In his bi-weekly Hot List newsletter, Validea CEO John Reese offers his take on the markets and investment strategy. In the latest issue, John examines three key reasons why he remains bullish on stocks as we move deeper into 2014.
Excerpted from the Jan. 17, 2014 issue of the Validea Hot List newsletter
Reasons for Optimism
While flows into domestic equity funds picked up in October and November, they have since fallen off rather sharply. And, while there are fewer disaster-type fears hanging over investors’ heads, the general mood is far from ebullient, with many expecting a weak year for stocks after 2013’s stellar — perhaps too stellar? — performance.
I wouldn’t be so sure. Of course, in the short term anything can happen, and no one knows just how much the market will return in 2014. After all, think how many people actually predicted that the S&P 500 would return close to 30% in 2013. But I do see reasons for optimism heading forward — signals that tell me this is not time to cut back on equities if you are a long-term investor. Here a few of those reasons.
The Economy: Yes, the economy still has a lot of lingering problems and growth is far from gangbusters. Unemployment — in terms of both the headline and broader measures — remains high, most notably. But there were a lot of really good signs in 2013, particularly in the second half of the year. Housing starts were more than 33% above where they stood a year ago in November (the latest data available). New home sales, meanwhile, were up about 18% through November, according to the Census Bureau. Manufacturing activity surged in the second half of the year, increasing in December for the 7th straight month, and at close to the fastest pace in two years, according to ISM. The group’s manufacturing sub-indices for both new orders and employment are at high levels. ISM also said the service sector expanded in December for the 48th straight month. And the latest revisions show that GDP increased at a greater than 4% rate in the third quarter, one of the better figures we’ve seen over the past few years. All of this occurred amid the government budget sequestration that was expected to put a major crimp on growth in 2013.
Valuations: On the whole, the market is no longer cheap (though plenty of cheap individual stocks do remain). But it’s also not grossly overvalued. The S&P 500’s price/earnings ratio based on trailing 12-month operating earnings is about 17; its forward P/E (using projected operating earnings) is about 15. The index trades for about 2.6 times book value, according to Morningstar, and about 1.7 times sales. Those figures have been rising, but they indicate that we are probably merely on the high side of the fair value range — at worst very slightly overvalued. And that’s nothing to be worried about. By definition, you’re sometimes going to be on the high side of an average. It seems to me that lingering fears from the 2008 crash, and perhaps even the 2000 crash, are making investors see anything but dirt cheap valuations as a reason to worry. History has shown that simply is not the case. Stocks can and usually do move far beyond their average historical valuations during bull markets — and they often do so for quite some time.
The False Fear: Kenneth Fisher, whose writings form the basis of one of my best performing Guru Strategies, has talked about the “fear of false factors”, saying that he takes it as a bullish sign when investors are worried about issues that in reality don’t matter that much. (He has used the fiscal cliff as an example.) Right now, I see a false factor being feared — the notion that the magnitude of last year’s gains was so great that this year makes us due for underperformance. The mindset among many investors seems to be that last year’s rally was so fast and strong and unexpected that in 2014, investors will quit while they’re ahead, take profits, and drive the market downward. But history shows that big years for the market do not, in fact, tend to be followed by some sort of corrective downturn. Since 1960 there have been 18 years in which the S&P has gained more than 20% (prior to 2013). The average return for stocks the next year: 11.4%, a little bit above long-term historical norms. The worst return following one of those big years came in 2000, when the S&P lost 9.1% — not exactly a disaster. That was one of only five years when a 20%-plus year was followed with a negative return. In half of those 18 occasions, the 20%-plus year was followed by a year in which the S&P went on to gain at least another 15%.
Perhaps you’re thinking that the current situation is a bit different, in that growth wasn’t particularly strong in 2013. Perhaps in those other 20%-plus years, strong growth merited the big gains, while in 2013 the market was “getting ahead of itself”, meaning that there’s more likelihood of a pullback in 2014. Well, the data tells a different story. In those 18 20%-plus years since 1960, GDP growth on average was a mere 2.5%. In five of those big years it was actually negative. In 1975, for example, the S&P gained 37.2% while the economy shrank by 0.2%. In 1976, the index gained another 23.8%. Interestingly, in 1976 GDP jumped by 5.4%, which you might think would provide good momentum going into 1977. It didn’t. In ’77 the S&P fell 7.2% — even though GDP continued to expand by 4.6%.
Of course that 1975 to 1977 period was different in many ways from today. Factors like inflation, politics, timing (1975 was the first full year of a bull market whereas in 2014 we’ll hopefully reach this bull’s five-year mark) were all surely involved in the gains and losses of those years. But isn’t that the point? Rarely do stocks move because of one single factor. Instead the market is a complex machine that factors in a myriad of issues and data points. The notion that 2014 would be a down year simply because 2013 was such a good year just has no basis in reality — and the pessimism that this false fear creates very well may lead to a buying opportunity.
As I noted earlier, no one knows what’s going to happen in the market in the short term. So many surprises can pop up that aren’t even on the radar right now. Given that, and given the exceptional history and upside that equities offer, the question to me is not, “how will stocks do in 2014,” but instead, “do I see such risks — be they economic, valuation-related, or otherwise — that I would want to pass up a chance to benefit from what has been the best investment vehicle of all time? Right now, I don’t see that kind of risk. In fact, to the contrary, I see more potential reward than risk for long-term investors.
