Are we in a new, multi-year bull market?
The stock market in the U.S. has started the New Year with a bang, following a fairly strong performance in the fourth quarter of last year. Signs of improved global growth, the postponement of the US fiscal cliff, continuing monetary policy support, a weaker Japanese yen, and reduced tensions in the Eurozone are among the factors supporting global equity markets a the beginning of 2013.
All this has some investors asking whether we are at the beginning of a new, long-term  bull market in global equities. After all, relative valuations to bonds, and investor positioning, suggest room for a broad-based re-allocation to global equities, which could push stock prices higher for considerably longer. In what follows, we consider how history can guide us in thinking about secular bull markets and whether the preconditions that gave rise to sustained strong equity performance in the past are in place today.
Things that are usually important for long-term bull markets, such as low macroeconomic volatility or strong earnings performance, don’t appear to consistently determine how stock markets perform. But one thing that does matter a great deal is valuation. And on that basis, the bulls may have to rein in their expectations. Current valuations do not make a compelling case for a sustained period of high equity returns, even if they do not preclude some advance in the years to come. In short, if history is any
guide, equities can out-perform other asset classes, including bonds, but absolute equity returns are likely to be modest, not stellar.
The preconditions for sustained equity market outperformance versus bonds, government as well as corporate, will be in place if the global economic recovery remains on track and if policy error (US fiscal follies, Eurozone crisis, high inflation, Chinese or emerging economy hard landings) can be avoided in the years to come. But even in that ‘best of all worlds scenario’ absolute equity market returns are likely to be modest, given the starting point of relatively elevated earnings and valuations.
Is there another recession coming?
Yes, but not this year. Given the constant drumbeat of economic news that’s either bad, worse, or downright ugly, it’s easy to jump to the conclusion that another recession is just around the next bend, if not here already. That would be a mistake. The economy in the U.S. and the rest of the world is still growing. Don’t assume that we’re optimistic about the near-term prospects, however. The risks to growth are very high, and especially persistent, due in large part to the toxic political atmosphere today.
We try very hard to avoid getting duped into making investment decisions that are based on irrational or overblown fears. We focus on the actual numbers that are reported by the institutions who are in a position to collect the data and report on it. We don’t listen to stories, rumors, or conspiracy theories. When viewed from this sort of clinical perspective, the evidence supports the case for continued economic recovery across the globe. There are plenty of things to worry about, like budget deficits, employment, and debt. But we don’t subscribe to the widely marketed notion that the global economy is headed for another armageddon-style meltdown. More likely is slow and steady recovery and growth, with bumps and spills along the way. This kind of environment is friendly to equity investors. Accordingly, we maintain our full exposure to equities in our model portfolios. That means we’re fully invested in stocks, but underinvested in bonds and cash. For more details, see our discussion of the model portfolios.
Consensus Forecast
Bearing in mind that the consensus forecast is usually wrong, here is what the so-called experts are predicting for this year and next. GDP will grow at 2.5% this year, and 2.8% next year. This is less than the typical 6% growth we see after a major recession. But if the economy only grows at 2.5%, it would not be enough growth to generate new jobs fast enough to absorb the 8 million souls who are currently out of work in the U.S.
For 2013 the consensus is that the S&P 500 index will gain 8%, closing around the 1525 level. This target is based on earnings of $105 for 2013 and a P/E of 15 times. Fed Funds will end the year at 0.5% and the 10 Yr Treasury Bond will be 2.75%.
Our Methodology
Our economic models are based on four key elements: output, employment, income, and sales. There are thousands of indicators that are published and available for anyone who cares to look them up, and our work over the years has taught us that these four elements are the most informative about the direction of the economy. This affords us the luxury of being able to tune out most of the economic data that is widely disseminated and often misinterpreted by the media. We can focus our attention and effort on those forces that have the most impact on growth. Let’s consider these four elements one at a time.
Output
Real gross domestic product — the output of goods and services produced by labor and property located in the United States — grew at an annualized rate of 3.2% 2010. The increase in real GDP was largely driven by the twin engines of massive government stimulus and inventory restocking. In order for output to show sustainable growth, banks will have to start lending and employment will have to start growing. Our forecast for 2011 GDP growth is 3.1%. That puts us in the optimistic camp, but it’s very achievable.
Employment
The employment picture continues to show signs of improvement. The numbers turned positive about one year ago, and we just got our 12th consecutive monthly gain in employment. With the unemployment rate stuck above 9% we don’t expect it to get worse. Employers have learned to do a much better job of getting ahead of economic downturns, and as a result they cut positions more quickly this time around. Our forecast for 2011 unemployment is 8.2% by year end.
Income
In another sign of an improving economy, personal income rose by 1.2% 2010. This is likely to continue showing improvement as companies start hiring again in 2011. With more disposable income, consumers will finally be able to start satisfying the pent-up demand for things like cars, vacations, and furniture.
Sales
One of the most surprising aspects of the current economic situation is the resilience of consumers. By almost all measures, the consumer should have pulled back on spending to a much larger degree than what we have seen in the numbers. Consumer spending rose 7.5% in 2010. While this is an encouraging sign, bear in mind that spending is still significantly below where it was in late 2007 before the recession hit.
Conclusion
The global economy is on the mend. We expect the economy to continue showing gradual improvement throughout 2013 as the mood of consumers and business managers continues to improve.