Rockefeller & Co. – Aging Bull & Opportunities After 8 Years of Rising Markets


Rockefeller & Co. Third Quarter 2017 Global Foresight

The Charging Bull

  • Eight plus years into the market recovery, we see valuations extended as most of the gains since 2014 have been driven by multiple expansion rather than earnings growth
  • Current equity bull market may have more years left, but its age and valuation make the case worth revisiting
  • We see valuations elevated in the US market, while we believe Europe is likely to continue its cyclical rebound
  • We believe there are a number of attractive emerging market opportunities but are mindful of the challenges most of these once-rapidly-growing economies face
  • It’s not just the bull market that is aging; it is most of the world, which has important sociological, economic and investment implications as demographics and debt are likely to constrain long-term global economic growth

The Challenge of High Valuations

  • Cyclically adjusted price-earnings (CAPE) ratio averages earnings over a 10-year period to minimize the impact of economic cycles when valuing equity markets
  • Present US CAPE ratio is the highest it has been except during two famous market peaks – 1929 and 1999
  • We believe the CAPE ratio is cause for concern but not alarm. It most likely suggests that US equities will have subdued future returns
    • We do not believe we are in the midst of an economic or market bubble
    • US GDP growth has been averaging about 2% – economy has not built up the excesses that it did during past peaks in the CAPE ratio
    • During the 1920s, US real GDP growth averaged 4.2% and from 1996-1999, it grew at least 4.3% in each calendar year
    • Since the CAPE ratios in those periods calculated off a base of very strong economic activity and earnings, those periods were more susceptible to crashing than today’s more muted environment

EM Growth

  • CAPE ratios are lower outside the US, with emerging markets even lower than those in developed markets
  • We believe there is limited relevance of CAPE ratios when comparing the very deep, diverse set of companies in the US, with most other markets
  • As an extreme example, Russia has the lowest CAPE ratio in the world, but its equity market is very concentrated in commodity businesses whose earnings are highly cyclical
  • 10 largest emerging markets (accounting for 89.2% of the MSCI Emerging Markets Index)
    • Median real GDP growth for the next 5 years is forecasted at 2.5% while population growth is expected to be less than 1%
    • Term “emerging markets” was coined in the 1980s but frankly, most of these economies have already “emerged”
    • Countries with the most long-term economic growth potential are namely India, Indonesia, and Malaysia but their equity markets combined do not even equal South Korea’s in size
  • China is a market that has looked attractively valued at times relative to its growth prospects but China has already had a spectacular recovery from a correction that rattled markets in August 2015 and in January 2016
  • South Korea is an emerging market that has screened well for valuation and poorly for governance – as the second largest emerging market after China, we believe that South Korea is an important economy and source for potential investments

Aging Population

  • Major challenge South Korea and China face is an aging population
  • Countries that are major economic powers are aging rapidly while most of the youth in the world is concentrated in the poorest nations
  • US, with a median age of 37.9 years ranks 62 out of 230 nations, making it one of the older nations in the world, though one of the world’s younger developed markets
  • Japan and Germany have median population ages of 46.9 and 46.8 respectively
  • While we consider demographics as an important long-term factor for investing, in the short run, it is eclipsed by economic cycles and political changes
  • However, in the longer run, demographics factor into economic growth as consumption declines dramatically in your 50s and 60s from where it is in your 30s and 40s
  • South Korea is the oldest emerging market with a median age of 41. East Asian economies have grown over the years due to migration from villages to urban centers, resulting in productivity gains that have fueled economic expansion. Although this migration may continue a while longer, EM investors should understand the reality that the economic growth case outside of South Asia and Southeast Asia is mostly limited to productivity gains

Aging Business Models

  • The FANG stocks have disrupted countless business models while seeing their own revenues and market values soar
  • Empty storefronts from Manhattan to malls in Middle America are evidence of the disruption facing rapidly aging business models like brick-and-mortar retail
  • When you include Apple and Microsoft in the FANG stocks, the six companies account for 12.83% of the S&P 500 Index
    • At the start of this bull market of $326Bn; today, their market value is $2.97 trillion
    • To maintain its ascent, the US bull market will need new sectors to emerge as market leaders
  • Companies that disrupt mature businesses, like many of the FANG stocks have, typically have not relied on a robust global economy to generate their amazing revenue growth. Most other sectors in the S&P 500 Index, however, would likely benefit from a stronger economy

Summary and Conclusion

  • As we consider future returns, valuation matters
  • In March 2009, the S&P 500 was selling for roughly 10x depressed earnings and is now selling for about 18.7x
  • US market leads the world in innovative companies and is priced for it
  • As we look for opportunities overseas, we see political fortunes improving in Europe with some lingering headwinds that may appear in 2018
  • We could argue that leadership in the House of Representatives in the US can easily switch parties next year
  • Emerging markets offer some attractive valuations but are not likely to be a panacea for global growth as the largest ones face the same challenges of aging and maturing development that confront most of the developed world
  • This bull market may keep moving but not at a pace that we are used to

Image Source: Bloomberg, IMF, CIA World Factbook, MSCI, S&P, Rockefeller & Co.