Positioning Get Real

GLOBAL INVESTMENT COMMITTEE
NOV. 18, 2014
Positioning
Get Real
MICHAEL WILSON
Chief Investment Officer
Morgan Stanley Wealth Management
[email protected]
+1 212 296-1953
While there is still some disagreement around the sustainability
of the current economic expansion and the equity market rally,
there is little opposition to the idea that longer-term returns are
likely to be lower than normal. Furthermore, the arguments for
lower returns are well established and accepted by most. After
all, it’s hard to disagree with the fact that we still live in an
overindebted world that has left us with insufficient demand to
meet supply in many goods and services. The result is weak
pricing in virtually everything from crude oil to T-shirts.
Real GDP growth is mainly a function of three things: population growth, labor productivity and credit growth. Over time, population and productivity don’t change that much,
leaving credit as the big swing factor, and it’s obvious that in the wake of the financial
crisis, this factor is going to remain sluggish. In recent years, households, corporations
and banks have gone to great lengths to improve their balance sheets. That’s a good
thing. However, that also means they are unlikely to go on another debt binge anytime
soon, which is likely to keep real GDP well below the trend of the past 30 years when
debt accumulation fueled the economy. Specifically, it means we can look ahead to 2%to-2.5% real GDP growth instead of the 4% we have come to expect since World War II.
Many investors have taken this slower growth to mean a recession is imminent and
hence, corporate profits and stocks are heading for a serious correction. The reality is
that corporations have done a great job of operating in this new slow-growth environment and continue to generate record profits and impressive earnings growth. With the
third-quarter earnings reporting season now complete, S&P 500 companies have
delivered nearly 10% year-over-year earnings per share (EPS) growth on just 4% sales
growth—a superb performance. Even energy companies, which have had to battle
collapsing oil prices, delivered more than 7% EPS growth on a 3.5% decline in revenues.
That’s efficiency!
The Global Investment Committee (GIC) does not see why this financial performance
will change anytime soon since cost pressures and interest rates should remain low for
the foreseeable future. Adam Parker, Morgan Stanley & Co.’s chief US equity strategist
and a member of the GIC, forecasts 7% EPS growth for next year. That’s far from a
recession but it also indicates that we have moved past the fat part of the cycle. In fact,
Please refer to important information, disclosures and qualifications at the end of this material.
POSITIONING
research that suggests nominal total returns for US equities are
likely to be only 6% per annum for the next 10 years.
It makes sense that a slower growing economy will deliver
lower-than-normal equity market returns, but there are a few
important points to consider. First, lower returns are not just an
equity phenomenon. This applies to bonds as well where MS &
Co.’s 10-year forecasted returns are 3.1% for investment grade
credit and just 2.5% for US Treasuries. Second, lower nominal
returns aren’t devastating in a low-inflation world. This point is
often overlooked by investors. The reality is that what we care
about is real returns—that is, after-inflation returns. Our forecast
for inflation is also below trend at close to 2% with a downward
bias. Using the above forecasts of 6% and 3% for US stocks and
bonds on a nominal basis leaves us with 4% real returns for
stocks and 1% for bonds.
These numbers are worse than the longer-term average annual
real returns of 7% and 3% for US stocks and bonds, respectively.
However, they are not negative as many people seem to fear. On
the other hand, the return on cash is negative right now and is
likely to remain negative for the next few years as we believe
that the Federal Reserve will be slow to raise short-term rates.
Also, if our long-term inflation assumption turns out to be too
low, the real returns for bonds have little margin of safety before
they turn outright negative, too. Stocks, on the other hand, are
typically a good inflation hedge as nominal returns tend to
increase with small unexpected increases in inflation as opposed
to bonds, which typically decline in value. Going forward, it is
important for investors to “get real” about their returns and start
thinking about how to beat inflation in a slow-growing world.
From where the GIC sits, equities are still the asset class of
choice.
severe and can last for more than 10 years. These downturns are
to be avoided at all costs because they can put a portfolio into a
deep hole from which recovery is more difficult—especially if
an investor is in retirement or close to it.
I am confident the US stock market entered a secular downturn
in the year 2000, which coincided with the top of the technology
bubble. Certain things are always present at the top of a secular
cycle—euphoria about the future, endless growth or a new
paradigm. Does that sound familiar? Secular downturns also
make the cyclical turns and twists more painful. To wit, the
recessions of 2001 and 2008 resulted in much larger US stock
market declines than a typical cyclical downturn. Secular
downturns usually cut across two or three recessions. So, are we
still in the secular downturn or are we now in a secular upturn?
First, from a cyclical stand, we believe the last recession ended
in 2009, but we are still several years from the next recession;
our analysis shows a low near-term risk of a cyclical downturn.
We have discussed this view all year and believe the
September/October correction was actually the finale of the
market’s adjustment to the end of the Fed’s Quantitative Easing
(QE) policy. In other words, we believe growth is likely to
continue in the US for several more years, which would make
the risk of a cyclical downturn low in the foreseeable future.
Therefore, we remain overweight equities and underweight
bonds.
