EFTA01071135.pdf

Eye on the Market I October 9, 2012 J.P. Morgan A look at US equity valuations after the rally, and a fiscal cliff scorecard; South Carolina In 2012, rising equity markets have mostly been a function of rising multiples applied to modestly rising earnings. While we have had a normal weighting to US equities in model portfolios since mid-2009, I would've put no more than a 1 in 4 chance on a 17% advance in the S&P 500 this year. Forecasting annual equity returns is a treacherous exercise; the second chart shows how annual gains and losses in equities have completely swamped annual industry forecasts since 1950. S&P 500: earnings and PIE multiples Futility of short-term equity market forecasting $100 S&P 500, 12 month return, percent 60% - 4— --- Ex-ante S&P 500 Forecast S&P 500 Index 13x 50% — Ex-post S&P 500 Returns $98 40% Trailing 4-qtr EPS 30% $96 12x 20% 10% $94 0% 11x .10% $92 -20% .30% $90 10x 40% 7/1/2011 10/1/2011 1/112012 4/1/2012 7/1/2012 10/1/2012 1953 1960 1967 1974 1981 1988 1995 2002 2009 Source: Bloomberg, Factset. Source: RBC CapitalMarkets, Federal Reserve Bankof Philadelphia. In any case, we're getting questions about where US equity valuations stand after the rally. To be clear, valuations might not be the driving factor at this point. The debasement of money by the Fed has altered the calculus of investing for many participants, and not necessarily for the better. An analysis we are still working on shows that since the Greenspan/Bernanke era of negative real interest rates began, stock market volatility is even higher than before the creation of the Fed in 1913, an era of recessions, depressions and widespread bank failures. Nevertheless, here's a look at the US equity valuation question, and what the current 13x-14x P/E multiple on the S&P 500 is worth in historical context. The traditional version of the Graham-Dodd/Shiller model makes equities look a bit expensive, cheaper only than the 1990's valuation bubble. In a May 2I'd note, we walked through this model in detail. Our primary concern: using ten years of trailing reported earnings' effectively assumes that the mayhem of the prior decade is highly indicative of the future. As shown in the second chart, earnings are usually volatile, but the 2008 collapse was something that hadn't been seen in over 100 years. Given the massive compositional shift in the S&P 500 since 2000 (240 of the 500 companies in the S&P changed), Fm not sure this is a great assumption. The use of reported earnings instead of operating earnings also has a large impact, given the abnormally large decline in the ratio of reported to operating earnings during the financial crisis. If the valuation model (a) incorporated the earnings history of the companies now in the index and not the prior constituents; (b) assumed that reported earnings rise back to their historical average level relative to operating earnings (88%); and (c) assumed that earnings declines during recessions are 20%-30% and not 70%; then valuations are pretty close to average. In short, anchoring expectations in the immediate past is a potential problem with the Graham-Dodd/Shiller approach. ley Graham-Dodd/Shiller valuation approach: expensive S&P 500 reported earnings drawdowns S&P Price to ten year trailing average reported earnings 2-year percent change, annualized 35x 0% 30x Expensive -10% y\py rrnW 25x • -20% -3056 20x- I -40% 15x -50% 10x -60% 5x • .70% Cheap Ox -80% 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 1873 1888 1903 1918 1933 1948 1963 1978 1993 2008 Source: Robert J. Shiner daaset. Standard& Poor's. Source: RobertJ. ShIIler, Standard &Poots. I The ten year assumption on trailing earnings is designed to smooth for business cycles. EFTA01071135  Eye on the Market I October 9,2012 J.P. Morgan A look at US equity valuations after the rally, and a fiscal cliff scorecard; South Carolina On the other side of the spectrum: an approach that takes current earnings at face value, and also adjusts for the cost of money. Assume that current earnings are not at a cyclical high, and represent ongoing earnings power (margins are high, but consistent with capacity utilization). The first chart inverts the P/E to derive an earnings yield. Nothing remarkable here; however, this is where the cost of money comes into play. Equities are one investment among many, and government bonds are a starting point for comparison. In the 2n0 chart, we subtract a proxy2 for long-term interest rates from the earnings yield to derive the "relative value" of equities. Using this approach, equities are cheaper than they have been in 60 years. [Quite a different answer than Graham-Dodd, right? These models rely on perpetuity formulas, and are very sensitive to their inputs]. S&P 500 trailing earnings yield S&P 500 trailing earnings yield. adjusted for the cost of Percent money (using 7 years nominal GDP proxy) 20% Cheap v Cheap 18% 16% Cheapest relative earnings yield in 60 years 14% 12% 10% 8% 6% 4% 2% t ve \itilA1 V? 