After feasting on the U.S. stock market’s 54% run-up from 2009 to 2010, we starved for performance in 2011, suffering a 1% loss.
Some said the markets were due for a respite, so this lull was healthy, and they were right. Stock markets both here and abroad subsequently had a good year in 2012 followed by a spectacular 2013, generating a 54% two-year U.S. market return. The 2011 loss is sandwiched between two 54% return 2-year periods.
The past five years have been among the best on record, almost erasing the memory of the previous five years ending 2012, as shown in the graph on the right. These past five years produced the third highest return, as shown in the following graph, albeit it follows two of the lowest performing 5-year periods.
This good performance has generated concerns about another market bubble, but the graph below suggests otherwise. Even though stock prices have surged, both dividends and earnings have kept pace, so prices appear to be reasonable.
It’s useful and insightful to examine the sources of these returns. The following formula works quite well:
Return = Dividend Yield + (1 + Earnings Growth) X (1 + P/E expansion/contraction) – 1
This formula is simple yet elegant, stating that total return equals dividend yield plus sources of price change, namely the compounding of earnings growth with investor-driven changes in the price/earnings ratio. I’ll use this formula again when we discuss the future.
The components of returns for the past two five-year periods are shown in the next graph. As you can see, P/E expansion/contraction has been the driving force. This component is primarily driven by investor behavior, and may well be the cause of future economic results rather than being a leading indicator of the economy.
In his 1998 book the Beast on Wall Street, Dr. Robert Haugen contends that the market crash of 1929 caused the Great Depression, as opposed to predicting it. In other words, the market drives the economy rather than anticipating it. If so, recent P/E expansion bodes well for the economy, if this expansion continues. The big question remains: what will be the ultimate effects of quantitative easing?
I personally continue to believe the bond market is being manipulated and that this has a material effect on stock markets. Specifically stock buybacks are proliferating because money is cheap. Corporations can borrow at very low interest rates to buy their own stock, which in turn drives up share prices. Can we expect buybacks to continue when the brakes come off of interest rates? What forces will drive future P/E expansion/contraction?
America the Beautiful
The U.S. stock market was one of the best performing markets in 2013. Consequently there is a wide dispersion of performance among multi-asset managers, especially target date funds. The primary benefits of target date funds are diversification and risk control, both of which suffered on a relative basis in 2013. The most diversified funds underperformed their U.S.-centric competitors, as did funds with rigorous risk controls. This leads to the potential for error on the part of plan sponsors, hiring and firing investment managers for the wrong reasons.
Using the return components formula above, the U.S. stock market’s 2013 return breaks down as follows:
33% Return = 2% Dividend + (6.5% Earnings Growth compounded with 23% P/E Expansion)
As usual, some styles and sectors have thrived while others have struggled. Similarly, outside the U.S. there was a wide range of country performance. The following section examines these results.
Winners and Losers in 2013 and the 5 Years Ending 2013
U.S. stocks
Growth stocks led the way in 2013, with small-cap growth stocks performing best, earning 44%. By contrast, large-cap-core companies earned “only” 23%, and large-value earned only 28%. Other than these extremes, style returns clustered around 30%, a pretty good place to be. This has been one of those unusual periods where the “stuff in the middle” (core) has not performed in line with the “stuff on the ends.” I use Surz Style Pure classifications throughout this commentary. In my opinion, it wouldn’t be surprising to see core outperform value and growth going forward, in a regression toward the mean.
On the sector front, consumer discretionary and health care fared best, earning more than 43%. By contrast, materials eked out a measly 7% return, and telephones and utilities also lagged with a 16% return. It was a year led by consumers, in contrast to previous periods that were led by infrastructure spending, and growth in China and India.
Looking back over the past 5 years we see that smaller companies of all styles have led the way, as have consumer-oriented stocks. The sector returns in this chart are shown in the same sequence as the year, so you can see that the big change in 2013 was in the leadership of technology stocks, which had performed relatively well prior to 2013. It’s also interesting to note that the previous 5 years (2004-2008) were led by value stocks in the energy and materials sectors. The leadership of the U.S stock market has shifted dramatically.
Foreign stocks
Looking outside the U.S., foreign markets earned 16.5%, lagging the U.S. stock market’s 33% return and EAFE’s 23% return. Japan and Europe are the big story, earning 30% on a dollar basis. The Japan return in Japanese yen was an even more impressive 44%. The Japanese stock market has soared this year as the yen was purposely weakened against the dollar. By contrast, all countries outside Europe and Japan earned less than 11%, and Latin America lost 4%, all in U.S. dollars.
On the style front, core surprised, as it did in the U.S., but core led rather than lagged, although not by much.
Looking back over the past five years we see that leadership in 2013 shifted away from Latin America and Australia-&-New Zealand to Japan and Europe, and style leadership shifted from value to core. Country returns are shown in the same sequence as the current year above. Note also that EAFE and ADRs have both underperformed. This is because smaller companies have performed best, earning 20% per year while large companies have lagged with annualized returns of 16% per year (size results are not shown in exhibit).
I made several calls in my 2012 Commentary, some good and some bad, and I observed that Japan had become a bargain, a deep value play, coming into 2013 — a pretty good call. As concerns about a weakening U.S. dollar have been allayed, at least for now, interest has diminished in emerging markets, Latin America, and Australia-&-New-Zealand.
We can’t change the past or the present, but we can plan for the future, and I will address that in my next blog post.
DISCLAIMER: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. The opinions and views expressed herein are of the portfolio manager and may differ from other managers, or the firm as a whole. Certain information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. The manager believes that such statements, information and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions. Investors cannot invest directly in an index. Indexes have no fees. Past performance is no guarantee of future results.
