There’s a lot of information contained on these slides, but we’re going to focus on some key themes and data points. Here on the two charts on the left, you see the YTD performance of the S&P 500 at 3.9% and a return of 11.3% for third quarter. What’s noteworthy is that four times this year, the S&P 500 has dipped into negative territory for the year and four times it has recovered. And whereas we considered much of the volatility of 2008 and 2009 due to deleveraging, we consider this year’s volatility more a function of uncertainty – that is uncertainty among investors. Looking at the chart just below it, the S&P has returned a remarkable 74% since it’s low on March 3, 2009. Yet is still 22% off it’s peak on October 9, 2007.
This chart is interesting because it shows the value, performance and consensus estimate P/E ratio for the S&P 500 at various peaks and troughs over the last 15 years. What is particularly interesting is that on March 24, 2000 – the S&P had a forward P/E of 25.6 – clearly expensive by historical standards. Subsequently the market crashed and then recovered by October 9, 2007 to that 1,500 level, but only trading at 15x forward P/E – just below the long-term average of 16.6 times. Obviously it crashed from there because many asset values – particularly those around real estate were artificially high and as well the credit worthiness of many consumers and bonds whose debt theirs was packaged into. Subsequently it as rebounded from it’s low on March 9, 2009. Again, with forward EPS expected to be around $80, that could support a level for the S&P 35% higher than it is now (which it would take to reach it’s long-term average valuation). Now that’s not without risks, namely deflation and/or a double dip recession, but we’ll talk more about that in a few slides.
The left had side of this chart is interesting because it shows the implied average annual return needed for the S&P 500 to return to its peak reached in 2007. So we could have four strong years of returns with the S&P 500 returning 10.7%/year – just to get back to its peak! This just gives you a sense of the returns required to reach those peak levels again. The chart on the right side is interesting because here we see the returns for various bear markets and subsequent recovery.
Last column – 10 year cum return of various asset classes. In ’90s, every time you bought equities on dips, you made money. Not true in ‘00. but in fixed income, just about every time you buy a bond, you make money and it reinforces you to buy more – exactly the opposite of what you should be doing.
Here we can see the Fed Funds Target rate currently at 0.25%. The blue line above that shows the yield on the 10 year treasury, currently at about 2.53% - around a historic low. Though inflation may remain low for the time being, a record issuance of treasuries, combined with a rebounding global economy should push yields higher, including those of other high-quality, investment grade, and longer maturity bonds. What’s the implication of that?
Impact on a 1% change in interest rates on price of bonds – last two columns.
Commodity prices to move up, driven by growth in EM infrastructure demand. In general 5% is considered a prudent allocation. Gold – speculation. Not a use asset, not driven by inflation, but maybe fear. Back in the early ‘80s, gold lost 60% of its value in just a few years and has yet to recover in real terms. Oil peaked at over $130/barrel the summer of 2007 and had you bought back then, you would be out about 40% of your money since then.
It is clear from the chart on the left that GDP growth is taking place. Why in the US, the consumption is so important to GDP growth – it makes up 70% of it! While it is certainly possible we could certainly see a double dip recession in the US, it is not probable. Here is why . . .
Economy growing since Sept ’09 per NBER. No recession has lasted more than 24 months except the great depression. And the average expansion has last 43 months – of which we’re 12 months into it.
Recession concentrated in certain sectors: Auto, Residential Construction, business equipment, and inventories. Which makes sense as these are often big ticket items and the first areas consumers and businesses are going to cut back in a recession. They account for only 20% of GDP, but in recessions, historically have accounted for 140% of the change in GDP. So far, they’ve contributed to 100% of the growth of GDP – which is great, but that the rest of the economy really hasn’t started to kick in yet. 3% growth in first year of recovery below long term average of 5% over last 7 recovers.
Right side – private payroll only, otherwise distorted by census and other seasonal workers. Possible 1% per year decline in unemployment. Need 1.5% gdp growth to add payroll jobs, need 2.3% to bring unemployment down. Hence, why unemployment has stalled. Expect slow growth to continue around 3% annualized, but to pick up in 2011.