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 Source: RobertJ. Shiller dataset, Standard & Po o es. 12% - Expensive 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 Source: Robert J. Shiller dataset. Standard & Po o es, BEA It is this latter dynamic that the Fed is seeking to build on. By driving interest rates down and promising to keep them there, a 7% nominal equity earnings yield (i.e., a 14 P/E) is transformed into a more compelling investment. To reiterate, we have reservations about all of this, but that's how the market has reacted to Fed policy so far. The divergent reaction from different classes of investors is striking. It has been widely reported that net equity mutual fund flows have been negative. However. as shown below. institutional investors continue to add exposure while retail investors have been fleeing en masse. US mutual fund cumulative net flows US equity mutual fund net flows by investor type Billions, USCI, starting in January 2007 Billions.USD.starting in January 2007 1250 600 Bonds 1,050 • 400 - 650 200 - Institutional 650 0 450 250 50 •I50 •350 •550 -1,000 2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012 Source: Investment Con-pany Institute. Source:Investment Company Institute. We have concerns about the adjusted earnings yield model as well. This cycle's profits have been boosted by weak labor compensation compared to prior ones (see next page). Given the unemployment situation we don't expect wages to rise anytime soon, but there are consequences that may affect equity markets at some point (outsized government transfers to households and large fiscal deficits). The other profit driver has been the increasing contribution from outside the US. This trend appears to be fading, given the slowdown this year in both Europe and China (from different starting points). The latter issue is putting downward pressure on 2013 earnings expectations, which have been falling steadily over the last year. As part of this ratcheting down of expectations, there has been a rise in negative earnings preannouncements. S&P earnings are expected to fall by 4%-5% in the third quarter compared to Q3 2011. In short, the earnings boom is not worth quite as much if derived from extraordinarily weak labor compensation and potentially unsustainable demand front Europe/China. 2 We don't use actual long-term rates since the Fed has been manipulating them for the last three years. Trailing nominal GDP growth rates have been a good proxy for long-term rates over several decades. 2 EFTA01071136  Eye on the Market I October 9,2012 J.P.Morgan A look at US equity valuations after the rally, and a fiscal cliff scorecard; South Carolina Current US recovery Past 5 US recoveries US foreign-sourced corporate profits $1.100 1958,1974,1982, Percent of GDP $700 Sales 1990,2001 3.0% $900 $500 2.5% Sales $700 Labor $300 2.0% com pen- $500 sation $100 1.5% $300 -$100 Profits 1.0% $100 0.5% -$300 Labor compensation -$100 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 0.0 /. Quarters since profit trough Quarters since profit trough 1947 1960 1973 1986 1999 2012 Source: Bureau of Economic Analysis, J.P. Morgan Asset Management. Source: Bureau of Economic Analysis. A couple of other things that stand out as we think about US equities: • Corporate free cash flow is high. while at the same time. dividend payout ratios are very low. As a result. the scope for additional dividends and stock buybacks is in place. This trend is already underway (2" chart). • Low interest rates have resulted in a flood into dividend-paying stocks, such that the relative valuation of cyclical stocks is close to the lowest level in 40 years (3'd chart) • The growth of corporate profits has delinked from nominal GDP growth, a departure from past cycles (4th chart). This is unfamiliar territory for investors, since it suggests that you should just ignore weak domestic growth concerns and watch profits keep rising. The political and social risks of this trend are self-evident. Dividend payout ratio and free cash flow yield Return of capital to shareholders rising Percent. 3 year moving average (both axes) Dividends + buybacks, percent of S&P 500 market cap. ex-financials 65% - 7% S&P 500 dividend 8.0% 60°/. 