Friday, November 28, 2014

the current bull market

It has been five years and seven months since the S&P 500 Index hit a dreadful low of 666.79 (intra-day) in the midst of the full force of the financial crisis. This August, the index passed the 2,000 mark for the first time in history, three times above the low of the crisis, retreating slightly at the end of September. Certainly, much has changed in the U.S. economic and business environment to trigger that impressive growth (a total return of 191.53%, or 228.05% including dividends). And certainly today we live in a healthier economy with improving fundamentals, along with restored consumer and investor confidence.

Reading the news and listening to investors, it seems that to many, five years and seven months of a strong market is too much of a good thing. In recent months there’s been a lot of commentary suggesting that stocks have appreciated “too much” for too long and are now overvalued. Pundits have exclaimed that the stock market has exhausted its growth potential, and that we are at the peak of the bull market and due for a correction. Others disagree, believing that the markets still have room to appreciate, supported by a not-too-hot/not-too-cold economy, even with the much-anticipated rise in interest rates at some point in 2015.

Five years seven months and a 192% return is indeed an impressive run, but it is merely average when compared to historical bull markets. The table below lists all bull markets since 1871 and ranks them by duration. We define bull markets as those with at least a 20% increase that lasted six months or more. The return magnitude of the current bull market is slightly above average and is sixth, as measured by duration. The current bull market does not come close to two of the largest bull markets, both of which ended with speculative stock bubbles: one the dot-com bubble, and the other the Great Depression. These impressive runs also had short-term event-driven corrections. The longest bull market experienced three of them, ranging from -33% to -19%: Black Monday in 1987, the Iraq war in the early 1990's, and the collapse of LTCM in 1997.

Bull Markets Since 1871
Includes all increases in the S&P 500 Index of 20% or more

that lasted at least 6 months

Start          End          months Rank  Return Rank
13-Aug-1982    27-Mar-2000   211.4   1 1387.85%  1
July 1949      12-Dec-1961   149.4   2  419.97%  2
September 1921 September 1929 97.0   3  385.27%  3
4-Oct-1974     28-Nov-1980    73.8   4  125.63%  9
September 1896 September 1902 73.0   5  132.28%  8
10-Mar-2009    30-Sep-2014    66.7   6  191.53%  4
24-Jul-2002    9-Oct-2007     62.5   7   96.21% 11
May 1942       May 1946       49.0   8  138.52%  6
July 1877      June 1881      48.0   9  141.03%  5
27-Jun-1962    9-Feb-1966     43.5  10   79.78% 12
November 1903  September 1906 35.0  11   60.22% 15
27-May-1970    11-Jan-1973    31.5  12   73.53% 13
February 1885  May 1887       28.0  13   39.15% 18
10-Oct-1966    29-Nov-1968    25.7  14   48.05% 16
December 1907  December 1909  25.0  15   64.80% 14
April 1935     February 1937  23.0  16  115.34% 10
January 1915   November 1916  23.0  16   38.91% 19
July 1932      February 1934  20.0  18  137.32%  7
January 1918   July 1919      19.0  19   39.85% 17
May 1938       November 1938   7.0  20   32.15% 20
AVERAGE                       55.6      187.37%

[Well, being ranked 6 and 4, I'd say that's above average.  And it also appears to be above average on a percentage gain per month basis -- about 2.9% per month.]

We think the current bull market has more room to run, but we do not expect the stellar 30%+ return from 2013 to repeat this year or next. We believe that conditions are in place to sustain attractive growth rates in the companies in which we invest and attractive returns in their stock prices. In our view, current levels of widely-used valuation metrics support our thesis. Valuations are at or moderately above their 100-year average, and there are plenty of good stocks at attractive prices to be found, in our opinion.

Current valuations also imply significant forward long-term returns, particularly for growth stocks. We looked at the historical relationship between stock valuations and future returns and plotted the results in
the following charts. While this analysis is not proof of cause and effect between P/Es and future returns, it reveals a pattern that suggests such a relationship – low valuations correspond to higher five-year future returns.

The result from this analysis suggests attractive stock returns over the next five years, with growth stocks being in a stronger position. At current valuations, the analysis shows that the implied forward rate of return for growth stocks is 11.7% over the next five years, while value stocks’ implied rate is 8.5%, although there is no guarantee this will be the case.

Timing the Market Would be an Amateur’s Mistake That Can be Very Costly

Investors appear to be anxious, as demonstrated by the negative year-to-date flows out of domestic equity mutual funds and ETFs. This may prove to be an over-reaction by investors, as well as a costly mistake.

The Patriots lost 41-14 to the Chiefs in week four and had a 2-2 record. The result was a lot of noise about whether the team should bench 37-year old Tom Brady. Many were ready to have him hang up his cleats. Other factors, of course, could have been responsible for the slow start, such as the offensive line or inexperienced receivers. An experienced coach like Bill Belichick didn’t waiver in his support of his seasoned quarterback. Week five saw the Patriots face the Bengals, a team that entered the game 4-0. Brady threw for 292 yards and beat the Bengals resoundingly, 43-17. Tom Brady is not done yet – there are still more successes to be achieved in an already successful career (in week five he became the sixth quarterback to have over-50,000 career passing yards).

Over-reacting to short-term issues, trying to time the equity markets, or abandoning the equity markets entirely, should not, in our opinion, be part of an investor’s game plan. It certainly seems safer to put your money in a bank account. Consider, however, what you earn from a one-year bank CD (around 1%) and factor in the consequences of inflation (currently around 1.7%, as measured by the Consumer Price Index), and you are left with a negative return.

Following what everyone else does in the equity markets will often result in selling after the market has gone down or buying after the market has gone up. Instead, it forces investors to participate in the downside and keeps them from participating on the upside, which is not a particularly successful strategy.

Linda S. Martinson
Chairman, President and COO
October 20, 2014

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