Bottom right, debt service ability improving b/c of refinancing, more personal investment, consumer spending building up and consumer in a better position to borrow and lenders more willing to lend. So a few slides ago, we talked about how cyclical expenditures have picked in the last year and the slide before that we talked about how consumption is the biggest component of GDP at 70%. Here we can see how personal balance sheets are actually improving, which will eventually lead to increased consumption. On the left you can see personal assets at $67 trillion and liabilities at $14 trillion. At top we see personal savings rate increasing to 5.7% and the debt service ratio falling. Again, with investors generally hoarding cash and other short-term low yielding investments, the could results in real lift to the markets and GDP. Leading indicators that consumption should be rising.
But I want to give you a balanced view and the economy is not without its risks. Obviously, individual and companies have been hit, but so has the government – shelling out $700B in TARP money and another $787B in fiscal stimulus. This year will be a record budget deficit and it cannot be made-up for in GDP growth and tax receipts alone. In the future, the budget gap will have to be narrowed, buy reducing expenditures. Many people believe the Fed will have to raise rates significantly from where there are now, which could cause the Dollar to fall. The reality the other major developed nations are in no better shape that US – The Euro zone, UK, & Japan all have debt to GDP similar to us. Where the dollar is likely to lose ground is to EM nations, that are currently more financially sound that us. Fear – grid lock after election and bush tax cuts expire, increase in chance of double dip recession. If they extend them, don’t fix budget and federal debt explodes. Economy not without it risks, stay diversified.
No let’s look overseas, I talked about the US economy and the rest of the developed world. As you can see on the top chart, for the last 11 years, global growth has exceed that of the US and it has largely been driven by Emerging economies. Now GDP growth doesn’t always translate into investment opportunities, but certainly it’s a factor. Obviously, international investing is not without its risks. Including, currency risk, political risk, market risk, liquidity risk, and financial statement risk – just to name a few.
Little inflation, no wage inflation. Deflation is often associated with a significant drop in GDP – talk about why prolonged deflation is bad, three symptoms – wages need to fall, monetary policy may not work, wait and see mentality; 2 periods – great depression (four year recession with a 27% drop in real GDP and 25% unemployment) and Japan: four differences – larger asset bubble, stronger currency, higher savings rate (which has prevented Japanese consumers from adding to economic growth), slower population growth.
Markets throughout the world have a history of rewarding investors for the capital they supply. Their expected returns offer compensation for bearing systematic risk—or risk that cannot be diversified away. An efficient market or equilibrium view assumes that competition in the marketplace quickly drives securities prices to fair value, ensuring that investors can only expect greater average returns by taking greater systematic risk in their portfolios. This graph documents compounded performance of fixed income and equity asset classes from 1926 to 2009, based upon growth of a dollar. It shows that US equities have offered higher compounded returns than fixed income investments. Within the equity asset classes, small cap stocks have outperformed large cap stocks, resulting in higher returns and greater wealth accumulation. Capital markets reward investors based on the risk they assume. Rather than trying to outguess the markets, investors should identify the risks they are willing to take, then position their portfolios to capture these risks through broad diversification in the capital markets.
Equities offer a higher expected return than fixed income assets over the long term. However, this return premium comes with higher risk, which is manifested in short-term volatility. This slide illustrates that short-term losses are often embedded in longer-term gains. The graph shows the growth of $1 invested in the S&P 500 Index in 1926 until the present, and details the index’s performance during a single year (1999). The first bubble plots monthly returns and the adjacent bubble shows daily returns for a single month (April 1999). Although the S&P 500 Index delivered a strong 21.04% return in 1999, five of the months had negative returns. The market delivered a 3.9% total return during April, even though it closed with losses on many days. Investors who want to capture the higher returns of stocks must accept the possibility of experiencing daily, monthly, and yearly losses along the way. Disciplined investors must focus on the big picture while knowing that short-term volatility will often test their resolve.
The recessions during the mid 1970s and early 1980s each lasted 17 months. There was no formal announcement of the 1973-75 recession because the National Bureau of Economic Research (NBER) did not announce business cycles prior to 1979. However, the NBER announced the 1981-82 recession 6 months after it began, and announced the recession’s end 8 months into the next recovery. In both recessions, unemployment peaked after the US economy had rebounded. Although the stock market declined early in both down cycles, stocks had begun to recover before the onset of each business upturn.
In both the early 1990s and 2000, the recessions lasted nine months each, but were not announced until after they were over. Moreover, the NBER did not announce each recession’s end until almost two years later. Unemployment also peaked in the months prior to the official end. In the 1990s recession, the market began its recovery before the end, while the market languished for two years before rebounding after the 2001 downturn. This provides additional evidence that the stock market does not behave predictably through business cycles.
