By: Tim Callan
In this year’s first quarter, growth in the stock market slowed significantly. The S&P 500 rose just 1.8 percent over the past three months, following a year in which the S&P 500 rose more than 32 percent. Recently, the most common question we hear from investors is, “Is the stock market overvalued?”
A decent-sized pullback would not be a surprise, given the past four years of upward momentum. After tremendous growth in equities, valuations by virtually every measure are back to long-term averages. The forward price-to-earnings multiple is 15.2 times forward earnings, while the 15-year average is at 16. We can no longer make the case that stocks are cheap on their own; however, when compared to competing asset classes like bonds, they remain attractive in the long term. When interest rates are low, stocks tend to have higher-than-average valuations because bonds are not paying investors enough yield. On a positive note, there is $10 trillion in cash sitting on the sidelines, which should help fuel further equity growth. Still, our expectation for stock market returns over the next three to five years is in the mid single digit range, below the historical average of 11 percent.
Though the overall economy continues to grow at a very slow pace, we are approaching five years of economic growth, which makes this the fifth longest economic expansion since the Civil War. There is very little evidence of economic growth being derailed in the near term. Overall household net worth has never been higher, which continues to drive consumer spending. Meanwhile, with the sequestration subsiding, government spending is expected to increase as well. However, we expect first quarter GDP growth to be around 1 percent, well below our 3 percent expectation for the year primarily due to weather-related effects.
Unemployment continues to trend lower, confirmed by the March report of an additional 192,000 jobs and an unemployment rate of 6.7 percent. We have now made up all of the 8.8 million jobs lost during the recession, an important milestone. Full employment is considered 5.4 percent so we still have a little ways to go. Our expectation is that we will reach a level of full employment by 2016 and that, until then, the Fed will keep the short-term federal funds rate extremely accommodative.
The Fed has already reduced the bond-buying program known as Quantitative Easing to $55 billion per month and we expect the program to end this year, putting additional downward pressure on bond prices and causing long-term interest rates to increase. We remain defensive in our bond portfolios and think this trend will continue for several years. Diversification outside the United States in fixed income securities is important to help protect against higher domestic interest rates.
Emerging markets remain attractive long-term investment opportunities, but there are some short-term concerns. Long-term growth is driven by growth in capital stock, growth in the labor market, and increased efficiency. With a young workforce, high levels of investment, and lower debt loads, the emerging markets remain attractive in each of these areas. In addition, valuations of emerging market stocks are the cheapest they have been in a decade. There is good reason for cheap valuations: China has been increasing its debt at about twice the rate that its economy is growing and has an overvalued housing market. However, valuations will eventually revert back to the mean, which will equate to a significant rally in emerging market stocks.
European equities look very attractive relative to the Unites States. Europe had a double-dip recession and, as a result, has had a much slower recovery. The unemployment rate in Europe is at 12 percent, which is a lagging indicator of economic growth. Earnings in the United States are 18 percent higher than the peak of 2007, while European earnings are 25 percent lower. The euro zone is in the early innings of economic expansion relative the United States. As a result, the equities have greater potential to outperform. Therefore, we have reduced our United States equity exposure in favor of Europe.