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Equity Perspectives

Historically, predicting the direction of the market has been a fruitless exercise.

 

In Brief

  • Investors who are worried about stocks being in a bubble would do well to view the market from a longer-term perspective. The return on the S&P 500® Index since June 1, 2000, through August 31, 2014, comes to just 2.2% on an annualized basis, less than that of similar periods in recent history.

  • Moreover, the market has failed to keep up with earnings growth over this period. Cumulatively, the S&P 500 has risen 35.8% while earnings, adjusted for inflation, have increased 48.5%, as illustrated in Table 1.

  • P/E ratios, whether forward or trailing, have been poor predictors of future performance.

  • A better approach for investors is to assume average earnings growth (6.7%) and consider a range of P/E scenarios. This approach suggests that the stock market may produce a total return of 8.6% over the 12 months ending August 31, 2015, assuming no change in the market’s P/E, or 14.5% if that P/E rises by one point. (See Table 2.)

 

Earnings drive stock prices in the long run, emotion drives them in the short run. In between, market speculation is a sport engaged in by many and mastered by few. With the S&P 500 recently reaching a historical milestone of 2,000, we believe the best perspective for understanding where the markets may go from here is not to follow the forecasts of equity strategists and professional prognosticators.

Over the past two weeks, I’ve come across one forecast for the market to fall 60% (putting the S&P 500 back in the neighborhood of 800), and another predicting the S&P 500 to eclipse 3,000 in a few years, with few pauses in a continuous bull market. We would argue that while there is a great deal of data behind these arguments, there has, historically, been (1) little correlation between the predictions of these strategists and the actual experience of the markets and (2) little to no consequence to them for being wrong. Conversely, for investors, the consequences for being wrong are substantial.

We instead believe that investors should:

1. View recent market increases in a broader context and over a longer time horizon to gain a more complete view.

2. Avoid the pitfalls of relying on trailing or forward P/E numbers to determine market valuation; instead, focus on earnings growth and scenario analysis to understand the most likely outcomes.

Does 2.2% per Year Sound Like a Bubble?
First, from a simple market return perspective, the price return of the S&P 500 over the past five-plus years has captured the bulk of recent attention by prognosticators. Since the infamous intraday low in March 2009 of 666, the index rallied to just north of 2,000 in August of this year for a total return right at 200%, or an annualized return of roughly 22%. That market action has provoked speculation among bears that a bubble is forming once again, or that returns will at least revert to their mean going forward, thus depressing returns in the next few years. Perhaps. It may, however, be more relevant to think about where the markets have been over the past two decades and what the path of corporate earnings has been during that time period.

 

Chart 1: In Light of Previous Peaks, the Rebound Looks Less Like “Raging Bull Market”
Performance of the S&P 500 Index, August 2, 1999–August 29, 2014
Source:  Bloomberg.
Past performance is no guarantee of future results.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. The index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment.

 

Looking at the chart of the S&P 500’s journey, the wobbly “W” shape that has formed over the past 15 years illustrates the long, winding road from the peak of the bull market in March 2000 to where we are today. With many investors focused on the steep rise illustrated in green, it is important to remind ourselves of two mathematical realities:

First, the math of loss vs. recovery:
Remember, that every percentage decline in price requires a greater rebound (in percentage terms) to get back to even. Moreover, the further you fall, the greater the difference between the decline and the necessary rebound. If you own an asset at $100 and it falls 20% to $80, you will need a 25% increase ($20/$80) to get back to $100. If the price falls from $100 to $50, you will need a 100% return ($50/$50) to get back to even. We mention this simple truth to point out that while the rise in the market from the bottom reflects many things—fiscal and monetary stimulus, economic recovery, bank stabilizations—the percentage return it has produced in rebounding is more a reflection of what was required to return the market to previous heights.

Second, the price return of the stock market since the peak in 2000 has been 2.2% annualized:
Compare that return to the prior 15 years of 1985–2000, where the average annualized price return was 14.5% per year. Even during the previous 15-year period (1970-1985), which included two severe recessions in 1973–74 and 1980–82, the average return was 6.7% per year. More important, as Table 1 suggests, there is a strong argument to be made that the returns generated since 2000 have significantly lagged corporate profitability growth. Comparing the earnings growth since 2000 to that of the period from 1970–85 or the period from 1955–70, it is difficult to argue that the market has gotten far ahead of itself.

