In BSW Blog, BSW Philosophy, Economic Outlook, Emerging Markets, Portfolio Commentary

As I write this commentary, first quarter earnings reporting season is swinging into full gear – and driving equity market gains to (potentially worrisome) new highs.  After pausing to catch their breath in March, equity markets have surged forward again following strong reports from companies like Apple (revenues up 83%) and Intel (profits up 29%).  With these recent gains, the Dow Jones Industrial Average closed at its highest level since June of 2008.

Economic Outlook:

When creating and monitoring our strategic investment allocation, BSW’s investment group relies on 15 to 20 key metrics, including equity valuation measures, GDP growth, inflation expectations, and consumer/investor confidence levels.  We are constantly monitoring these metrics looking for signals of opportunity or warning.  To that end, here are just a few key observations that are shaping our current thinking:

US Equities:

  • The S&P 500 has almost doubled from its low in March 2009 (676 on 03.09.09, current value 1330).  According to estimates, annualized S&P 500 earnings are expected to exceed $91 per share.  The prior earnings peak of $90 per share was in 2007.  This earnings recovery (50 months) would faster than the time it took earnings to recover following the bubble (52 months) and the Great Depression (19 years).
  • The S&P 500 price to 10-year earnings ratio (P/E-10) is now 23.5.  This is now 43 percent higher than the long-term average (16.4) since 1881.

Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years (Shiller PE Ratio, or PE 10). Data courtesy of Robert Shiller, Yale Department of Economics.

Emerging Markets:

  • As many as half of all emerging markets equity managers have closed their funds to new investors, many at the end of 2010.  The closures were driven by years of strong performance prompting large inflows from institutional in retail investors and straining capacity in smaller, less liquid emerging market stock exchanges.
  • According to the International Monetary Fund, over US $35 billion was invested in emerging market debt mutual funds in 2010, nearly doubling the size of the asset class.

Real Estate Investment Trusts (REITs):

  • The broad category of REITs, as measured by the FTSE Nareit All Equity REITs Index, gained 204.7% from the March 6, 2009 market bottom through 03.31.11.  That compares with a 112.8% gain by the Dow Jones US Total Stock Market Index during the same period.
  • The dividend yield on the US REIT Index is now 3.5% — which is equal to the yield on 10-Year Treasury Notes, the standard “risk free” asset.
Data courtesy of SNL Financial

Data courtesy of SNL Financial

Cash & Money Markets:

  • $6 Trillion: sum of money in US savings, checking, and money market accounts – the largest amount ever held in liquid accounts.  The money earned an average interest rate/return of 0.44%.  The annual inflation rate in February was 2.1%.

Investor Sentiment:

  • Bullish investor sentiment has been on the rise in recent weeks, reaching 42% on 04.14.11, slightly above the historical average of 39%, according to the American Association of Individual Investors.
  • Many investment advisors, including BSW, are fielding calls from clients wanting to invest more aggressively in the equity markets.  The clients calling are the same ones who asked to go to all cash three years ago, as the markets bottomed.
Chart courtesy of the Yale School of Management

Data courtesy of the Yale School of Management

Anecdotal Information:

  • Facebook is valued at $65 billion, making it more valuable than Ford, Home Depot, Visa, Boeing, Nike, Colgate-Palmolive, etc.


  • Groupon, which emails cute coupons to people, is valued at $25 billion, making it more valuable than General Mills, Kellogg’s, Starbucks, etc.

Looking Ahead . . .

These are challenging times for investment managers.  Despite many indicators that equity market values may have climbed too high too fast, there are several wild cards which could continue pushing things higher still – perhaps even “irrationally” higher.  First, an astonishing amount of cash (see above) remains on the sidelines – having missed out on the tremendous equity market rebound while earning virtually nothing.  As these retail investors realize what they have missed, they could pour back into the market – the classic case of selling low and buying high.  Second, corporate profits are being artificially inflated by government attempts to stimulate the economy.  Despite the scheduled end of Quantitative Easing II (QE2) this June, the Federal Reserve has shown little backbone in enforcing discipline and inflicting pain on corporations or consumers.  If the Fed loses its nerve and instead opts for QE3, equity markets could continue their easy-money fueled growth.

From a broader perspective, two macro issues will determine economic and investment conditions over the coming years.  First, the massive accumulations of government debt by developed nations.  The US, Europe, and Japan have all essentially adopted a similar strategy of trying the print their way back to prosperity.  Too Big To Fail has seemingly mutated into a “policy measure” – which has not gone unnoticed by investors.  But what happens when (if?) the gravy train of free money finally ends?  Second, this unabashed money printing has created dramatic ripple effect around the world, most notably in the Middle East, where the root cause of political upheaval can be traced to unemployment and inflation, NOT grand visions of liberal democracy and representative government.  The Middle East has the world’s youngest populace, for whom an inability to find jobs and spikes in energy and food prices has been expressed via revolts and coup d’états.  As long as these economic drivers persist, we can expect unrest to continue to spread and intensify.  The world and its economic players have never been so closely interlinked.

As markets hitting new highs and investor sentiment grows more bullish, investment discipline is hard, yet absolutely critical, to muster.  Our effort to practice this discipline is reflected in our current portfolio allocations, as well as our tactical shifts during the past quarter.  Here are a few examples:

Emerging Markets:

The emerging markets continue to suffer the inflationary effects of outsourcing their monetary policy to the US Federal Reserve.  Further, although BSW is a big believer in growth story of the emerging markets (see our 1Q-2010 blog post here), by a number of measures (price-to-book, price-to-cash flow, dividend yield, etc.) emerging market equities currently look expensive relative to their developed market peers.  As such, we took some profits in emerging markets and transitioned much of our exposure to dividend-paying companies focused on the rising Asian middle-class rather than resource extraction or export manufacturers.


We trimmed and took profits on our REIT position in January, missing out on some of the gains posted by REITs during the remainder of the quarter.  REITs now trade a premium to their net asset value (NAV), a measure of the underlying value of their assets.  That, to us, smacks of frothiness.  Although we may have been a bit early booking profits, taking the “easy money” off the table is a key part of our investment discipline.

Software & Healthcare:

Our tactical positions in software and healthcare both outperformed the S&P 500 for the quarter and we continue to like the sectors, albeit for different reasons.  The software industry enjoys very strong margins and should continue to benefit from economic expansion coupled with a “jobless recovery.”  Meanwhile, many healthcare companies still trade at discounted or reasonable valuations relative to the broader market and should enjoy stronger growth due to demographic trends and a more industry friendly legislative climate.


We hope this Portfolio Commentary provides you with better insight into the components of your growth equity portfolios and our current economic and investment outlook.  If you would like to discuss these positions or your portfolio in greater detail, please don’t hesitate to contact BSW.  As always, we are happy to help.

-David Wolf, Chief Investment Officer

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