The stock market was basically flat in the first quarter of 2014 as investors worried about whether or not the five-year bull market will continue. The Dow Jones Industrial Average was down 0.15%, the S&P 500 Index was up 1.81% and the NASDAQ was up 0.83%. We have seen volatility increase this year and it will probably continue.
The stock market is not highly overvalued at this point, but fairly valued compared to historic values. Historically, the S&P 500 Index has had an average trailing Price/Earnings Ratio of 19.1x. At the end of March 2014 the trailing P/E Ratio was 17.9x. Using the expected earnings of the S&P 500 for the year 2014 the forward P/E Ratio at March 2014 was 15.2x. This compares to an historic average of 14.9x. Other measures lead one to the same conclusion that the stock market is fairly valued.
We think that the stock market still has room to go up between 5%-15% in 2014. We expect volatility to be higher than past years like we have seen in the first quarter. We are not worried about a rise in interest rates in 2014. We think the yield on the 10 year Treasury will fluctuate between 2.25%-2.75%. You can see on page 20 of the performance report in the Market Data section that when interest rates do rise the negative effect on the S&P 500 is not dramatic until rates rise to 5% on the 10 year Treasury. We will keep this in mind when rates start rising. The logic is that if rates are rising it must mean that the economy is improving; therefore, earnings will rise in the companies in the S&P 500.
Our friends at Hoisington Investment Management Company have made some excellent observations once again in their “Quarterly Review and Outlook – First Quarter 2014”. They point out that the Federal Reserve’s Federal Open Market Committee (FOMC) has continuously been overly optimistic regarding its expectations for economic growth in the U.S. since the last recession ended in 2009:
The Federal Open Market Committee (FOMC) has continuously been overly optimistic regarding its expectations for economic growth in the United States since the last recession ended in 2009. If their annual forecasts had been realized over the past four years, then at the end of 2013 the U.S. economy should have been approximately $1 trillion, or 6%, larger. The preponderance of research suggests that the FOMC has been incorrect in its presumption of the effectiveness of quantitative easing (QE) on boosting economic growth. This faulty track record calls into question their latest prediction of 2.9% real GDP growth for 2014 and 3.4% for 2015.
A major reason for the FOMC’s overly optimistic forecast for economic growth and its incorrect view of the effectiveness of quantitative easing is the reliance on the so-called “wealth effect”, described as a change in consumer wealth which results in a change in consumer spending. In an opinion column for The Washington Post on November 5, 2010, then FOMC chairman Ben Bernanke wrote, “…higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion”…This year, in the January 20 issue of Time Magazine, the current FOMC chair, Janet Yellen said, “And part of the [economic stimulus] comes through higher house and stock prices, which causes people with homes and stocks to spend more, which causes jobs to be created throughout the economy and income to go up throughout the economy.”
FOMC leaders may feel justified in taking such a position based upon the FRB/US, a large-scale econometric model. In part of this model, employed by the FOMC in their decision making, household consumption behavior is expressed as a function of total wealth as well as other variables. The model predicts that an increase in wealth of one dollar will boost consumer spending by five to ten cents….Even at the lower end of their model’s range this wealth effect, if it were valid, would be a powerful factor in spurring economic growth.
After examining much of the latest scholarly research…we found the wealth effect to be much weaker than the FOMC presumes. In fact, it is difficult to document any consistent impact with most of the research pointing to a spending increase of only one cent per one dollar rise in wealth at best. Some studies even indicate that the wealth effect is only an interesting theory and cannot be observed in practice.
The wealth effect has been both a justification for quantitative easing and a root cause of consistent overly optimistic growth expectations by the FOMC. The research…suggests that the concept of a wealth effect is in fact deeply flawed. It is unfortunate that the FOMC has relied on this flawed concept to experiment with over $3 trillion in asset purchases and continues to use it as the basis for what we believe are overly optimistic growth expectations.
Scholarly research has debated the impact of financial and housing wealth on consumer spending as well. The academic research on financial wealth is relatively consistent; it has very little impact on consumption.
Economists have found that a threshold income level of $74,046 had a wealth coefficient that rounded to one cent. Income levels between $74,046 and $501,000 had a two cent coefficient, and incomes above $501,000 had a statistically insignificant coefficient.
In total, the majority of the research is seemingly unequivocal in its conclusion. The wealth effect (financial and housing) is barely operative. As such, it is interesting to note its actual impact in 2013.
We reiterate our view that nominal GDP will rise just 3% this year, down from 3.4% in 2013. M2 growth in the latest twelve months was 5.8%, but velocity should decline by at least 3% and limit nominal GDP to 3% or less.
