First Quarter 2013 – So Far, So Good
In a near replay of last year, stocks leapt out of the starting gate in 2013, posting what most would agree is a strong annual return in a single quarter. U.S. stocks, as measured by the S&P 500 Index, rose 10.6% to reach new highs. Last year, after gaining 12.6% in the first quarter, and then retreating in the second, stocks went on to post a 16% gain for the year.
Impressively, the S&P 500 Index is now up 153% from its Financial Crisis low reached in March 2009. Where stocks finish this year is anyone’s guess, but we do know that all-time highs are a necessary gateway to even higher highs. According to Morningstar, since 1955 the S&P 500 has set a new all-time high about every 17 days on average (that is, 874 new highs spread out over 14,670 trading days). Of course, new highs come in clusters (many in the 1950s, 60s, 80s and 90s, only a few throughout the 1970s and over the last decade). A new high for the stock market may indicate that future returns are lower than they could have been from lower prices, but that doesn’t mean that future returns are necessarily bad.
One of the challenges that investors face today is a lack of good return-generating alternatives to stocks. Cash yields nothing. Long-term U.S. Treasuries offer yields that are likely to be below the rate of inflation. Other fixed income securities, which involve incremental risk, may or may not prove especially worthwhile in the context of current yields. And, commodities have been weak (in particular gold, which is down about 20% year-to-date, is showing that owning it offers no guarantee of capital preservation, let alone profit).
The chart at left displays the relationship between corporate bond yields and the valuation of stocks. By taking the inverse of the Price-to-Earnings ratio, this gives us the ability to compare the “earnings yield” on stocks to the yield on corporate bonds. In the early 2000’s corporate bonds yielding 8%-9% were a far better value than stocks that had an earnings yield of only 4%. In 2009, both were about equally as attractive (above 9%). Today stocks are priced with an earnings yield of about 7% and corporate bonds yield a little less than 5%. On this basis, stocks appear more attractive.
We noted in last April’s Insight one year ago that many investors were chasing returns, piling into bond funds after a period of strong results. This trend continued throughout 2012 and into the first quarter of this year. The chart at right shows the net flows into bond funds vs. stock funds since 2007, with bond funds receiving five times the amount of new money as stock funds ($1.5 trillion into bond funds vs. only $278 billion for stock funds). The good news is that the rising stock market has not been pushed ahead by a flood of new money into stocks. Should a rotation out of bonds eventually occur it could prove to be a powerful driver for future stock returns. That said, we are not counting on this in order for investors to earn attractive returns on stocks.
Experience tells us that the path is never smooth for investors. Going forward we certainly expect more bumps in the road. The graphic below shows that every year the stock market experiences significant declines. Yet despite average, intra-year drops of almost 15%, the market has posted positive returns in 25 of the last 33 years. Such is the nature of investing.
“Pollyanna investors are occasionally crushed by real bear markets, and “super bears” (i.e. ever-pessimistic investors) tend to miss most of the long-term growth in capital that stocks can provide. Finding the right middle ground of intelligent risk taking is part of the “art” of investing. Stock picking mistakes and occasional corrections are inevitable.”
Wallace R. Weitz, Chairman, Weitz Funds