Some have claimed that the "cult of equities is dying."1 But word of stocks' demise may be premature. Indeed, now may be a particularly poor time for long-term investors to be avoiding stocks. Not only can stocks play an important role in long-term wealth creation, inflation protection, and portfolio diversification, but stocks look relatively cheap by many measures, and progress on the fiscal front could lift a cloud that’s been hanging over equity markets.
That’s the conclusion of a new study "U.S. Equities: Light at the End of the Tunnel" by Dirk Hofschire, Fidelity’s senior vice president of asset allocation research, and Lisa Emsbo-Mattingly, director of asset allocation research.
Despite below-average returns over the last 12 years that sent many investors rushing out of stocks into bonds (see graph below), Hofschire and Emsbo-Mattingly think stocks2 can generate above-average returns over the next five to 10 years. "Bonds should continue to play a core role in a diversified portfolio," they write, "but while many investors may have felt that owning U.S. equities over the past 12 years did not justify the risk, the greater risk during the next several years may be underallocating to U.S. equities."
Have you fled the stock market or reduced your equity holdings significantly?
If so, now may be a good time to step back, and think about your long-term goals and asset allocation. Consider Hofschire and Mattingly's seven reasons to consider U.S. stocks—plus the four equity themes that our portfolio managers have identified as compelling strategic opportunities. Particularly if the market pulls back in the months ahead, you may want to have these ideas handy.
1. Stocks look cheap by historical standards
Valuation analysis has historically been a useful indicator of future performance, particularly over five- and 10-year horizons. Our analysts looked at earnings data since 1926. Although different valuation metrics suggest different conclusions about the U.S. stock market outlook, many indicate that stocks are inexpensive, and historically that has led to higher-than-average returns over a five- and 10-year time frame.
Consider the current price-to-earnings (P/E) ratio, using the trailing one-year earnings of the S&P 500 Index. At the end of the second quarter of 2012, it stood at stood at 13.8, putting it in the second least-expensive quintile of all quarterly valuations for the market since 1926. Historically, owning the stock market at these inexpensive levels has produced above-average returns—8.1% on a five-year annualized basis and 10.1% on a 10-year basis, versus historical averages of only 6.5% and 6.9% respectively.3 Please keep in mind, however, that past performance does not guarantee future results.
2. Stocks look cheap vs. bonds
When the ERP has been at such levels, stocks historically have produced far above-average real returns relative to bonds in the subsequent five and 10 years. For instance, using one-year trailing earnings for the S&P 500, stocks at current ERP levels outperformed bonds by 13.2 percentage points over the next five years, and 12 percentage points over 10 years, versus averages of only 4.3 and 4.9 percentage points between 1926 and 2012.
But what if this time is different? After all, the Fed is implementing an unprecedented monetary policy that anchors bond yields low. The last such period was 1942 to 1951—when the Fed pegged Treasury bond yields to help finance World War II. Then as now, real bond yields were negative, P/E multiples were low, and the equity risk premium was high. But five and ten years later, stocks produced higher returns on both an absolute basis and relative to bonds on an inflation-adjusted basis (see chart right).
3. Stocks can be key to growth and diversification
Over the last 12 years, bonds outperformed stocks, generating a 3.9% inflation-adjusted total return versus a 1.1% real loss for stocks. As a result, investors have not needed to take on the added volatility of stocks to generate returns.
But that could shift going forward, particularly if the U.S. economy grows faster and interest rates rise. Historically, periods of outperformance of one asset class over another have tended to reverse themselves. (see chart below right)
Also, stocks historically have provided the potential for wealth generation over time. Remember, over the last 30 years, equities outperformed bonds, producing an 8.1% real return versus 6.1% for bonds. That appreciation potential is something you miss if you own only bonds, particularly in this low rate environment.
What’s more, since 1926, the correlations between stocks and bonds have been low.3 So, stocks can provide valuable diversification benefits to a portfolio.
4. Stocks can offer inflation protection
During the past 30 years, equity investors have largely been able to ignore inflation as a source of risk due to the secular trend of disinflation and declining interest rates. But what if inflation returns?