6% 7.0% 55% 6.0% 5% 50% 5.0% 45% 4% 4.0% 40% 3% 3.0% 35% 2% 2.0% 30% 1.0% 25% 1% Ma -CO Mar-04 Mar-08 Mar-12 1955 1963 1971 1979 1987 1996 2004 2012 Source: UBS. Source: RobertJ. Shiner data set. Standard & Poo es. Empirical Resea ch. Cyc icals trading very cheaply vs. Defensives Earnings outperforming the economy Cycl cats /Defensives trailing P/E Ratio of 2-year earnings growth to 2-year nominal GDP growth 1.8 - 15x 16.6x 1.4 - 4.0x 5x - Average • ak: 4.2x 1.2 - Average peak:2.1x — — — 1.0 - Ox 0.8 - -5x • 0.6 - 0.4 I Ox 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 1952 1959 1966 1973 1980 1987 1994 2001 2008 Source: J.P. Morgan Securities LLC. Source: Stand and & Po or's. BEA. J.P. Morg an Asset Management. 3 EFTA01071137  Eye on the Market I October 9, 2012 J.P. Morgan A look at US equity valuations after the rally, and a fiscal cliff scorecard; South Carolina Conclusions Equity markets have taken off in anticipation that the monetary stimulus shown below will start working. This seems to be as much of a factor in the equity rally as the small recent improvement in leading indicators. Last week's employment report, after filtering through the noise and accusations around it, suggests that there will not be a recession in the US. However, the report is also consistent with a very slow rebound in payrolls, below-trend GDP growth of -2%, and a continuation of the Fed's zero-rate policy. With this backdrop, 13x-14x P/E valuations on US equities that are simply average become more compelling, but at the point of a bayonet: the Fed has simply lowered expected returns on a lot of the alternatives (cash, Treasuries, agencies, credit, convertible bonds, MLPs, REITs and other dividend-paying stocks). For now, we remain close to normal US equity weightings in model portfolios, but recognize that this year's gains have already factored in an improvement in growth, profits and as described below, politics. To infinity....and beyond!! Equity rallies usually coincide with high or rising leading Central bank balance sheets, percentof GDP indicators, but not in 2012 45% 1.400 - . .European Central Bank 57 P.1SCI World 40% • Bank of Japan 1.350 56 Equity Index 35% • Federal Reserve 4— 55 1.300 Bank of England 54 30% • 1.250 53 25% • 1.200 52 20% - 51 1.150 15% - 50 1.100 10% • 49 1.050 48 5% Global manufacturing PMI survey 2008 2009 2010 2011 2012 2013 1.000 47 Source: FRB, BEA, ECB, Eurostat, BoE, UK Office for National Statistics. 2010 2011 2012 BoJ, Japan Cabinet Office. Source: Bloomberg. J.P. Morgan Securities LLC. Fiscal Cliff Scorecard The fiscal cliff Normally this subject is about as Anticipated 2013 fiscal adjustments USD billi ns slated Scenario 1 Scenario 2 Increased Revenues from: interesting as watching paint dry, but Expiring payroll tax holiday 115 115 115 this year, it plays a larger role in the Expiring stimulus taxrelier 27 market outlook. While S&P profits Expiringleopired non-2001/2003 but relief (Exlenders)2 75 have delinked from growth trends, a New healthcare taxes 24 24 24 4%+ fiscal hit in 2013 would be a large NAT no longer indexed for inflation' ea Expiring 2001/2003 Upper Income tax relief 83 83 hurdle for the economy that markets Capital gain and dividend tax 8 8 would probably notice. The table Ordinary income and deductions 44 44 shows all the components of the fiscal Estate tax 31 31 Expiring 2001/2003 remaining tax relief 171 austerity scheduled to kick in, along Total increase in revenues 535 222 139 with a couple of scenarios that show Reduced Expenditures from: what we believe are the compromises Lower Medicare physician reimbursement (ending 'Doc" fix)' 14 markets assume will get made. Ending extension of unemployment benefits 33 33 33 Anything more than 2% of GDP could PlandabryBudget Control Act spending reductions (Sequester) 85 Total expenditure reductions 132 33 33 be a shock to the system. Total fiscal adjustment 667 255 172 Total fiscal adjustment (c1aGDP) 4.3% 1.6% 1.1% Michael Cembalest Source: Urban.8roolengs Tax Policy Center. Congressional Budget Office.IP. Mogan Asset Kra agerrent J.P. Morgan Asset Management Consists parody of credts such as the Earned Worm Tax Credit. Chid Tax Credit. American Opportunity Tax Credit. Mscellaneous provisions such as Research & Spenirentabon Tax Credit. Charitable IRA Rollover relief. AMT exerrpton anount no longer indexed for inflation. 4 Ends deferral of Medicare Sustanable Growth Pate adjustrrent. Wildlife advisory alert: I took my 10-year old for what was marketed to us as "light tackle inshore fishing" in South Carolina. Not that far offshore from where people swim, we caught a 6-foot 145-pound blacktip shark that missed the state record by 19 pounds. There were signs that there are alligators in all the lagoons, and someone found a 7-foot diamondback rattlesnake under a porch. 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