Market & Economic Commentary

Equities are rallying because global monetary policy remains ultra-easy. We’re pleased that the market is up significantly from the lows of last summer but we want to caution clients and readers not to get too excited. Why? Equity valuations are fair – and far from cheap! Further, earnings growth is poised to slow markedly from the pace we’ve experienced over the past two years as higher input costs and rehiring combine to pressure margins. Big gains in equities over the next decade would require significant economic growth – which, in our over-indebted world – appears unlikely.

No Bargains in Equities

Many valuation metrics can be used for stock markets. Of the many P/E ratios that one can look at(historical, forward, etc.), one we believe to be particularly useful is the price to earnings ratio of the median stock in the S&P 500. This measure strips out the most overvalued and the most undervalued stocks, and so provides a measure with greater consistency over market cycles. Right now, that median P/E stands at 17, slightly above the post-war median of 16.

Other measures tell a similar story.

For example, using data from BCA Research, the price of the market relative to 10-year average historical earnings (the so-called Shiller P/E) is 13% above its median valuation; the price to book is 26% above its post-war median, and so on. One can argue with the details of all these measures, however, it is hard to argue convincingly that stocks are cheap, except when comparing dividend yields to interest rates on bonds. But of course, that comparison is driven by the Federal Reserve’s easy money policy, not by any underlying economic reality.

Arriving at a Long-Term Expected Return

Let’s assume that earnings grow at roughly the growth rate of the economy and that S&P stocks will offer a dividend yield of 2% to 3% over the next decade. Putting these two metrics together – absent multiple expansion – we estimate that stocks might deliver 3% to 6% annualized returns. Not bad, but not earthshaking either.

Of course, rising profit margins here would bode well for equities. Unfortunately, it looks likely that we are nearer to the top than the bottom of profit margins. Both before-tax and after-tax profit margins for nonfinancial corporate businesses are at roughly 40-year highs. Productivity growth correlates with profit margin growth but productivity growth in the non-farm sector grew by only 0.7% in 2011 and is on track to grow weakly again in 2012. The reason? Firms are being forced to rehire some of the workers that they laid off in 2008-2010. For example, total hours worked are currently tracking to increase by 3% in Q1 while gross domestic product growth is tracking at only 2%. That is, some of the “productivity growth” associated with the dramatic layoffs of 2008/9 will prove to be illusory.

The Investment Strategy Group of Contango Capital Advisors provides regular updates on economic and financial conditions and trends. In this issue, we examine the relatively lean markets of the last 10 years and take a look at what current financial conditions may mean for the future.