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VOL. 38 | NO. 37 | Friday, September 12, 2014

Woeful period for US markets

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September 8, 2014, S&P 2000 = 11 + 4 percent + 11 percent + 1.5 percent + 2.5 percent. The last five years have been consistently wonderful for the U.S. markets. Over the time period, the S&P 500 has advanced more than 17 percent annually. Only four bull markets (advances uninterrupted by a 20 percent decline) have lasted longer and returned more. What has this bull been eating?

Entry Point Valuation. When the bull began in 2009, the trailing 12-month P/E ratio on the S&P 500 started below 11x earnings. That number stands over 17 today. That amounts to a 55 percent increase in valuation alone. At 17 the P/E now exceeds its long-term average.

Nominal GDP/Corporate Revenues. U.S. nominal GDP (includes inflation) has grown at an average of nearly 4 percent annualized over the time period. Corporate revenue growth has exceeded this average by tapping into ex-U.S. growth opportunities.

Corporate Profits. Within the S&P 500, profit margins have nearly doubled since mid-2009 to over 10 percent today, well above the long-term average. Profit growth of 11 percent annually has more than doubled revenue growth over the time period.

Inflation. Inflation takes on different characteristics at different speeds. Too slow, and inflation becomes alarming (see Europe). Too fast, and inflation becomes alarming (see Venezuela). Just right, and slow and steady inflation provides corporate pricing power, slowly erodes debt burdens, and helps increase asset values. Since 2009, U.S. inflation has averaged slightly more than 1.5 percent. Inflation expectations remain well anchored around the Fed’s target rate of 2 percent.

Interest Rates. Benign inflation rates typically translate into benign interest rates. With the overnight lending rate pegged at zero by the Fed, short-term borrowing costs are zilch. Further out the curve, 10 year lending rates have drifted lazily around 2.5 percent over the five-year period. Further still, 30 year Treasury yields remain near record lows at just over 3 percent. Imagine that! Factor in inflation, and profit seekers can borrow at near zero rates of interest. These record low interest rates promote investment risk taking and therefore increased asset prices.

While there are many other variables that impact market performance, these five tend to be the ones with greatest influence. Converting these factors into an equation, low-entry point valuations (11) + steadily rising nominal GDP (4 percent) + rapidly rising profit growth (11 percent) + low and steady inflation (1.5 percent) + low and steady interest rates (2.5 percent) = rising earnings + rising valuations for a long and strong bull market!

Bottom Line: The trailing five years for investors have been nirvana. The combination of low entry point valuations, rising nominal GDP, expanding profit margins, low inflation and low interest rates rightly propelled stocks vigorously. Today, we have lost propulsive power from valuations and margins. Therefore, market returns will correlate more with corporate revenue growth as long as inflation and interest rates remain low. Since inflation drives Fed policy and interest rates, a spike in inflation would threaten our win streak. Absent that, the formula holds and this resilient bull will continue to climb the leaderboard.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.

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