Joe Battipaglia: The Bullish Case
06/16/2006 12:00 am EST
"The market pullback presents a buying opportunity as fundamentals remains intact," says Joe Battipaglia, chief investment officer of Ryan Beck & Co. While much longer than our typical articles, this overview of the bullish case is a "must read" for investors.
"Valuations still favor equities over bonds despite anxiety about further Fed rate actions. Short of an outright recession, bonds should continue to under-perform equities. Our basic premise for this year remains that the US economy will continue to expand and that the Fed will come to rest on the issue of interest rates despite a high level of "inflation fighting" chatter. Of late, the economy has been growing ahead of our expectations and that has helped produce faster earnings growth for the market but also raised expectations for more aggressive tightening of monetary policy.
"Ben Bernanke, the new Fed chief, wants to prove his resolve as an ‘inflation fighter’ and appears to be introducing an element of surprise back into policy making after several years of ‘transparent’ direction by the Fed. While the surprise element can make for a more effective Fed, this shift in tone from the Fed is disconcerting to the markets and accounts for much of the recent weakness in stock prices. In the meantime, markets will remain sensitized to all data relating to inflation.
"On this front, we are encouraged by the recent drop in gold and other commodity prices and the narrowing of the TIPS spread (the difference between the nominal ten-year Treasury yield and similar duration inflation-protected treasury securities that reflects market expectations for long-run inflation). These forward-looking indicators of inflation are, no doubt, on the minds of Federal Reserve governors as well.
"As for portfolios, we remain watchful for signs of changes that would likely affect asset class performance. Some of the key items on our watch list are: the flat yield curve (for a sustained inversion that often foreshadows recessions), further significant upward movements in energy prices (which have not had a material adverse impact on the economy recently), and a resurgence of inflation (which could prompt the Fed to move more aggressively on interest rates than currently expected).
"We are also aware that we are entering our sixth year of expansion which puts the current expansion beyond the post-war average duration of 5.7 years. Lastly, we are aware that profit margins, on an economy-wide basis, are near record levels suggesting limited upside to profit growth from here with significant profit generation power concentrated among financial and energy companies.
"At some point in the future these issues may lead us to the conclusion that equity exposure needs to be reduced. For now, however, we are maintaining our expectations (year-end S&P 500 target 1,350 and ten-year Treasury yield of 5.25%) and recommended asset allocations (75% equities / 25% income and defensive assets for a growth-oriented investor).
"Most often equities provide a higher total return than bonds. Over the past 80 years, stocks (defined by the S&P 500) have returned about 10.4% a year, on average, according to Ibbotson Associates. Long-term Treasury bonds have returned about 5.47% per year with essentially all the return coming from the coupon payment whereas the equity return was a combination of dividend income and capital appreciation.
"And while there can be substantial differences in return from year-to-year, the higher returns accruing to the riskier stock market asset is consistent with the idea that, over time, assets are priced by the market with a risk premium being paid to investors taking on greater risk. In the example above, the long-run risk premium is approximately 4.9% per year, on average.
"This ‘risk premium’ can be a useful tool in helping to spot risks and opportunities in the market. One way to use this premium is to take a ‘60,000 foot’ viewpoint on financial markets looking at performance over long periods of time. This viewpoint is often a refreshing one because it allows for a broader perspective on the market’s day-to-day gyrations.
"In particular, the relationship between stocks and bonds over time is an important relationship to observe in determining the relative attractiveness of each type of asset. We follow the ratio of equity prices to long-term government bond prices and the performance of the ratio back in time to the start of the 1990s. From 1991, a 4.9% average outperformance by equities would put the above stock/bond ratio nearly 40% higher indicating that equities are still significantly undervalued when compared to long-term bonds.
"Another way to come at the same valuation issue is to compare yields on the two asset classes. At present, the earnings yield on the S&P 500 (inverse of the oft-cited price-earnings ratio) is 5.8% on a trailing 12-month basis and 6.7% on a forward-looking, next 12-month basis using analyst estimates provided by Thomson Financial.
"By contrast, an investor can earn a yield of 4.98% for a ten-year investment in a US Treasury bond. The higher yield offered by equities suggests that investors are well paid to take on the risk of equity ownership at this time. The adjacent chart shows the historic "spread" relationship between equity earning yields and long-term bond yields. So long as earnings remain strong and bond yields remain at current levels, this measure will continue to support the case for equities.
"This relationship and the long-run performance analysis on the previous page is suggestive of a favorable valuation and reward/risk relationship for equities when compared to bonds. This analysis does not, however, lead us to a timeline for when a valuation gap will close or how it will close (either by stock prices rising, bond prices falling, the passage of time with little change in either asset’s price, or some combination of all three of these effects). We also know that no asset class dominates forever and that performance can be interrupted by events such as recessions.
"It might sound obvious that stocks perform worse than bonds in a recession, but we thought that it might be instructive to take a look at how stocks and bonds perform on a relative basis in the time leading up to recessions. Stocks tend to move from significant outperformance in the 18- to 12-month period prior to onset of recession to a mixed performance in the six months heading into recession to underperforming close to 75% of the time from the start of recession with an average underperformance of 11%. Our study encompassed all recessions dating back to the 1920s.
"This tendency for equity outperformance to diminish as recessions occur and for long-term Treasuries to outperform offer us another tool to assess the likelihood of recession in our forecast and afford us an opportunity to adjust portfolio allocations in varying economic conditions. Once again, we do not currently expect a recession to emerge over the next 12-18 months that would require a change to recommended asset allocations. It is, however, never too early to think through portfolio tactics should the environment become more difficult."