Here is an Excel spreadsheet we prepared using both ThomsonReuters Sp 500 earnings data, and Morningstar Ibbotson data from the Stocks, Bonds, Bills and Inflation (SBBI) handbook.
The reason we put the spreadsheet together was to try and show readers the relationship between SP 500 earnings growth and SP 500 returns.
From eyeballing the data, the “coincident” relationship is poor, which supports the long-held premise that the SP 500 and the stock market is a discounting mechanism. In other words, stock market returns typically lead earnings growth, sometimes by a considerable time. That being said, if you track long-term SP 500 earnings growth versus the SP 500 returns, the two correlate pretty closely.
We highlighted a few of the years (black boxes) where there was a significant difference between SP 500 earnings growth and the return on the SP 500. Note 1994, one of our “favorites”: SP 500 earnings were on fire, growing 19% year-over-year in 1994, but yet the SP 500 returned just 1% thanks to the Fed and Greenspan raising rates 6 times.
Here is what we have guided clients to expect in 2014, from an asset allocation standpoint: (Since I personally loathe making predictions, we stick to “probabilities”, to make it simpler for clients to grasp):
Equities: our official SP 500 total return forecast for 2014 is +5% – 15%, but that was also our forecast for 2013. We’ve told clients to expect another year of positive returns for the SP 500, although we are sticking with our large-cap focus, and blending both growth and value styles to reduce volatility. US equities are still “the only game in town” so to speak for “probabilistic” expected positive returns. There is a 10% chance we could see high teens, 20% on the SP 500 this year. There is also a better than 50% /50% chance we see at least a 10% correction. The math is pretty doable on the potential for a 20% year for the SP 500, but we’ll reserve the calculation for the next blog post.
Bonds / Fixed-Income: No surprise here that after 2013’s negative return for Treasuries, and the negative 1% 2013 return for the Barclay’s Aggregate, (we download our complete 2013 index data on Thursday, January 9th, so we will know exact returns for the various fixed-income asset classes then), the probability for positive returns in fixed-income in 2014, particularly after adjusting for inflation, remain quite low. The kicker is though, that popular Street sentiment feels similarly. Positive fixed-income returns then for 2014 is definitely the “contrarian” trade. Hating fixed-income is a very popular trade right now, and we also remain short some Treasuries via the TBF.
Barron’s is out this weekend noting the record-low credit spreads on both high yield bonds (+397 bp’s at the end of December), and the record low credit spreads on investment-grade bonds (+127 bp’s). More and more, the probability of decent returns in the corporate credit market is shrinking.
If there is a problem with the US stock market, we will likely see it in the corporate credit markets first, in the form of spread-widening, and credit risk-aversion.
Money-markets/Cash: Cash is still trash. Clients get very little return keeping cash balances, even after adjusting for the very low inflation rate. Inflation-adjusted money market returns are still a negative 1% – 1.5%, which has been the case since late 2008.
Commentary / perspective: one 2014 goal is to keep blog posts short and sweet. We read one post over the weekend that explicitly stated that there has never been two years in a row of negative Treasury returns. That is not correct: look at 1977 -1980, when the Prime Rate soared to 20% under Paul Volcker and the 30-year Treasury hit a high yield of 15% – 16%. Treasury prices declined 4 years in a row.
We enter 2014 telling clients that the US economy and the SP 500 earnings growth will likely be stronger than expected, and in fact the Fed and FOMC could wind up tapering faster-than-expected. But that could temporarily suppress equity market returns. Again, I don’t think the SP 500 will have a negative year, I just don’t think it will be nearly as positive or robust as 2013. Expect more volatility and expect at least a 10% correction in 2014 in the SP 500.
The other aspect to the stronger-than-expected 2014 is that Japan is recovering from 30+ years of deflation, Western Europe and the EU is now stable and might see some growth in 2014, and China was thought to be stabilizing, but their PMI data was weaker last week, so our “return to global” growth thesis, may be shot in the foot already.
2014 will be an interesting year. We are prepping clients for more volatility, and more subdued equity returns.
Trinity Asset Management, Inc. by:
Brian Gilmartin, CFA
Portfolio manager