After several years of avoiding stocks, investors started coming back into equity markets early this year, perhaps signaling the end of a period characterized by massive outflows and risk-averse, macro-driven markets. Mutual fund investors put $37.9 billion into equity funds in January, the largest monthly inflow since the dotcom era peaked in March 2000, and the first positive month over the last ten. Even as the major equity indexes more than doubled in value since the market bottomed in March 2009, investors pulled more than half a trillion dollars out of retail stock funds, while putting more than $1 trillion into bond funds since 2008.1 In short, we have experienced a strong equity bull market, but many investors did not participate in it.
The recent reversal of equity flows and strong price momentum comes as the economy has shown steadier growth and increasing resilience. While the early inflows to equity funds were significant, it remains to be seen whether this momentum will continue and whether investors are truly “rotating” out of bonds, as fixed income flows have remained strong so far this year. What does seem evident, however, is a relative “normalizing” of equity markets, as individual stock prices have begun to respond more to underlying company fundamentals and less to macro-driven events such as the European debt crisis, budget battles in Washington D.C. and China’s economic growth.
With heavy flows into stock funds and new record highs for some broad market indexes so far this year, many investors may wonder whether this latest rally has room to run. Bill Riegel, TIAA-CREF’s Head of Equity Investments, recently talked about his view on the value of equity markets, the return of favorable conditions for active equity managers and some risks to watch out for in the coming months and years.
Exhibit 1: Strong equity flows in January reversed 10 months of outflows
Source: Investment Company Institute, Haver Analytics as of March 2013. S&P 500 Index (right-scale) shows end-of-month level.
What is your current outlook for stocks?
We are generally favorable toward equities this year, as economic conditions continue to improve and some of the major macroeconomic issues that have concerned investors over the last few years have faded. Markets and investors have moved from crisis to crisis since 2007, from subprime, to the European sovereign debt crisis, to the debate in Washington D.C. over spending, debt limits and taxation, and to China, which has faced questions about the sustainability of its economic growth, the potential for inflation and its own possible housing bubble. While none of these issues have been fully resolved (witness the most recent kerfuffle over the bailout of Cyprus), each has generally been addressed enough to satisfy the market. This has resulted in a compressed equity risk premium, which is the return an equity investor expects to earn over U.S. Treasuries (the riskless alternative). A lower equity risk premium has been accompanied by very strong corporate earnings. Even with the year-to-date narrowing of the risk premium, stock valuations are just above their long-term averages and are clearly below the most recent peak seen in 1999 to 2000.2
Exhibit 2: Earnings recovered but valuations remain low
Source: Standard & Poor’s, Haver Analytics, March 1999-Dec. 2012
Does the current rally have legs?
While we remain optimistic about economic growth and earnings, stock prices have increased rapidly this year and we are concerned about slower price appreciation going forward, or perhaps even a correction in equity markets. This fear is compounded by very high levels of optimistic sentiment in markets—which is sometimes a warning sign that prices are overheating. Additionally, with the strengthening U.S. economy the yield on the 10-year Treasury recently moved above 2%, indicating that the market has begun to discount stronger U.S. growth and maybe even higher inflation. When that rate moves higher, it reduces the relative attractiveness of U.S. equities, however, because higher interest rates provide a better return and compresses the risk premium versus stocks and could threaten the current attractive relative return for U.S. equities.
We are also optimistic about international equity markets, where long-run expected returns are higher than U.S. markets. However economic growth relative to the U.S. has been disappointing thus far in 2013. While emerging markets ended 2012 on a strong note, they have underperformed the S&P 500 in the first few months of this year because of slower-than- expected growth from China. However, over time we believe that those markets may offer better relative upside given the better growth dynamics in many of those economies.
Is record-breaking corporate earnings growth sustainable?
Corporate earnings growth has been strong over the last five years, while equity valuations remain only slightly above their long-term averages. By one broad measure, the earnings per share of the collective companies in the S&P 500 index have doubled in just the last five years. The last time that happened was during the technology stock boom from 1993-1999.
There are many factors that influence earnings, and they are always changing. One favorable component over the recent stretch has been the historically low interest-rate environment.
Companies have been able to borrow at increasingly lower interest rates, which have provided a significant boost to their net profit margins. A rise in interest rates could reduce profit margins, although other factors, such as economic growth and moderate inflation, could offset the negative effect of rising rates. Accelerating U.S. economic activity and inflation could help boost profits even during a rising interest-rate environment. Another risk to sustained strength in corporate earnings growth is the cost of labor, which has remained low over the last several years. Over time, labor costs should rise, creating another challenge to rising profits. This is why in our expected returns models we forecast that U.S. margins will “mean revert,” i.e., return to their lower historical average levels over time.
Have conditions improved for active equity management?
