few years ago.

It is also worthwhile to point out the relationship between P/E ratios and inflation. In general, when inflation is lower P/E ratios tend to be higher and vice-versa. This tends to be true mainly because lower inflation generally means lower interest rates. Back to Finance 101, when you discount a series of future cash flows at lower interest rates they become more valuable. Since 1926, when inflation has risen at the 1.0 to 2.0% level (similar to our current environment), the CAPE ratio has averaged 21.5x.

We believe current US market levels can best be described as being within the upper half of a broad fair-value range. Overseas equity markets, however, look very different, particularly those in Europe and emerging markets. Non-US markets comprise about half of many clients’ equity holdings, and we notice valuations well below historical averages; thus, we would not be surprised to see significant outperformance by those markets over the medium-term.

Central bank support is not going anywhere.

We have run out of superlatives to describe the unprecedented level of central bank intervention over the last five years. In short, it is historic, has had a large impact on financial assets, and has been necessary to prevent a less favorable economic outcome.

Figure 8: Change in central bank balance sheets since January 2007, Trillions

Source: Fed, BoJ, BoE, ECB, PBoC. JPMAM estimates, as of June 2013.

It is also clear that at least some of the recently higher volatility is coming from the notion that once the Fed ends its asset purchase program, one of the legs supporting the stool will give way and asset prices will come crashing down. While there is no question the Fed’s policies have been part of the appreciation equation, this perspective is overly myopic and largely disregards the bigger picture, which is that monetary policy (around the world) will remain unusually accommodative for the next few years. Some key comments:

“Not Wild Turkey to cold turkey”: Dallas Fed President Richard Fisher. His point was that any potential withdrawal of the Fed’s asset purchase program will be gently managed and highly data-dependent (read: potentially reversible). Reducing the level of asset purchases should be viewed as an encouraging development, as it means officials have observed substantial improvement in the labor markets, and is a good omen for both the US economy and for long-term investors.

Fed remains committed: With inflation tepid, the Fed is committed to keeping short-term rates low until it sees marked improvement in unemployment (estimated mid-2015). Ben S. Bernanke’s post-Federal Open Market Committee comments indicated a willingness to keep short-term rates lower for even longer. It is also likely the European Central Bank will adopt an easier stance while the Bank of Japan announcements indicate a firm commitment to asset purchasing.

Status quo has benefits: Reflationary agendas of central banks ease the burden of servicing higher public sector debt levels acquired during the financial crisis and can also stimulate exports through a weaker currency. These are often over-looked and convenient side benefits to maintaining the policy status quo.

Leadership transition outlook: If Bernanke does not indicate an interest in a third term as Fed chairman (early indications seem to support this perspective) his role ends in January, 2014. The leading candidate is thought to be the more dovish-leaning Vice Chair Janet L. Yellen. At the very least, this means there could be little, if any, risk associated with a policy change resulting from any leadership transition.

A key take-away for investors is not to interpret any tapering as tightening. Specifically, the most recent announcements indicate a potential reduction in the pace of easing or in the words of Bernanke, “…any slowing in the pace of purchases will be akin to letting up a bit on the gas pedal as the car picks up speed, not applying the brakes.” In that regard, the monetary policy leg supporting the proverbial stool remains mostly in place.


Over the near-term a bit of high anxiety on the part of equity investors will likely induce more volatility and perhaps even an overreaction to the downside. Even though we seem to have more clarity from the Fed in terms of timing, the uncertainty will remain as the Fed has announced a preference for being more data dependent in its decision making. This means markets will likely be subject to ongoing adjustments regarding Fed timing as economic data either fails to meet, or exceeds, expectations.

Long-term investors should remain optimistic and focus on the renewed growth story unfolding in the US economy heading into 2014. The supporting cast includes compelling corporate fundamentals, reasonable equity valuations, a reviving housing and consumer sector and committed central banks around the world.

David C. Grecsek, CFA
Chief Investment Officer (Interim)

Nathan Wong, CFA
Senior Analyst – Investment Strategy & Research


1 Sinai, Allen and Husby, Andrew, “Taking Stock of the Stock Market in the ‘Financial Cycle’ - The Best is Yet to Come,” Sinai’s Economic and Market Perspectives. Decision Economics. June 2013.

2 Hui Shan, We; Young, Marty; Himmelberg, Charles; Henson, Chris, “United States Housing Monitor,” Credit Strategy Research. Goldman Sachs. June 2013.

3 “Global Wage Report 2012/13: Wages and Equitable Growth,” Geneva. International Labour Office. 2013.

CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

1Bureau of Labor Statistics, Change in Total Nonfarm Payroll Employment (June 2014).

Important disclosures: Past performance is no guarantee of future performance. All investments can lose value. Indices are unmanaged and you cannot invest directly in an index.

S&P 500 is a market-capitalization weighted index that includes the 500 most widely held companies chosen with respect to market size, liquidity, and industry. The volatility of an index may be materially different than that of a model. You cannot invest directly in an index. Index returns assume the reinvestment of dividends and capital gains. The MSCI ACWI All Cap Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. It is not possible to invest directly in an index. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

S&P GSCI: The S&P GSCI is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment.

Wilshire Global RESI: Is a broad measure of the performance of publicly traded global real estate securities, such as Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs). The index is capitalization-weighted.

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