Equity investors have enjoyed over 18 percent annualized stock market returns since the bottom of the Great Recession in 2009. Much of these returns can be attributed to a rebound in the economy fueled by an ultra-accommodative Federal Reserve policy that has: 1) infused our financial system with three rounds of quantitative easing programs; and 2) has lowered interest rates to near zero percent to encourage borrowing activity and economic growth.
However, future stock returns will likely moderate- to single-digit returns going forward, reflecting modest growth and inflation as the Fed signals an increase in interest rates in the near future.
The Fed has been successful in its quest to stabilize the economy, which is evident as stock prices have rallied to all-time highs, with revenues and companies' earnings pushing stock valuations to levels not seen since the tech bubble. Stock valuations, as measured by price to earnings (P/E) multiples, are currently at 17.5 times forward earnings, which is nearly 20 percent higher than the 10-year average of 14.9.
A number of factors have contributed to why stock valuations are where they are today. However, interest rates are likely to rise soon, and thus the catalyst that has recently boosted stock gains may soon diminish, making it challenging for P/E multiples to expand much further.
Low interest rates have allowed companies to increase their corporate debt as they have been using the capital to implement massive share repurchase programs. Share repurchase programs have contributed significantly to market performance and increasing P/E multiples to where they are today.
This has not only assisted in increasing stock prices but has also boosted company earnings per share, as earnings are divided into a smaller number of outstanding shares. As rates begin to increase, this strategy of issuing corporate debt will become a less attractive option for corporations and share buybacks will start to evaporate.
Corporate operating margins have been exceptionally high as companies have been able to keep expenses low by enjoying little to no wage increases while also benefiting from historically low interest expenses. However, with strong job creation since 2009, the unemployment rate has been reduced to 5.3 percent and companies may soon be faced with higher salary costs to maintain quality skilled workers.
Also, as the Fed moves to increase interest rates, new issuances of corporate debt will carry a higher cost of capital. Both wage growth pressure and high corporate debt expense will eventually weigh on corporate profit margins, which will hurt earnings.
Additionally, fixed income investors have witnessed bond prices rally to extreme lengths as investors flocked to the safety of Treasury bonds and the Fed's multiple rounds of quantitative easing compressed yields to record low levels. Investors looking for predictable income streams were forced to take on additional risk and find alternative investment in high dividend paying stocks.
As interest rates normalize, the risk/reward aspect of buying high paying stocks will diminish, reducing the amount of new capital buying fixed income alternative investments.
The days where you could throw a dart against a board and pick a stock that would rise are over. Wage growth and higher borrowing costs will eventually put pressure on margins and share repurchase programs, thus moderating future stock returns to mid-single digits in the future. With these conditions, having a high quality active money manager will prove to be very valuable as we enter a rising interest rate environment.
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James Quackenbush is a senior domestic equity analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.
Published: Mon, Jul 20, 2015
