Market Notes

September 3, 2013
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Revisiting the building blocks of investment opportunity
By: Rex P. Macey, CFA, CIMA, CFP®, Chief Investment Officer
Wilmington Trust Investment Advisors

Key points

With summer having drawn to its unofficial close and workers returning to their desks, we revisit the building blocks of long-term investment opportunity: share-price valuations and the outlook for corporate profits and economic growth. In our view, the U.S. stock market appears fairly priced in aggregate. The allure of the market, at this point, is at least two-fold. First, the U.S. remains the world's dominant market, both a source of long-term investment opportunity and a perceived safe haven relative to competing markets. Second, the U.S. "took its medicine" earlier than other countries in the wake of the financial crisis. The nation enacted tax increases, cut spending, and for a long time maneuvered to make inflation-adjusted interest rates negative, at least among shorter-term securities, punishing savers but encouraging investment. Now the United States may be benefiting from the notion that it is further removed from its economic trough than competing economies.

S&P 500 Index company profits rose about 1.5% in the second quarter, compared to the year-earlier period. We believe earnings per share will continue to grow. We expect growth of about 5% on a yearover- year basis for the current quarter and of roughly 8% for the fourth quarter. These estimates make us slightly more conservative than the consensus of profit forecasters surveyed by Bloomberg. Our conservatism on profits dovetails with our slightly-below-consensus estimates of U.S. economic growth, which appear in Figure 1.

Figure 1: Projections of real (inflation-adjusted) U.S. economic growth


3Q 2013

4Q 2013

Full-year 2013

1Q 2014

2Q 2014

WTIA estimate












Source of consensus data: Bloomberg

We are concerned that the quality of U.S. job gains has been low. For instance, there are now fewer fulltime U.S. workers than there were before the financial crisis of 2007–2009. We also expect personal consumption to be weaker than most observers expect. The increases in household tax rates in January seem to have had little effect thus far on consumption, though they have caused savings rates to dip.

On Syria
Given concerns about the possibility of U.S. military action in Syria, we consulted Strategas Research Partners, a New York City-based market research firm, about the history of stock market performance in the days leading up to and in the immediate wake of recent U.S. military actions. Figure 2 presents Strategas' findings in regard to the 10 most recent major U.S. military actions. On average, stock prices, as measured by the S&P 500 Index, rose over the following 1-, 5-, and 20-day periods following the beginnings of military action, though there were substantial deviations from the averages. Stock returns were negative, on average, over the 20-day period before the onsets of U.S. military action, but positive for the preceding 1- and 5-day periods. Our interpretation of this conflicting historical data is that it does not make sense to liquidate stocks in anticipation of possible military actions; the market may not perform as we expect.

Figure 2: Very short-term stock market performance in the run-up to the beginning of U.S. military actions, on the day hostilities commenced, and in the wake of the onset of military actions: Cumulative total returns of the S&P 500 Index

Expected Fed policy and market gyrations
The Federal Reserve's policy-setting Open Market Committee recently released the minutes of its July 30–31 meeting, sending the U.S. stock market on a roller coaster ride. Our central bankers suggested they are on track to slow this year their program of purchasing $85 billion of bonds per month, and to conclude it around the middle of 2014.

We do not believe the Fed is going to act based solely on the passage of time. We expect it to curtail its "monetary accommodations"—in this case, its interest rate suppressing bond purchases—only if the improvement in economic conditions, primarily employment, continues and inflation remains contained. Stock investors—or more precisely, perhaps, speculators—have over-reacted, in our view, at the suggestion of near-term tapering. The price of a stock should reflect the present value of all the cash flows it is expected to generate. This value depends on future earnings and the rate at which they are discounted—a discount being appropriate because a dollar tomorrow typically is expected to have less purchasing power than a dollar today, and also due to the uncertainty of future cash flows. Will a reduction in Fed bond-buying reduce future corporate earnings? In our view, no—not, at least, if policymakers are true to their word that they are going to reduce their monetary stimulus in step with economic growth. This is a tricky dance for the Fed, as the economy is hard to read and prone to an occasional lurch. Perhaps the market has been reacting strongly because it thinks the Fed is going to act prematurely, thereby causing the economy to fall into a recession. We don't think so.

Another explanation for recent share-price gyrations is related to the types of investors in the market and their time horizons. Some market participants, notably hedge funds, have short horizons and employ leverage—that is, borrow money to invest. One strategy they employ is to borrow in markets where interest rates are low and lend in markets where they are higher. Given the power of leverage, such investors must be nimble, as leverage can work against as well as for them. Such investors may move markets in the short run and this may be what we are witnessing. Over long periods, prices should approach their true values. Thus, we counsel long-term investors not to be alarmed by short-term market movements. What constitutes the "long" and "short term"? It depends on your investment horizon. We believe that many of our clients' investment horizons are, or should be thought of as, decades long. For such investors, a month—or even a year or two—of market volatility should not necessarily prompt dramatic changes in the composition of long-term holdings. From time to time, however, volatility may present opportunities to rebalance back to carefully considered target allocations.

The next chair of the Federal Reserve Board of Governors The leadership of the Fed will change next year. We don't know who will assume the mantle, but we believe monetary policy would initially be similar under either Larry Summers or Janet Yellen, the perceived frontrunners to succeed Ben Bernanke when his term expires on January 31. That said, Summers' views on monetary policy are not well known, as he has never worked for the central bank, so we would not be surprised if his appointment prompted some additional market volatility. President Obama could nominate Bernanke's successor as soon as next month, an announcement that's almost certain to spur speculation about changes in Fed policy. Speculation, of course, could drive interest rate changes, if only temporary ones. While it's conceivable that the Fed could stumble, we are confident that it will remain accommodative while inflation is below its target and unemployment exceeds its target.

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