 

Table 1:  Earnings and Market Returns Haven’t Always Kept Pace
Earnings growth, returns, and valuations on the S&P 500 Index

Source: Bloomberg and Lord Abbett calculations.
*14 years and two months.
Past performance is no guarantee of future results.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. The index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment.

 

Re-thinking Forward and Trailing P/Es
P/E ratios are generally considered on a forward or trailing basis. In our opinion, the usefulness of these two methods in determining how fairly the market is valued is limited. With forward P/Es you are forced to guess, either company by company or at a macro level, what the future holds for corporate profits, based on a multitude of very inexact assumptions. With trailing P/E’s, you are measuring current market prices against stale earnings, which may not reflect the current economic situation accurately. 

In both cases, you must compare the valuations of today to those at some point in the past to assess whether the market is expensive, fairly valued, or cheap. This approach can lead to great confusion and bad decisions. Take, for example, the valuation of the S&P 500 in both January of 1994 and January of 2008. In both instances, the trailing 12-month P/E was roughly 21. Given that a five and a half year raging bull market followed 1994 and the greatest financial market collapse in a generation followed 2008, how was that data point helpful?

So instead of using one of these choices, we propose a scenario analysis approach whereby we simply assume earnings growth reverts to its historical average and then determine potential outcomes, given a range of changes to the P/E (expansion versus contraction). In Table 2, we begin with current earnings, which after all the second-quarter data has come in, lands right at $110 per share for the S&P 500 Index. That number put the trailing P/E at 18.1 (as of August 31, 2014). Current 12-month estimates for index earnings, according to FactSet, are for $129, indicating a 17% growth rate. That number seems quite high, and so we instead choose a more reasonable earnings growth rate right at the historical average, 6.7%, giving index earnings of $118.4. 

In the top row of the chart, you can see we built in that 6.7% growth rate and then examined various market outcomes based on where the market P/E could be in a year. Based on this data, we can then get an S&P 500 level 12 months from now and calculate both a price return and total return with dividends. 

So, for example, if earnings grow to $118.4 and the P/E remains unchanged, that will translate into a total return of 8.6% over the 12 months ending August 2015. On the other hand, if the P/E rises two points over that period, the total return will amount to over 20%. On the other hand, if the P/E falls by two points, the total return will come to -3.2%.

This approach is not bulletproof, of course. If aggregate earnings plummet into negative growth territory, or a geopolitical event causes so much risk aversion that P/Es contract to single digits, then of course there could be a more negative outcome. However, this exercise points out how much would have to go wrong in the short run for an undesirable outcome to occur. This approach also helps to ground investors and decision makers in the math of the market.

 

Table 2: The Market Could Produce Gains Even on Average Earnings Growth
S&P 500 Index earnings and P/E ratios, current and projected

Source: FactSet and Bloomberg.
* FactSet bottom-up EPS estimates for trailing 12 months.
** Projections assume that the dividend rate of 1.9% remains constant for the next 12 months. Projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
*** Trailing 12-month return.
EPS are based on market convention index earnings, calculated by summing up the equity member contributions (trailing 12-month earnings per share of the member company equity multiplied by the number of shares of the equity in the index) and dividing the sum by the index divisor.
Trailing 12-month earnings per share are reported earnings per share over the previous 12 months.
Price return is the change in the value of an index or investment over a specified period of time, excluding dividends and interest.
Total return is the change in the value of an index, plus the value of dividends or interest.
Past performance is not a reliable indicator or a guarantee of future results.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. The index is unmanaged, does not reflect the deduction of fees or expenses, and is not available for direct investment. The investor will not experience similar results.

 

It's All about Earnings, Not Gut Feelings
The myriad of declarations that “we’re due for a pullback” or “this market is becoming a bubble” or “there’s still a long way for this market to run” have permeated the financial news airspace in the wake of the S&P 500 reaching the 2,000 mark. We believe this is not a time to make a directional bet on stocks based on a belief that we’re “due” for something, but rather an opportunity to invest in companies that are able to navigate a slow-growth economy. In light of the data above, we certainly cannot make a call on market direction, but we can argue that there is strong evidence that stock markets have delivered weak returns despite strong earnings growth and positive returns even when earnings have fallen short of high expectations. 

 

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