I. Market Review
The U.S. stock market continued its eight-year climb in Q1. Fed Chair Janet Yellen’s comment that “the simple message is the economy is doing well” pretty much sums up the market’s attitude. Volatility was low; there were only a few days the markets moved even 1%. We’re not sure we’ve seen a larger sentiment disconnect between the markets and current events.
International stocks also had a strong quarter, with both developed and emerging markets outpacing the U.S. There was nary an asset class down in Q1, from real estate, to Treasuries, to high yield bonds.
II. U.S. Market: An Anxious Climb
Typically, a prolonged run of gains breeds exuberance. Instead, memories of 2000 and 2008 are short-circuiting excitement. More than in bull markets past, clients ask about rich valuations and whether we are overdue for a downturn.
Both are valid concerns. But there’s important context in both discussions.
“Stocks are overvalued” is receiving loud media coverage. Most valuation metrics do show the market is expensive. CAPE, the most widely-cited metric, ended Q1 just below 30. Only in 1929 and 2000 has it been higher. Before sounding the alarm, it’s important to understand the data’s limitations.
First, with a 10-year look back, the depressed earnings of 2007-09 are still affecting CAPE. Without the Great Recession, CAPE still shows stocks are expensive, but not as egregiously so.
Second, historically low interest rates have lifted stock prices. Unprecedented monetary policy provides some uncertainty about the old rules’ usefulness.
As Mark Twain said, “history doesn’t repeat itself but it often rhymes.” We’re not here to dismiss history because “this time is different”. In our experience, prognosticators say this right before history reasserts itself.
Our point in exposing quirks in CAPE is to highlight the limits of using metrics to forecast the next downturn. Valuations are still the best measure of long-term expected returns. However, financial metrics can be misleading a long time before the long-term trend finally kicks in.
Our current bull market dates to March 2009. During the last eight years, the S&P 500 has never dropped more than 20% peak to trough. Crossing that 20% mark is the technical start of a bear market.
The previous bull market was unusually brief, lasting less than five years, from February 2003 to October 2007. Of the dozen bulls since 1903, the current one is only the seventh longest and sixth strongest. To match the length of the post-WWII bull market, the S&P would have to continue unabated until late 2023. To match its size, the S&P would need to gain another 600+%.
The 21st century notwithstanding, the 20th century shows that relative to past bulls, the current bull market is not long in the tooth. History provides no guide to how much longer the current one will run.
III. Strong Quarter for Emerging Markets
Amid concerns about a trade war, emerging markets (EM) jumped 11.5%, nearly equaling their 2016 gains. Seafarer, a boutique EM manager, cites three reasons that may account for the gains:
- EM earnings growth accelerated for the first time in five years.
- EM valuations started the year significantly cheaper than U.S. stocks.
- Despite three interest rate rises since December 2015, the U.S. dollar has not risen relative to EM currencies.
While the above trends are encouraging, our mindset to EM is chiefly long-term. The following visual illustrates how much untapped demand may exist in places like India. In the coming decades, billions will join the global middle class and seek the same goods we take for granted. Tremendous value will be created. We want our clients to participate.
 CAPE stands for Cyclically Adjusted Price-to-Earnings ratio.