At 12:01 pm, on Thursday, September 20, 1920, a bomb exploded outside 23 Wall Street, the worldwide HQ of J.P. Morgan & Co. The massive dome on “The Corner“–the pride of J.P. Morgan–shattered. Dwight Morrow, Morgan partner, college friend of Calvin Coolidge, and later ambassador to Mexico, was hit and suffered cuts and bruises. 38 people died and 143 were hurt. The “Wall Street bombing” took more lives than the 1910 bombing of the Los Angeles Times building–the deadliest act of domestic terrorism up to that time.
All of the ticker machines inside the offices of J.P. Morgan & Co. were destroyed–save one. The clacking noise of Clarence Barron’s Dow Jones ticker machine could still be heard–printing out news of the bombing, speculation on the consequences, and news that the NYSE will reopen the next day. The clacking on the Dow Jones ticker machine sent a clear message to the terrorists, anarchists and socialists: U.S. commerce–and the U.S. entrepreneurial spirit –will not be stopped.
Indeed, the 1920s would come to be known as the “Roaring Twenties”–one of the most prosperous times in U.S. history.
A review of 2013 shows something extraordinary: The S&P returned 30% YTD, while the Russell 2000 of U.S. small cap stocks returned 34%. The performance of U.S. stocks in 2013 ranks as the 8th best performing year going back a century. In our 2013 outlook last year, I gave Developed Markets (which includes Canada, Western Europe, Japan, Australia, Singapore, and Hong Kong) a return rating of “7,” suggesting an above-median return. I was also relatively bullish on U.S. stocks versus other developed markets. I (Henry) expected U.S. stocks to return in the mid- to high-teens. An inherent optimist, even I did not anticipate that U.S. stock market returns would hit 30% this year (we were more bearish on emerging markets equities–but we certainly did not foresee their -6% return this year).
With the exception of the Greek (+39%), Finnish (+38%) and Irish (+37%) markets, the U.S. was the best-performing stock market in the world this year. The U.S. Consumer Discretionary sector returned 40%, while Healthcare returned 39%. This extraordinary performance in U.S. stocks sends a strong signal to the doubters, the terrorists and socialists: U.S. capitalism remains alive and well. U.S. commerce, innovation, and ingenuity will not be stopped.
That said, we are much more cautious on the U.S. stock market outlook for 2014. As mentioned, this year’s performance of 30% was extraordinary, especially with the major U.S. indices making all-time highs week after week. In our opinion, the market has already discounted a stable global macro environment, improving U.S. employment in higher-paying healthcare and engineering professions, as well as future productivity improvements stemming from increasing automation and the U.S. energy revolution. As such, we believe U.S. stocks will return 5% to 10% in 2014, or slightly below the historical average. We anticipate the S&P 500 to settle in the 1,900 to 2000 range by the end of 2014. This is equivalent to a return rating of “4” for Developed Equities (on a scale of 1-10).
As part of our 2014-16 “barbell” investment strategy, we recommend selective risk-taking within various industries in the global equity markets. As discussed in our latest issue (please contact us for a copy), we believe there will be a buying opportunity in gold (-29% YTD) and low-cost gold producers sometime in H1 2014 (note that we recommended a short position in gold in January of this year). More details are forthcoming in our next global macro newsletter in January 2014.
I now want to address a couple of clients’ questions or concerns regarding valuations of U.S. equities. Firstly, yes, U.S. stocks are the most expensive relative to that of Europe, Japan, or Emerging Markets (using traditional ratios such as P/E, P/B, and PEG). While we are slightly concerned (this is why we are only targeting a 5-10% return in the S&P 500 in 2014), clients should recall that valuations–even on an individual stock level–have not been a great timing indicator. Firstly, none of our proprietary fundamental, technical, or sentiment indicators are flashing strong sell signals–signals that were paramount to us exiting/shorting the U.S. stock market during the March 2000 and October 2007 peaks. Secondly, the valuation factor (namely, the price-to-book ratio) only comes second to the momentum indicator (12-month price change) in terms of predicting performance in relative individual stock timing. In fact, investing in value stocks (i.e. cheaper on a P/B basis) has been a big loser for sustained periods of time, namely the 1930s, the late 1990s, and 2007-08. One academic study after another has shown that momentum investing is superior in most periods in global stock market history.
That said, we certainly keep track of valuations–both absolute and relative valuations. We never bought the S&P at a trailing 40 P/E ratio in early 2000; we became very concerned once the 10-year Treasury yield rose above the S&P earnings yield in late 1999. As of December 19, 2013, the S&P earnings yield (chart below courtesy Goldman Sachs) is still 3.5% higher than the 10-year Treasury yield. This 3.5% yield gap is just below its 10-year average but is still high on a historical basis (1976-present). That is, U.S. stocks are still cheap relative to U.S. Treasuries.
Finally, after 18 months of consistent outflows, U.S. equity fund flows turned positive in January this year (source: ICI). By the summer, investors began rotating their investments from bonds to stocks for the first time since late 2008 (chart below courtesy Goldman Sachs). Since fund flow trends tend to last for many months (401(k) investors don’t change their investment selections very often), we believe U.S. equity fund inflows will remain strong in 2014–further supporting U.S. stocks. We will not become concerned until the S&P 500 rises above 2,000 or the 10-year Treasury yield surpasses 3.5%.