“Radiance of Tomorrow”-Ishmael Beah
In our note to clients at the end of last year we addressed the anxiety felt by investors working to understand the ramifications of Washington’s fiscal cliff, the Eurozone crisis, and a lethargic recovery. We believed that the issues were manageable and that cheap equity valuations offered some downside protection. Now we are confronting another angst as many investors question whether we’ve just had too much of a good time. The most common subject to which we’re responding is “what’s next?” While the question is simple, a thoughtful response is multifaceted; one which we’ll attempt to provide in this quarterly update.
First, stocks are neither as cheap as they were last year, nor are they overly expensive. At the beginning of 2013 stocks were trading at 11.8x projected earnings. As we enter 2014, stocks are trading at 12.7x consensus earnings. Yes, there has been multiple expansion but we are not near the peak market multiple reached in 1999 of over 18x earnings. One ongoing worry is that the quality of earnings growth has been poor because its been driven by margin expansion and share repurchase programs, not revenue growth. Looking into 2014 revenue growth is likely to strengthen moderately as GDP recovers from 2.3% toward an estimated range of 2.8-3.2% and corporate share repurchase programs continue.
Second, how skillfully the Federal Reserve executes the Quantitative Easing (QE) exit will influence the equity and bond markets. The December Minutes of the Federal Reserve Open Market Committee reveal it is working hard to minimize market disruption as the QE programs conclude. The Fed is projecting accelerating real GDP growth over the next few years which would lessen the impact of the unwind but if QE tapering hurts the economy the Fed will slow the scale-down. The Minutes also note that increases in nonfarm payroll employment is running at a pace that is lowering unemployment and that inflation remains tame; key justifications for unwinding the QE programs. Under the perfect scenario (to dream!), the Fed will exit QE as the economy strengthens propelling corporate revenue and earnings higher.
Third, the outlook for bonds remains challenging. The Fed first hinted it was contemplating exiting the QE programs late in the second quarter of 2013. Even though the Fed didn’t actually curtail its bond buying program, it was effective “talking up” rates in 2013 as the 10 year Treasury yield rose from a low of 1.6% to close the year yielding 3%. (As yields rise bond prices fall.) Junk bond yield spreads (yield premium over treasuries) are near an all-time low of 400 basis points, last reached in 2007, versus a peak of almost 2000 basis points during the height of the financial crisis in November 2008. A lower yield spread is a sign of complacency as investors demand less premium for the risk they are taking in owning a bond. Yield spreads have also contracted for investment grade corporate bonds. It is questionable how much further the yield spreads can contract so we remain wary of committing new money to these instruments at this time. With a negative outlook for bonds, equities are likely to continue attracting new investor money.
During the quarter we made few changes to client portfolios. We sold Qualcomm after owning if for many years due to concerns that the licensing revenue would moderate and future growth would be driven more by the volatile chip business. We purchased shares of Google because the company is a clear beneficiary of the secular trend toward greater mobility in technology. However, the biggest bet we made was to do nothing and let our “winners” run. The year was unique in that we had only one stock (IBM) post a negative full year return. (Past performance is no guarantee of future returns!) That’s a testament to the fact that owning companies generating free cash flow with a record of utilizing those funds in shareholder friendly activities creates value over time.
We enter the New Year with a constructive outlook, recognizing that investing money requires a balance of optimism and caution. We believe in the radiance of tomorrow, that we live in a dynamic society that possesses the ability to learn from past mistakes, evolve and grow. Yet, our views are tempered by the fact that human beings have an uncanny ability to interfere with success and that equity markets can be very volatile. Economic forecasts can disappoint and politicians can create dysfunctional policies. In the US, there are unsustainable trends in local, state, and federal budgets and many people approaching retirement haven’t saved enough to support themselves in their later years. We continue to believe that one of the most bullish forces that could benefit our economy would be to tackle our fiscal woes, including tax reform and entitlement spending. Our world is dynamic and not static, so there is always the chance for betterment.
As always, thank you for entrusting Ayrshire Capital Management with the management of your money. Happy New Year and best wishes for health and happiness in 2014. We look forward to speaking with you.
JM Sam Nevin, Jr.
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