There has been a great deal of discussion about Mohamed El-Erian’s recent departure from PIMCO. The press has accused Bill Gross and Mohamed of having a falling out and arguing at meetings, and has embellished Mohamed’s value at PIMCO. I would like to express Monroe Vos’ view of Mohamed’s departure and what if any effect it will have on PIMCO.
Let me start by saying that we have known Bill Gross for twenty-six (26) years. We have had many meetings with him and other senior people at PIMCO, including Mohamed, over these years. We have had significant dollars invested in the PIMCO Total Return fund over these years with excellent results. Mohamed joined PIMCO for the first time in 1999. He left to run the Harvard Endowment in 2005, and returned to PIMCO in 2007. Mohamed’s education is in economics. He has a doctorate from Oxford University. He is a very good economist in our opinion. Bill is an excellent bond trader. During Mohamed’s last stint at PIMCO he managed or co-managed the PIMCO Global Multi Asset fund and the PIMCO Global Advantage Strategy Bond fund. Both of these funds have performed average to poor over the last one-, three- and five-year periods. In addition, when he left the Harvard Endowment in 2007 he was responsible for the asset allocation and management of the portfolio. In 2008 the Harvard Endowment was hit very hard. In fact, as of June 2013 it was still $5 billion behind its value at the peak in 2007. Mohamed positioned the portfolio so that it was not liquid enough to get out of the way of the financial crisis.
Bill Gross started PIMCO in 1971 and is the person who has led it to be the largest bond manager in the world. He is surrounded by seasoned veterans who have worked with him for a long time. The deputy CIOs that have been appointed have been for the most part at PIMCO for some time. They are briefly described as follows:
Andrew Balls is Deputy Chief Investment Officer and a member of the Investment Committee. Prior to Joining PIMCO in 2006, he spent eight years at the Financial Times as an economics correspondent. He has 15 years of investment experience and holds a bachelor’s degree from Oxford and a master’s degree from Harvard University.
Daniel Ivascyn is Deputy Chief Investment Officer and is head of the Mortgage Credit Portfolio Management team. Morningstar named him Fixed Income Fund Manager of the year in 2013. He joined PIMCO in 1998.
Mark Kiesel is a Managing Director in the Newport Beach office, Deputy Chief Investment Officer, generalist portfolio manager, global head of the corporate bond portfolio management group and a senior member of the investment strategy and portfolio management group. Morningstar named him Fixed Income Manager of the Year in 2012, and a finalist in 2010. He joined PIMCO in 1996.
Virginie Maisonneuve is a managing director in the London office, Deputy Chief Investment Officer and Global Head of Equities Portfolio Management.
Mihir Worah is a Managing Director in the Newport Beach office, Deputy Chief Investment Officer, Portfolio Manager and Head of the Real Return Portfolio Management team. He joined PIMCO in 2001.
Our opinion is that Mohamed is a fine gentleman and an outstanding economist and spokesman for PIMCO. That said, the real value at PIMCO is Bill Gross and the excellent team that has been with him for a long time. It was a mistake to make Mohamed Co-CIO instead of Chief Economist.
We continue to recommend PIMCO Total Return Fund for 401(k) plans and the PIMCO Short Term Fund and PIMCO Income Fund for pension plans and endowments/foundations.
Dynamic Asset Allocation
As you know, Monroe Vos initiated Dynamic/Tactical Asset Allocation in 2000 by lowering the allocation to stocks and increasing the allocation to bonds. This paid off well in the 2000-2003 Tech Crash and the 2007-2009 Financial Crisis. Our clients recovered quickly from both of these crises. In an article from Think Advisor dated April 15, 2014 entitled “10 Richest Foundations Are Still Recovering From Recession”, it says that the 10 wealthiest foundations in the U.S. are now worth $110 billion, but are still $20 billion below their value in 2007 when inflation is taken into account. Only one foundation among the top 10 increased giving from 2007-2013. The Harvard Endowment as of June 2013 was $5 billion below its peak value in 2007 according the Wall Street Journal.
Last year (2013) was an excellent year and the first quarter of 2014 has been basically flat. Recently the technology “momentum” stocks have pulled back, bringing the NASDAQ down almost 10%. These stocks were overpriced. As I am writing this, the Dow, S&P 500 and NASDAQ are almost back to historic highs. Earnings are coming in mixed, but generally higher. The economy is plodding along at 2.5%-3.0% GDP growth rate, and the Federal Reserve is keeping interest rates steadily low. In this environment the stock market can rise. Bonds should continue to provide low returns. We think that our current asset allocation is the right one to have at this time.
Please visit our website at www.monroevos.com.
Chairman & CEO
Released: April 28th, 2014 10:00 AM