Positive developments in 2013
1) Lower expense ratios on many Exchange Traded Funds (ETFs). Last year, Schwab started the trend of lowering ongoing management fees on their ETFs and eliminating the transaction costs to buy and sell these products on the Schwab platform. This move attracted the attention of competitors and now many ETFs are cheaper to own than ever before. These products allow the broadest diversification across entire market segments at the lowest possible cost.
2) The government has increased the contribution limits for retirement accounts for the first time since 2008. Annual IRA contributions were bumped up by $500 to $5,500 for people 49 and under and $6,500 for 50 and over investors. Employer retirement plan contributions also increased. Individuals under 50 can contribute $17,500. The over-50 catch up contribution can add another $5,500 to get to $23,000 total.
3) Congress adopted higher federal estate tax thresholds ($5.25 million per person and $10.5 million per couple in 2013) than expected by most pundits. This effectively eliminates the prospect of paying federal estate tax for 99.86% of estates according to the Tax Policy Center. It also provided much more clarity for estate planning professionals who work with high net worth individuals on estate planning issues. Many states still have lower estate tax thresholds, however. For example, in Washington state the limit is $2 million. If a person dies with an estate value of $1,999,999 no state estate tax is due. But reach $2,000,001 and an estate tax return and payment are necessary.
4) Investors have returned to markets. According to Leuthold Group, through April 24, net cash flow into mutual funds was at its strongest pace ever with year-to-date positive cash flow $223 billion.
Trends that concern us:
1) Regarding that cash flow, the point of concern is that $106 billion of the incoming investments have gone to bond mutual funds. We think bonds will be severely challenged to generate meaningful returns over the next several years. Combine the premium many bonds are trading at with current low yields and the fact that total return could turn negative when interest rates rise and particularly U.S. government bonds will struggle to post returns anything like the past decade. By comparison, $22 billion of new investments have entered U.S. stock funds so far this year.
2) The low interest rate policy set by the Federal Reserve Board. This policy has lowered the borrowing costs for the U.S. Government, but it has also changed the way that we all invest. Bond investors who are searching for yield are taking considerably more investment risk with their fixed income portfolios than ever before. When the Fed finally increases interest rates, three things may happen: inflation could increase dramatically, bond default rates may rise, and returns for bonds could turn negative as investors seek newer bonds at different increasing interest rates.
3) Less affordable long-term care insurance. A few trends are becoming clearer for the LTC marketplace. A) most residents of nursing homes are women, b) Most baby boomers don’t have long-term care insurance because they either feel that it is too expensive or they don’t think that they will ever need it, C) Rates paid for LTC policies are becoming gender based, and although they have stabilized somewhat in the past year, the combination of the continuation of the low interest rate policies by the federal government and higher claims rates by women will force LTC prices to continue to grow at higher rates than inflation.
~ Allyn Hughes, CFP® — Brooks, Hughes & Jones – Partners in Wealth Management, Tacoma, WA
Forward to a friend
Stock market rally justified by earnings, reasonable market value
The U.S. stock market turned in a strong first month of 2013 as the S&P 500 gained 5.2%.
This coming after a 16% total return for the S&P 500 in 2012 has some wondering if the rally is close to exhaustion.
While we don’t expect double-digit gains to build throughout 2013, we don’t think the market is close to being overheated either. We’re not making a forecast but thought it might be helpful to see a couple charts that help explain value of the market. Of course, these charts and analysis portray a rational view and markets can become irrational from time to time. There’s no sense in trying to predict a return for the year or any short time frame. As Warren Buffett has said: “short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also grown-ups who behave in the market like children.” However, we can confidently forecast that you’ll want stock market exposure over long periods regardless of short-term results.
So on with the show.
Two charts from presentations I’ve watched recently demonstrate how market prices may have room to grow to catch up with the reported earnings of U.S. companies.
This view of S&P 500 inflection points is from J.P. Morgan. Look at the first peak, March 2000. A measure of market value is the price/earnings ratio of the market. What price are investors paying for each dollar of company earnings. At this euphoric time, the P/E ratio (based on forward earnings expectations) was over 25. It had become excessive and the market needed a cleansing to get back down to a P/E ratio closer to historic norms.
The recovery from the internet bubble peaked in October 2007. At that time, even though the price of the S&P 500 had surpassed the March 2000 price, the price/earnings ratio was 15.2, 40% below the 2000 P/E ratio. The market had not been bid up by speculative investors quite like in 2000. Of course, that didn’t stop a significant bear market due to the credit crisis and recession of 2008.
So where are we at today? The recovering S&P 500 has crossed a price of 1,500 again. But corporate earnings have also grown at a strong rate. This means the price is generally justified by the earnings. The forward price/earnings ratio at the end of 2012 was just 12.5, roughly half of the irrational exuberance peak of March 2000.
Add January’s price appreciation and the forward P/E ratio is about 13.3.
The combination of earnings and investor confidence in the trajectory of those earnings will be critical to determining how long this rally will continue.
Here’s another view – from economist Fritz Meyer – demonstrating how the market price has some catching up to do if history can be trusted as a guide.
The black line of the S&P 500 price over the past 25 years has generally kept an edge above the red line (S&P 500 earnings). It’s clear to see however, that the late 1990s S&P 500 value and the 2007 value grew disconnected from the reality of earnings.
Since 2010, though, good corporate earnings have not been reflected in stock prices that grow at the same pace. The S&P 500 black line has spent most of the time below the earnings line. Look at projected earnings going forward for 2013 and 2014 and you could rightfully judge that there is justification for stock prices to continue growing without getting too expensive.
Recovering investor confidence could have something to do with that. If cash flows shift back toward stocks and away from the bond market, gains may continue.
Of course, there are many potential shocks to the global economy which could erode emerging confidence and disrupt the growth in corporate earnings. But at this point, even significantly lower earnings would justify the current value of the S&P 500.
The S&P 500 is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor’s.
~ Gary Brooks, CFP® – Brooks, Hughes & Jones – Partners in Wealth Management – Tacoma, WA
www.BHJadvisors.com
→ Leave a comment
Posted in Commentary, Investments
Tagged earnings, investments, market valuation, s&P 500, stock market, stocks