Next big move up or down?

So far it has been a fairly boring — if not nerve racking — year for global stock investors. Though global stock indexes have bounced around a bit, they remain at levels that we saw at year end. This type of trading range where stocks fail to make new highs can make investors nervous as to the next direction of stock prices. As always, we have some thoughts that we would like to share with you about this…

2013 was a great year for global stock indexes and your portfolio of equities. Often after significant advances, stock prices temporarily stall as investors digest the price and earnings of the market as a whole. We like to call this the “pause that refreshes.” In recent weeks, the media and some investors have become concerned that the next important move for equities will be significantly lower. While a normal correction is a possibility, we strongly disagree with these recent concerns for a few reasons. First, stock prices are a reflection of economic activity and corporate profit growth. The economy is growing in a healthier manner than we have seen in years. The declining unemployment rate is just one sign. Corporate profits continue to beat expectations on the upside with 78% of the S&P 500 companies reporting better than expected earnings this quarter alone. Recessions are almost always the cause for significant declines in stocks prices and from our view — and that of our research partners — that risk appears to be very low at this point in the economic cycle. Is the stock market overvalued based on price and earnings (P/E ratio)? Not at all. The current P/E of global stocks markets is a mere 15 — significantly lower than what one would see at market tops. As a comparison, prior to the big declines of 2001 and 2008, P/E ratios were at 33 and 25 respectively. Lastly, and strangely, global stock ownership is at its lowest level ever! This tells us a few things: first that most investors have not been participating in this bull market — most likely because they were so disappointed in 2002 and 2008 that they have yet to come back. Instead they have been investing in bond funds and money markets at practically a zero return. Last year we began to witness this money flowing from these “safer” places into stocks — driving prices up. According to our research, there is still a huge imbalance of assets in bond funds and money markets that will likely flow into stocks over the next 12-18 months — particularly given the fundamentals that we outlined above.

The last third of a bull market, which is where we think we are in the market cycle, is usually characterized by rising stock prices (with corrections along the way) and rising interest rates, both of which we have seen occur over the past 12 months. This will eventually be great news for fixed income investors as the yield on high quality bonds will be attractive. It will also be welcome to those of us who eventually sell overvalued stock — as we will have an attractively yielding, relatively safe place to wait out the storm.

As with all forecasts, there is always the possibility that we may be incorrect with our assessment of the current financial conditions. Therefore, in an effort to mitigate the possibility of catastrophic declines, we manage the risk of your portfolio through its asset allocation, sector management and the use of carefully placed stop loss orders. Keep in mind that stop loss orders are indications to sell your stock at a certain price. Once a stop loss is executed, a market order is placed to sell your shares (this may be a half position or all of your shares). You may get the price at which the stop loss was set, a higher price, or possibly a lower price depending on market conditions.

We hope that this strategy update finds you well. We continue to manage your assets according to your stated objectives. Please let us know should your circumstances or investment objectives change. If you have any questions, please let us know.

Sincerely,

Your Team at Main Street Research