In theory, stocks are better able to withstand inflation than fixed-rate bonds because companies can raise prices, which can buoy profits. In practice, equities have generally maintained an advantage over bonds during periods of higher inflation. From 1970 to 1980, inflation averaged 7.8% annually, more than double its historical average. During this period, high-quality bonds returned 6.6%, resulting in a 1.1% real loss; equities returned 8.0%, and had a 0.2% real return (see graph below).4
Despite three economic recessions that took place from 1970 to 1980, nominal profit growth was well above average at 9% per year, showing the ability of nominal earnings to adjust upward with inflationary pressures.5
From today’s historically low interest-rate levels, the potential of equities to outpace inflation is an important risk-management consideration, even if inflation does not rise above historically average levels as seen during the 1970s.
5. The U.S is not Japan
Are you worried about the U.S. following Japan down a path of extended slow growth? Our analysts aren’t. Relative to Japan, they note, the U.S. property and stock bubbles were less extreme. Its post-crisis policy response was quicker. And adjustments in key economic sectors (i.e., corporate, banking, housing, employment) have been much more rapid.
Compared to Japan at a similar post-crisis stage, the U.S. also has a more positive inflation environment underpinned by supportive central bank policy, a healthier nonfinancial corporate sector, stabilizing housing and banking systems, and a more advanced private-sector deleveraging process. Even the U.S. demographic outlook is more favorable than that of Japan and many other major economies (see chart right).
In simple terms, our long-term real GDP growth expectations are based on projections of the rates of growth in population and productivity. Over the next 50 years, U.S. working-age population growth should average only about 0.4%, roughly one-third the rate of the past 50 years. That points to real GDP growth rates of just above 2%—lower than the roughly 3% average during the past 60 years, in our view.6 Nevertheless, our analysts believe this backdrop should provide a solid environment for U.S. equity returns.
For more on this topic, read Viewpoints: Are we on Japan's slow-growth path?
6. Cash-flush corporations can raise dividends
The U.S. corporate sector has perhaps even more compelling attributes than the U.S. economy. Since the start of 2000, the companies in the S&P 500 Index have generated earnings at a nominal compound annualized growth rate of 5%, and they have continued to maintain high levels of profitability, despite weak economic growth.7
U.S. corporations have sturdy balance sheets, with roughly $1.8 trillion in cash, and continue to generate strong free cash flows.8 More of this money is being returned to shareholders, as more companies have continued increasing dividends and buybacks, giving back around $250 billion in dividends and $400 billion in buybacks over the past 12 months.9 More than half of the S&P 500 has a dividend yield higher than the 10-year Treasury bond yield, and historically low payout ratios provide room for additional dividend increases.10
For more on dividends, read Viewpoints: A new era for dividends?
7. Progress on the fiscal front could boost stocks
Our analysts’ base-case scenario is that during the next 12 months, legislative progress will lead to an improvement in the medium-term sustainability of the U.S. fiscal situation. The path to achieving such progress may be bumpy. In particular, the 2013 fiscal cliff11 threatens to push the economy into recession and drive down corporate profits, which would be extremely negative for the U.S. equity market.12 However, in our analysts’ view, the rising fiscal urgency and the prospects for a new post-election political dynamic offer a greater probability that the intermediate-term fiscal outlook will look better by the end of 2013 than it does today.
If such progress is achieved—even if it is suboptimal from an economic standpoint—it has the potential to significantly reduce a key source of uncertainty that has weighed on business sentiment and equity markets during the past two to three years. The confidence provided by greater intermediate-term fiscal sustainability and transparency would be a key ingredient in ensuring that U.S. long-term growth prospects are not impaired. Near term, such progress would offer the opportunity for stock valuations to expand as macro concerns take a back seat to more positive corporate fundamentals.
For more on the fiscal cliff, read Viewpoints: Fiscal cliffhanger.
Where to invest?
The depth, liquidity, and diversity of the U.S. stock market offer active investors a range of opportunities, regardless of economic conditions or other macro factors. The next four sections highlight four compelling investing ideas culled from Fidelity’s equity portfolio managers.
