As we approach the end of the first half of 2013, global stock prices have risen significantly, particularly relative to just about any other investment alternative. Though the pace and trajectory of global equities may seem unprecedented, from a historical perspective, surprisingly it is not. No one could be blamed however for an inability to recall the last time investors have enjoyed such a profitable period. The advance in stock prices has trounced that of safe haven investments such as traditional bonds, and commodities (particularly gold). It is as if all of the big risks we know of — and we cannot recall a time when there were more to list — have either vanished, or have been ignorantly ignored by investors. Or is it possible that investors are simply buying stocks because they, collectively, believe that most of the world’s big problems are behind us and are getting better? Market history and our research suggest the later. If this is true, how much further could equity prices rise? And what is the forecast for bond and commodity returns?
Though the pace and percentage return of global stock prices for the past few quarters is welcome, it is not historically unprecedented. In 1995, equity prices reached a similar level by mid-May and surprisingly doubled again by year-end. Coincidence or not, similar to this year’s global stock market, stock prices refused to correct by more than 5% along the way — until December of that year. However, during the following 3 years, global stocks — particularly foreign equities — outperformed all other investments. We are not suggesting we are in a 1995-1998 redux, but there are striking similarities. Like today, in 1995 the global economy was growing at a moderate pace, stock prices were cheap relative to history, and global companies that could produce consistent earnings proved to be stock market winners. For those that do not recall the 1995-98 rally, it was not part of, but proceeded the dot com tech boom.
As we have written during the past year, our research and fundamental analysis continue to point to the possibility that global equities — with corrections along the way — could continue to outperform for a number of years. Even at today’s levels, stock prices relative to earnings (or Price Earnings Ratios, P/E’s) are at 13 — far from the historical average of 17 and worlds away from what would be considered overvalued. In addition, the risks of recession — the biggest hazard for stock prices — appear to be low from our vantage point. As we have documented, most investors, individual and institutional, have not been fully confident with nor invested in this rising market. A glance at the record amount of assets still residing in bond funds provides a clue to this disparity. As one can imagine, a rotation in earnest from bonds to stocks would be enough to fuel stocks much further and make our forecast reality. But what of the laundry list of global problems? We would suggest that investors might be predicting that these problems will eventually be solved. If history is any guide, stock investors (including you) may be very well rewarded for owning equities over the next few years. More often than not, stock prices have a way of rising in the midst of big trouble and in hindsight have proven to be the first sign that things were getting better. As stock market maven Bernard Baruch would say “to make money in stocks, you have to buy when there is blood in the streets!”
Though we continue to be optimistic about global stock prices (particularly large cap domestic and foreign equities), we realize that there will be corrections along the way. We also recognize that our research based optimism may be incorrect. Therefore, we continue to actively manage the risk of your investment portfolio through its asset allocation, sector management and the use of carefully paced stop loss orders (unless you have instructed us otherwise). These risk management tools are intended to mitigate the risk of catastrophic loss.
The most popular investment for the past “lost decade” has been the traditional bond market, which our research suggests is doomed for the foreseeable few years. If we are correct about global stock markets, interest rates will eventually rise (can they go any lower?) and bond prices, particularly long maturity bonds, will decline in many cases much more than the annual interest received. If you own high quality short term bonds — as is our strategy — you need not be concerned, given that your principal will be returned in short order.
Until recently, the second most popular investment was commodities, particularly gold. At this point the prices for gold, copper and just about every commodity have fallen significantly. Fortunately, we have not participated in this recent phenomenon and we would suggest that the decline of these prices has yet to reach its end. However, if we are even close to being right about the future of global stock prices, rising interest rates and inflation will eventually re-ignite higher commodity prices and the stocks they represent.
As we celebrate our 20th year in business, we reflect on the fact that for the past 12 years, investors in general have experienced unprecedented volatility in both stock and real estate prices. We also have reflected on the lessons we have learned such as the necessity and benefit of actively managing risk. However, given this past, we look forward to the possibility of a period of price appreciation with less volatility.
We hope that this update is helpful. If you have any questions please feel free to contact us. Also, if your financial circumstances have changed please let us know.
Sincerely,
Your Team at Main Street Research