Last week I gave a presentation to a group of clients and prospective clients in Bethesda, Maryland. In what has become an annual event, I provided a brief summary of the current economic landscape along with my outlook for the months and years ahead. Below I provide a brief summary of the major points I covered.
The S&P 500 closed at 1,436 ten years ago today. From that level, the widely-utilized proxy for the market is down 22% over the past ten years, or 2.5% per year on a compounded annual basis. If we include dividends (reinvested back into the index), the loss over the past decade was about 11%, or a little over 1% per year. We have just experienced one of those rare decades in which bonds outperformed stocks, and handily so. While nobody can say with any certainty what stocks will do over the next ten years, historical stock returns following one of these rare periods of underperformance have been excellent.
When we talk to our clients about what they can expect in terms of long-term returns on stocks going forward, we usually use a quick-and-dirty algorithm. The S&P 500 is currently trading at around 15x forward earnings using FirstCall’s consensus estimate for index operating earnings in 2010 ($74.24). This multiple is roughly in line with the long-term historical average for the market overall. Therefore, if we assume that 1) the market simply maintains this long-run average multiple; 2) index earnings grow at 5-6% per year beginning with next year’s estimate (which is down 16% from the all-time high of $88.19 posted in 2006); and 3) the market maintains the current dividend yield of around 2.1% on the S&P 500, then it would not be unreasonable to expect returns of 7-8% on stocks over the long term. While these returns may not seem all that great compared to historical long-term returns on stocks (10+%), we believe the returns must be compared with the returns possible in the bond market. With the 10-year currently yielding 3.75%, and inflation expectations increasing due to the huge amount of stimulus money injected into the economy, we believe there is a strong likelihood that stocks will outperform bonds over the next decade.
Another theme we discuss with our clients is our belief that stock investors will begin to more highly value quality, financial stability, transparency, and earnings predictability. We are still working our way through the worst financial crisis and economic downturn since the Great Depression. Despite the perception of a V-shaped recovery that government intervention has created, we believe the next several years could be trying for the US consumer and the economy at large. Consider the following: 1) the consumer is still carrying near record amounts of debt (on an absolute basis and relative to income); 2) numerous factors suggest the housing price declines may not be over; 3) baby boomers are ill-prepared for retirement following $11 trillion of lost wealth in the housing and stock markets; 4) the sharp decline in the supply of and demand for credit continues; 5) businesses remain reluctant to hire given weak end demand, reduced access to credit, and government policy uncertainty (taxes, healthcare costs, increased regulatory oversight); and 6) the effects of the massive federal budget deficits are unknown. In a nutshell, the US consumer must save more and strengthen her financial condition, and the process of deleveraging across the economy is likely to be a drag on growth for many years. Therefore, it is quite possible that investor sentiment has gotten ahead of the economic fundamentals following a 60%+ move in stocks since March. Given this backdrop, we believe investors will flock to those companies able to withstand volatility and offer dependable earnings growth, financial strength and transparency.
But the news is not all bad! We have decidedly averted a collapse of the global financial system. Action among central banks has been coordinated, and access to capital markets has improved dramatically. Inflation and interest rate increases have been contained (at least for now). And perhaps most importantly, stock valuations are reasonable from a historical perspective.
So what does the world look like over the next ten years? We see the following: 1) a permanent shift in consumer spending and savings patterns as baby boomers are ill-prepared for retirement; 2) higher inflation, interest rates and taxes as a result of the orgy of federal government spending; 3) more federal government incentives and subsidies to invest and save for retirement; 4) the POTENTIAL for price/earnings multiple expansion for stocks as baby boomers increase savings rates and stocks offer some protection against inflation; 5) stocks should outperform bonds following a decade in which the opposite occurred; and 6) stock investors will begin to more highly value quality management teams, dependable cash flow, financial stability, transparency, earnings predictability and dividends. High-quality and defensive blue chip stocks have lagged lower-quality companies since this market rally began in March. This was to be expected as many of these lower-quality companies had been left for dead in the throes of the financial panic. However, going forward we see a dramatic reversal of this trend. And in the process, stock investors will eventually become accustomed to and satisfied with more modest returns of 7-8% as this transition takes place.
In closing, let me extend to each of you my very best wishes for this holiday season and the year to come. Your continued support for me and everyone at Farr, Miller & Washington is most appreciated.