One of the chief defining characteristics of equity markets over the last several years has been the so-called “risk-on, risk-off” trade, with investors lurching in and out of stocks and bonds depending on the latest headlines out of Europe, China and the U.S. On days when investors feared that the European Union would not survive the debt crisis, for example, they sold stocks en masse and bought safer assets, such as U.S. Treasuries. Many investors were buying and selling the asset class and not making much, if any, distinction among individual stocks in broad market indexes. This was a challenge for many active managers and has caused many investors to move into passive or index funds.
We can see this phenomenon in the cross-correlation of stock prices. Typically, about a third of stocks will move up or down in tandem with each other and the broader market, but during various periods over the last several years, we’ve seen between 80% and 90% of stocks behaving this way. That extremely high level of correlation between stocks makes it very difficult for active stock managers to add value, because good companies are not rewarded for strong performance, and bad ones are not punished.
These conditions have changed over the last several months, however, and we are now seeing equity cross-correlation levels trend back to normal levels of around 30%. This means that stock picking can add value, which in turn means active managers like TIAA-CREF have more opportunities to add value.
Have we been in a long-term bear market, and if so, is it over?
The last major peak in the equity market was March 2000, and since then, the strongest returns have come from bonds and Treasuries. This simple fact confirms that we’ve been in a secular bear market: secular bear markets usually last anywhere from 14 to 16 years. While the 14 to 16 term is not iron clad, that history means that this current bull run (occurring in year 13) may yet give way to more weakness. However, this current rally has exhibited some very powerful signals that may mean 13 years was the limit and that we have begun a new secular bull run. We certainly hope so.
History however is a very powerful guide on long-term market cycles for both equities and commodities, each of which tends to move in 30-year waves driven by demographics and investment cycles. The previous secular bull run through the 1990s was driven heavily by the Baby Boomer effect. While saving for retirement, Boomers put record amounts of money into stocks. As they aged (the peak was paradoxically 2000), and moved closer and into retirement, they naturally became more risk-averse. The market experienced record bond inflows when Boomers were in the savings phase of their retirement, followed by large-scale movement away from equities as they moved into the latter stages of their careers. Not all of this asset flow activity is attributable to the Boomers, but they did have an effect. As this demographic group continues to move out of the workforce and into retirement, however, their children will increasingly move into the workforce and start saving for retirement, which could drive a strong reversal of fund flows back toward equities. Looking at demographics, it appears that 2015 will be the year when the children of Baby Boomers begin moving into the workforce in large waves. That may be the start of our next 30-year stock cycle and parenthetically a weaker period for bonds.
What are some final thoughts for investors as they seek to mitigate risk and enhance return potential in equity markets?
As a rule, we think investors are best served by staying well-diversified in their equity portfolios as they save for retirement or for other long-term savings needs. There is tremendous focus on the major indexes, such as the S&P 500 and MSCI EAFE, but those only cover a portion of the total equity universe. That means investors who focus solely on strategies tied to those benchmarks may be missing opportunities for better diversification and return potential that may be available elsewhere. The S&P 500, for example, is a capitalization-weighted index representing the largest U.S. companies—and the largest companies within the index are given the most weight, which means dramatic price moves of these names may have a significant influence on the benchmark characteristics and on strategies that seek to beat or even match it. Yet other pockets of the equity universe, such as mid- and-small cap stocks, not to mention international developed and emerging markets, also offer attractive investment and diversification opportunities. Looking back over time, investors with exposure to these areas of the equity universe have tended to benefit from lower equity volatility overall and in some cases, higher returns.
Exhibit 3: Since January 2000, U.S. large-cap stocks have underperformed broader U.S. and international stocks
Source: Standard & Poor's (S&P); Moody's Analytics, as of March 2013, monthly index levels.
Consider, for example, the Wilshire 5000 Total Market index. This index, like the S&P 500, is U.S.-focused and capitalization-weighted, which means the largest companies have the greatest influence over index performance. However, the Wilshire 5000 also includes mid- and small-cap stocks. Since 2000, investors with this multi-cap exposure would have outperformed those who allocated solely to large-cap stocks such as those in the S&P 500.3 Similarly, the MSCI ACWI (All Country World Index) ex-U.S. would have provided broad exposure to international developed- and emerging-market equities, including the dynamic economies of China, Brazil and India, and other fast growing nations. While past performance is no guarantee of future results, the benefits of diversification both among and within asset classes have been demonstrated over time. Long-term investors seeking to take advantage of these benefits can consider making allocations beyond large-cap U.S. stocks to include equities across the full complement of available capitalization ranges and geographic regions.
1 Investment Company Institute data as of February 28, 2013.
2 See Exhibit 2 for a comparison of earnings and valuation.
3 See Exhibit 3 for a comparison of how these major indexes have performed since 2000.
The information provided herein is as of March 21, 2013.
The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc, is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). Past performance is no guarantee of future results.
The performance discussion above concerns various market indices. It is not possible to invest in an index. Performance for indices does not reflect investment fees or transactions costs.
Please note that diversification is a technique to help reduce risk. There is no guarantee that diversification will protect against a loss of income. Past performance does not guarantee future results.
Please note that equity investing involve risk.