With nearly double-digit gains in every major U.S. equity index in the first quarter of 2013, stocks have reached or surpassed their pre-financial crisis levels. That this feat occurred only recently is as much due to continued investor skepticism as it is to the hesitant stabilization of the financial markets and the slow, but improving economy. In order to bolster investor confidence, the Federal Reserve and other central banks have injected an unprecedented amount of liquidity into financial markets. While flows into equity funds finally picked up after the market had more than doubled from its lows, investors still remain skittish.
When interest rates are at near zero percent yields, it is impossible to expect bond returns to meet the long-term investment targets of already underfunded pension plans. Regulatory proceedings against several high profile hedge fund managers have also reduced the appeal of some alternative investments, making traditional equities an attractive option, finally again garnering investor attention.
The timing of the rally is curious and further evidence that most investors cannot anticipate the near-term direction of the market. Our January client letter discussed the risks of sequestration and the fragile global economic and geopolitical conditions. Except for pockets such as the U.S. housing market and manufacturing data from a still unstable China, it is more accurate to describe conditions as “better than feared”, rather than steadily improving. Tough earnings comparisons remain until the fourth quarter, but slight upward revisions in earnings estimates have occurred as business conditions have improved. Continued deployment of corporate cash to benefit shareholder interests, through buybacks and expanded dividend payouts, should continue to support share prices.
The “better than feared” atmosphere has not led to a meaningful pickup in capital investments, but unemployment has continued to trend lower. There is little risk that the U.S. unemployment rate will meet the Fed target of 6.5% before its 2015 time frame for sustaining quantitative easing policies. Consumer credit is improving, but there is considerable dependency on continued improvement in the housing market to unlock value and remove restrictions posed by underwater mortgages. Thus far, housing has been a bright spot in the economy.
The atypical lack of euphoria following such a strong advance reflects the lack of resolution on many long-term challenging issues. The fears that sequestration will plunge the economy into recession seem overblown, though certain areas, such as defense, will suffer disproportionately. Our flawed political system has forced minimal unilateral spending cuts and raised taxes without any meaningful bi-partisan resolutions on the budget. The bar seems to have been set so low that “kicking the can down the road” has temporarily satisfied financial markets, but the massive bill for the expanded healthcare program will dampen growth next year as the resumption of payroll tax deductions did to start this year.
Domestic issues aside, international headlines undoubtedly play a role in the evermore connected global economy. The recent situation in Cyprus is a reminder that the unresolved European debt crisis can derail the fragile rebuilding process. Nuclear threats from desperate regimes can destabilize important regional sources for energy and trade, while China has its own real estate bubble and is threatened by its lack of infrastructure.
It has been a long-standing objective of our quarterly correspondence to comment on recent timely issues, but it is also necessary to share a historical perspective that is significantly more important for long-term investment success. The market advance over the past four years has been supported by earnings growth. Much of the initial earnings growth was the result of cost cutting, but margin improvement is no longer forecasted for the majority of businesses. Revenue growth over the next several years is likely to expand, but at a slow pace, and earnings per share should increase near their historic levels of about 8%. With stocks still slightly below their average forward earnings multiple and interest rates at such low levels, we believe there is still good value for equity investors at current levels, especially in select companies.
There is a transformative shift predicated by both the aging trends in the U.S. and other developed nations and the high levels of debt with no effort to reign in entitlement programs or raise revenues. The result should be a “new norm” for U.S. economic growth of 2%-2.5%, versus the century old rate of about 3.5%. Investors are generally well served when valuations are reasonable and the Fed is accommodating. We believe that the Oak Ridge portfolios are well positioned for the more rational market environment that is likely looking ahead for the rest of the year and thank you for your continued confidence.
David M. Klaskin
Chairman and Chief Investment Officer