Party Like Its 1914
Forget the last two day's decline. The consensus opinion for 2014 is pretty uniform: stocks will go up modestly, bond will decline in similar fashion. Job growth will grind higher, as will inflation. The Fed will taper its bond-buying program, slowly. And so it may all come to pass... But ConvergEx's Nick Colas ponders what could go wrong, or at least different. Top of his list: fixed income volatility, in conjunction with stock market valuations that are, at best, average. Colas reflects ominously on 1914, where if you read the papers of the day you would have seen much of the same "Yeah, we got this" tone that prevails today.
Seven months later, and the New York Stock Exchange had to shut for +4 months due to the start of World War I. No, we aren’t calling for Armageddon. After all, the Dow started 1914 at 57.7 and ended at 54.6, even with the European war. But one thing we know for sure – the time to worry is when no one else seems concerned.
Via ConvergeEx's Nick Colas,
Consider the following quote from the New York Times: “Whatever may be said of the stock market there can be no doubt that the investment situation afforded grounds for a most hopeful view of the outlook.” Aside from the archaic-sounding wordiness, it is a good summary of the current outlook for U.S. stocks. Economic conditions are improving, as is investor confidence. Last year’s 30% return for the S&P 500 means even retail investors are returning to stocks, much as swallows portend the arrival of Spring after a chilly Winter. Things look good for 2014, both in the domestic economy and stock markets.
The date of the quote, however, is not January 2014, but rather a hundred years ago: January 31st 1914. The Dow Jones Industrial Average stood at 60.6, up 5.0% from the start of the year. The first few days of 1914 had been choppy, to be sure, but the good returns of January were enough to give investors some hope that things were solidly on the mend. The Times did feature some stories about the political situation in Europe, but there was more ink spilled about the fabulous parties given by New York’s 1% of the day. Fifty person sit down dinners seemed common, with a separate guest list for those who merely attended the coffee and entertainment afterwards. Not quite as spicy as Bethenny Frankel’s lastest boyfriend – today’s hot news – but close enough.
Just six months after that quote, the New York Stock Exchange closed for over four months. The start of World War I meant that foreigners – mostly British subjects – wanted their money out of U.S. stocks and repatriated back to their local currency. The Treasury Secretary at the time felt that suspending the gold standard – the method of exchange between different currencies at the time – was too costly to America’s reputation. The only alternative was to freeze the U.S. capital markets, and the NYSE did not reopen until December 12th.
Despite the opening salvos of the Great War, U.S. stocks fared pretty well in 1914. The Dow ended the year 54.5, down only 5.5% for the year. America’s entry into the conflict would come in 1917, and at the end of the war in 1918 the Dow closed at 87.2 - 38% higher than the beginning of 1914.
Fast-forward a century, and the lessons of 1914 ring true: be careful when the market thinks it has everything under control. And such is the case as I write this note. Despite today’s 16 point drop in the S&P 500, the narrative of the U.S. equity market is resoundingly bullish. A few of the more optimistic sound bites:
Stocks have just finished a very strong year – up 30% for the S&P 500 – and that will draw further money flows. If you exclude the last 5 years of data from mutual fund money flows, that is generally what happens. Up markets do tend to pull in more capital from retail investors. Strength begets strength, as the old market aphorism reminds us.
The Federal Reserve has set up market psychology to welcome a tapering of its bond-buying program. Chairman Bernanke first raised the issue at the June FOMC press conference. Then economic data started to improve modestly, and at the December Fed meeting it followed through with a $10 billion reduction in the program. If the Federal Reserve follows through with further reductions in 2014, markets will see it as further sign of economic strength.
Interest rates are still low enough that they offer little competition to equities. With the 10 year U.S. Treasury yielding 2.99%, bonds are still bringing a knife to a gunfight with stocks. The common wisdom has it that bonds will gradually decline in value of the course of 2014 as interest rates rise with a stronger domestic economy.
Europe and Japan will turn their corners in 2014, albeit in slow motion. The Yen will weaken, and the euro will hold steady. The “Smart money” trade to own Japanese stocks (hedged against the currency) and European equities should work in 2014, as it did in 2013.
U.S. equity valuations have room to grow as revenue growth accelerates due to better economic fundamentals. Right now, the S&P 500 trades for 15.3x this year’s expected $120/share expected earnings. The bulls would say 17-18x earnings is fair for a recovery year, so stocks can rally another 18% in 2014.
All this sounds so neat and compact, and the rally last year seems to confirm the basic outlines of the case. Yet that quote from the Times shows that the easy case may ignore a lot of important factors. It wasn’t a surprise that Europe was a tinderbox in 1914. It was the how, the when, the who, and the why that no one knew.
Happily, there is no World War in the offing in 2014, but let’s take a moment to consider some less-than-perfect outcomes that might make the consensus wrong.
The U.S. economy speeds up more than expected. Right now, economists peg GDP growth here at 3% for 2014. What if they are too conservative, anchored in the recent past rather than more typical economic recoveries?
The problem with this scenario is that it takes a predictable Federal Reserve and makes it harder to understand their future policies. No one thinks 3% is the “Right” yield on the 10 year Treasury, given the Fed’s aggressive buying over the last three years. And with a gradual reduction in this program, we will find out – slowly – what the market rate actually is. A quicker pace of economic expansion will drive inflation and force the Fed to cut the program more quickly than expected. Fast rising rates will also make car purchases and mortgages more expensive, taking two legs off the stool of a typical economic recovery. It is bond market volatility which challenges the bull case for stocks most profoundly.
Stock valuations begin to feel too full. Stocks multiples tend to grow like teenaged children – growth spurts followed by periods of consolidation. Last year’s rally was essentially all valuation expansion – earnings expectations actually came down as the year progressed. Yes, the bullish call for further multiple expansion has some limited history on its side. We did get to 18x earnings in the 1990s and we could again now.
In the historical spirit of this note, however, lets look at the Shiller P/E – a 10 year look back at earnings as compared to current prices. The average for this measure is 16.5x, going back to 1880. We are now at 26.2 times. Now, U.S. stocks can still grow into these numbers if earnings continue to climb. But the Shiller P/E illustrates an important point: we HAVE to grow into this number, for there is little margin of safety otherwise.
The butterfly of chaos theory flaps its wings. We start 2014 with U.S. stocks at all time highs, expectations of improvement to come, and a high degree of confidence that the future will be predictable. That initial condition leaves very little gas in the tank if something goes awry. It doesn’t have to be a policy mistake from the Fed or a twitchy bond market. The disruptive event may be nothing more than a January swoon for stocks that pulls back the indices 7-10% and gives investors pause about the year ahead.
As the great market sage Yogi Berra once opined, “It’s tough to make predictions, especially about the future.” Our historical case study about 1914 comes neatly on the 100-year anniversary of the start of World War I, but you needn’t expect a cataclysm to take its cautionary tale to heart. The U.S. economy and capital markets have much to commend them, but the current optimism seems to run ahead of fundamentals for the moment. Perhaps today’s pullback is the start of a correction, and that would be both healthy and positive for 2014. Either way, a cautious outlook is the better part of valor so early in the year.
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