Updated: Mar 4, 2020
As we enter a new decade, we thought we would take the opportunity to look back on the past 10 years, a period of remarkable growth in the U.S. equity markets.
The long recovery. The 2010s began in the shadow of the global financial crisis (GFC) of 2007‐08, an aberration in an otherwise steady long‐term trend of global economic growth. In fact, the GFC is the only time the global economy has contracted in the past 50 years (see Figure 1). In response to the crisis, the U.S. Federal Reserve began its quantitative easing program and cut interest rates; actions designed to steady the economy, keep inflation in check and reduce unemployment. This has proved to be a success – at the start of the decade, U.S. unemployment was at its peak at over 10% and has declined ever since ending the decade at ~3.5%. Inflation has also not materialized and has hovered at just under
2% for almost the entire decade.
At 128 months and counting, the current
economic recovery is both the longest in U.S. history and the slowest since WWII (see Figure 2). Peak to peak, the current expansion has achieved cumulative real GDP growth of ~22%, while most previous expansions have reached this level of GDP growth in about half the time.
U.S. (growth) stocks soar. The lengthy economic recovery has been accompanied by a prolonged bull market for U.S stocks. The annualized total return of the S&P 500 in the 2010s was 13.6%, ranking as the fifth best performing decade since the 1880s. However, there are reasons to believe that
the specific tailwinds fueling U.S. stock prices in the past 10 years may not sustainable. For one, arguably, much of the money that was pumped into the financial system by the Fed as a result of quantitative easing found its way into the stock market in the form of increased dividends and share buybacks. Additionally, the one‐time stimulus in the form of the 2017 corporate tax cuts expanded after‐tax profit margins without the need to increase organic revenue or pretax profits. Most importantly, the sustained low interest rate environment has made money cheaper, encouraged consumer and corporate spending and has driven investors seeking higher returns towards stocks. An analysis by Ray Dalio of Bridgewater Associates shows that removing the effects of falling interest rates, corporate margin expansion, corporate tax cuts and share buybacks would reduce U.S. equity valuations by well over half (see Figure 3).
Foreign stocks did not see similar growth compared to U.S. stocks. Over the course of the decade, the relative valuations of U.S. stocks to non‐U.S. stocks (based on price‐to‐book value) rose from ~1.3x to ~2.1x, well above the 25‐year average of ~1.6x (see Figure 4). In other words, foreign stock valuations are abnormally cheap compared to U.S. stocks.
Within the U.S. public equity market, investors showed a broad preference for growth stocks over value, with the Russell 3000 Growth Index outperforming the Russell 3000 Value Index 15.05% to 11.71% annualized over the decade. However, among U.S. growth stocks, the gains were not evenly distributed. As Figure 5 demonstrates, while the S&P 500 delivered a strong cumulative return of nearly 190%, this performance was overshadowed by the performance of large technology stocks, particularly the so-called FAANG stocks (Facebook, Amazon, Apple, Netflix and Google).
There are warning signs that the continued growth of the U.S. tech behemoths may not
be sustainable. As these companies gobble up more and more of the digital commerce
space, they have looked to expand into physical, capital‐intensive businesses in order to grow (think Amazon buying Whole Foods). In fact, the combined 2020 capital expenditures of Facebook, Google, Microsoft and Amazon are projected to top $100 billion, five times their 2013 levels and over twice what they were in 2016. Historically, capital‐intensive companies have tended to underperform non‐capital‐intensive businesses, which may not bode well for the FAANGs (see Figure 6). Additionally, these companies will continue to face new regulatory pressures as their power and influence expand, potentially limiting their growth.
Finding value outside of U.S. public stocks. As mentioned above, non‐U.S. stocks are historically cheap compared to U.S. stocks. While the S&P 500 Index trades at a 22.2x trailing price‐to‐earnings ratio (“P/E”) and a 3.4x price‐to‐book ratio (“P/B”), the MSCI Emerging Markets Index trades at a 15.0x P/E and 1.7 P/B, while the MSCI EAFE (representing international stocks) trades at a 16.3x P/E and a 1.7x P/B. These non‐U.S. stocks also have much higher yields (a 3.2% dividend yield for the MSCI EAFE compared to 1.9% for the S&P 500). Our active managers continue to see many of the best opportunities outside of the U.S. and there is plenty of evidence to support maintaining a diversified global portfolio over the long term. Between 1970 and 2010, the MSCI World Index (a global index) outperformed the MSCI USA Index in three of the four decades and returned 8.68% annualized over that time compared to 8.48% for the U.S. index.
Finally, the opportunity set for equity investors has dramatically changed in the past decade. While the number of U.S. publicly listed companies has shrunk, the number of foreign public companies has grown dramatically (see Figure 7). At the same time, the number of privately held U.S. companies has risen (see our 1Q19 letter for more on this), and they have attractive relative valuations compared to U.S. public companies.
To sum, it’s challenging to predict when markets will shift, but it is safe to say that the next 10 years will not look like the last 10. Market trends play out in cycles and can sometimes adjust quickly – domestic high‐growth stocks may soon come back down to earth in favor of non‐U.S. and value stocks. As fundamental investors, we at Mangham believe it is wise to construct portfolios with managers that are sensitive to overvalued stocks and that seek opportunities beyond the U.S. Should the market turn, we believe that having exposure to skilled active managers and to high‐quality diversifying strategies (such as long/short equity managers) will help our portfolio weather the storm and take advantage of increased market volatility.
Coronavirus fears. Finally, we’d be remiss if we did not mention the coronavirus. China has employed remarkable containment efforts and is able to do this efficiently by the nature of its authoritarian government. The more recent spread of the virus into parts of Europe and Iran is troubling and worth monitoring. World health organizations are better equipped than we at Mangham to comment on potential virus outcomes, but in general these circumstances point to the benefits of diversified portfolios containing multiple asset classes including bonds.
As always, we welcome your questions, comments and conversation.
The Mangham Associates Team
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