This graph documents bull and bear market periods in the S&P 500 Index from January 1, 1926 to March 2010. The market cycles are identified in hindsight using historical cumulative daily returns. All observations are performed after the fact. A bear market is identified in hindsight when the market experiences a negative daily return followed by a cumulative loss of at least 10%. The bear market ends at its low point, which is defined as the day of the greatest negative cumulative return before the reversal. A bull market is defined by data points not considered part of a bear market. The rising trend lines in blue designate the bull markets occurring since 1926, and the falling trend lines in red document the bear markets. The bars that frame the trend lines help to describe the length and intensity of the gains and losses. The numbers above or below the bars indicate the duration (in calendar days) and cumulative return percentage of the bull or bear market. Keep in mind that this graph does not show total compounded returns or growth of wealth since 1926. Once the cycle is established in retrospect, the first day of that cycle resets the performance baseline to zero. Investors may draw a number of lessons from this graph. First, since 1926, bull markets in the S&P 500 Index have lasted longer than bear markets and delivered price gains that are disproportionately greater than the bear market losses. Second, fluctuating performance within each trend illustrates that volatility and uncertainty occur even within established market cycles: bull markets may have short-term dips, and bear markets may have short-term advances. The immediate trend is not readily apparent to market observers, and in fact, may become clear only in hindsight. This illustrates the difficulty of accurately predicting and timing market cycles. Finally, the graph suggests the importance of maintaining a disciplined investment approach that views market events and trends from a long-term perspective. Investors who react emotionally to short-term movements are at risk of making ill-timed decisions that compromise long-term performance.
The third slide in this format compares the performance of short-term fixed income instruments to the S&P 500 Index. The bars indicate the percentage of the time that S&P 500 Index outperformed one-month T-bills for each rolling period. For example, the S&P 500 Index beat T-bills in 68% of the one-year periods, in 76% of the five-year periods, and in 95% of the fifteen-year periods. Equally revealing, the S&P 500 outperformed Tbills 100# of the time in twenty-, thirty-, and forty-year holding periods. Although the S&P 500 Index has outperformed Treasury bills for every twenty-year period since 1926, investors should not conclude that stocks are guaranteed to outperform over every twenty-year period in the future. There is no time period over which investors can be assured of a positive equity premium—that is the nature of risk. In summary, long-term success in the capital markets requires a long-term exposure to the risk factors that reward investors with appropriate compensation.
This is what happens to volatility over time. Over the last ten years, gold has returned 15.5% a year on average and over the last 20 years, 5.2% year on average and over the last 30 years just 2%/year. No five year period in the last 60 when a 50/50 portfolio last money during a five year period. Per the chart in the upper right corner, 10.8% may not seem that much greater than 6.2%, but it compounds to create over twice the wealth over a 20 year period.
This cartogram depicts the world not according to land mass, but by the size of each country’s stock market relative to the world’s total market value (free-float adjusted). As you can see, the US stock market is 42% of the world’s market capitalization. However, the typical US investor has 76% of their equity invested there. Population, gross domestic product, exports, and other economic measures may influence where people invest. But the map offers a different way to view the universe of equity investment opportunities. If markets are efficient, global capital will migrate to destinations offering the most attractive risk-adjusted expected returns. Therefore, the relative size and growth of markets may help in assessing the political, economic, and financial forces at work in countries. The cartogram brings into sharp relief the investible opportunity of each country relative to the world. It avoids distortions that may be created or implied by attention to economic or fundamental statistics, such as population, consumption, trade balances, or GDP. By focusing on an investment metric rather than on economic reports, the chart further reinforces the need for a disciplined, strategic approach to global asset allocation. Of course, the investment world is in motion, and these proportions will change over time as capital flows to markets offering the most attractive returns.
Given what we’ve been through, investors have been adopting an increasingly conservative posture. The amount of money held is cash in remarkable – at $2.8 trillion, it’s equal to 90% of the capitalized value of the S&P 500. What is equally remarkable, is this money is earning close to zero. Market is at extremes, stocks to bonds, and here investors are putting money into bonds at extremes. Another measure of conservative behavior is that more money has gone into bond funds in last two years than into equity funds of the last two years of the tech bubble. September marked the 33 rd consecutive month more money has gone into bond funds than equity funds.
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