1. Dividend growth
3. Small caps
4. Information technology
1. Dividend growth
Collapsing nominal bond yields and concerns about long-term growth rates have caused the market to treat distributed earnings (i.e., dividends) more favorably than undistributed earnings, resulting in multiple expansions among stocks with high dividend payout ratios. Identifying companies with above-average yields and low payout ratios, and those most likely to increase their dividends may provide a source of active return going forward.
In our view, that takes a nuanced combination of backward- and forward-looking analysis of each company’s cash flows.13 Further, in our view, a focus on firms with robust balance sheets and management teams committed to returning capital to shareholders can help mitigate downside price risk and increase the probability of steady income generation and price appreciation.14
For more on dividend-paying stocks, read Viewpoints: A new era for dividends?
After outperforming in the 1980s and 1990s, high-quality U.S. stocks—those with high returns on equity, low leverage, and stable business models—have lagged their low-quality counterparts for most of the past decade, leading many investors to shift their attention away from blue chips and other stocks with high-quality characteristics.15 This market development has created a wealth of opportunities among stable, creditworthy multinational brand leaders, many of which appear poised to benefit from a reversion to the mean.
Moreover, many high-quality companies have turned economic conditions to their advantage over the past few years. Slow growth often gives quality companies a chance to boost margins and take market share: Many high-quality companies used recent economic downturns as an opportunity to become more efficient by reducing the size of their workforce, improving the efficiency of their supply chains, and accelerating new-product innovation.16
For more on investing in quality, read Viewpoints: Case for mega caps.
3. Small caps
Due to the fact that many smaller U.S. companies derive the bulk of their revenues domestically, these stocks tend to be less sensitive to global macro influences than those higher up the capitalization spectrum. Therefore, they generally experience lower correlations with larger stocks.
Further, small firms are more likely acquisition targets for larger counterparts with strong cash flows than other large firms. Acquirers may be attracted either by the small firms’ success, or by intellectual property such as licenses, patents, or proven research and development that the acquiring company may be able to leverage more quickly as a result of its larger scale.
The depth and variety of the small-cap segment—and lower analyst coverage at the individual stock level—have allowed some active investors to add value in good times and in bad. Despite the poor performance of U.S. equities overall in 2008, there were hundreds of small-cap U.S. stocks that realized positive returns during that year, which illustrates the broad range of returns and potential to beat the averages that’s available within this category.17
For more on small caps, read Viewpoints: Can small caps shine?
4. Information technology
The perception that macro forces dominate the information technology sector often obscures the positive fundamental developments taking place at an individual company level. The advent and adoption of new technologies and products often create opportunities that can grow irrespective of the broader economic backdrop.
For example, the proliferation of smartphones over the past five years illustrates how a product can experience rapid growth even during a period of severe economic stress. Additional drivers of differentiated performance within this sector include cloud computing for server and desktop virtualization, as well as enterprise-level security, which has come to the forefront due to the rapid diversification of devices used to access company information.
Strong management teams can put the right resources in place to develop best-in-class products and components to meet the needs of an increasingly demanding customer base, and by doing so they can position their firms to overcome the economic headwinds that may dampen the performance of their competition.
For more on information technology, read Viewpoints: State of info tech.
History reminds us that stock markets are volatile and can decline significantly in response to adverse events from company developments to political, regulatory, market or economic events. Nevertheless, being underexposed to equities entails its own risks. In our view, the primary attributes of equities—potential for capital growth, some protection from rising inflation, and diversification—are essential components of a well-conceived strategy designed to help investors meet their objectives over an extended period.
Keep in mind:
- Starting from today's attractive valuation levels, equities have historically produced higher-than-average absolute returns over the intermediate term.
- Equities provide the potential for long-term wealth creation.
- Equities offer the potential to achieve positive real returns if inflation rises from today's low levels.
- If historical patterns are repeated, equities could experience improved risk-adjusted performance over time relative to the past decade.
- Equities continue to play a strategic role in a diversified portfolio.