Markets are like an endless rollercoaster with their ups and
downs and there are many ways to ride it. Some embrace the
thrill, putting their hands up not worrying so much about the
turns and plunges. Others grip the safety bar with white
knuckles and scream every time the coaster dives. My view is
that it’s better to have a little of each approach, and understanding the difference between cyclical and secular swoons is
one thing that can help investors enjoy the ride.
What about the secular cycle? Are we finished with it or will the
next cyclical downturn be another 50%+ correction for equities?
In my view, the secular downturn ended in August 2011.
Secular cycles tend to crest and bottom with major societal
events that are arguably obvious in hindsight, such as the top of
the tech bubble. What happened then that marked the secular
cycle low? How about the downgrade of US Treasury debt? I
cannot think of a more cathartic event in the recent past or even
more historical past. August 2011 was also a 30-year low for the
University of Michigan Consumer Sentiment Index. Not
coincidentally, this same measure made its high in January
2000—the same month the Dow Jones Industrial Average
peaked and two months before the S&P 500 made a secular top.
By itself, this is a pretty good argument that August 2011 was in
fact the secular-cycle trough rather than the nominal price lows
made in March 2009.
Cyclical downturns take place during the normal course of a
typical business cycle, usually around economic recessions.
They come around more frequently than secular downturns and
are worth avoiding, but they can easily be endured by most
well-balanced portfolios. Secular downturns are much more
This got me thinking and so I decided to look for a way to
measure the real price of the US stock market since that is what
we care about as wealth managers. Simply adjusting for
inflation would not be enough in a world with so much currency
volatility. There is also a case to be made that the Consumer
Secular Versus Cyclical
Please refer to important information, disclosures and qualifications at the end of this material.
Nov. 18, 2014
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POSITIONING
Exhibit 1: Consumer Confidence Lines Up With Gold-Priced Equity Market Cycles
500 in Gold-Price Terms (left axis)
1,000 S&P
University of Michigan Consumer Sentiment Index (three-month average, right axis)
120
11 Yrs.
110
Log Scale
100
90
13 Yrs.
12 Yrs.
100
80
Nominal S&P 500
Bottom, March
2009
70
60
10
1927
US Enters World War II,
Spring 1942
1934
1941
1948
US Treasury Debt
Downgrade,
August 2011
Iran Hostage Rescue Fails,
April 1980
1955
1962
1969
1976
1983
1990
50
40
1997
2004
2011
Source: Bloomberg as of Oct. 31, 2014
Price Index (CPI) is somewhat flawed as a measure of inflation
as it is felt by the average American and confirmed by the actual
cost of living experienced during the past decade. From the
consumer’s standpoint, the dramatic decline in the US dollar
between 2002 and 2011 was not accurately captured by the CPI.
secular bull and bear markets last much longer than cyclical
bulls and bears. In fact, we’ve only had three secular bears since
1925 and two secular bulls. From Exhibit 1, it’s pretty easy to
distinguish between the two. Importantly, they aren’t that
different on a nominal scale, but there are distinct differences.
Therefore, I decided to discount the price of the S&P 500 by the
most stable currency known to man—gold. Gold fluctuates just
like currencies, but over time represents stable value. One
compelling argument for gold as the most stable currency is that
one ounce of the shiny metal has consistently equated to the cost
of a fine suit of clothes. In other words, a certain amount of gold
holds its purchasing power over time—something the US dollar
or other major currencies cannot claim. Before I go any further,
let me assure readers that I am not a gold bug and this note is
not going to devolve into a tirade against the US dollar. Instead,
our view is that the dollar has likely entered a structural bull
market, which should have a positive impact on one’s real
returns from US stocks going forward. This is also why the
average consumer feels better—it’s no coincidence that the
trade-weighted US dollar also bottomed in August 2011.
Let’s focus on the three secular bears—the 1930s-40s, the
1960s-1970s and 2000s. They all lasted between 11 and 13
years, collapsed between 85% and 95% in gold, or real, terms
and ended with a negative seminal event that, in retrospect,
could be recognized as cathartic. With regard to the most recent
secular bear, notice how the final low wasn’t made until August
2011, coinciding to the month with this cycle’s negative seminal
event—the downgrade of US Treasury debt—amazing! Perhaps
even more amazing is how consumer confidence lines up
perfectly with the peaks and troughs of the secular bear and bull
markets—almost to the month.
Now, look at Exhibit 1, which shows the S&P 500 since 1925
divided by the price of gold. In essence, this is the real price, or
purchasing power of the US stock market. As you can see, it
fluctuates over time like the nominal S&P 500 as we see it on
our screens. However, it does not go up over time nearly as
much. This makes perfect sense as no asset goes up as much in
real terms as it does in nominal terms. While the stock market is
a great measure of corporate value, it is also a great measure of
the public’s collective mood—some call it “animal spirits” and
it is a big part of what drives asset prices. As mentioned earlier,
Why does this matter to investors? Most people look at the US
stock market and see it breaking to new highs every day,
making it hard for many to remain confidently invested. This is
especially true after two 50% corrections in the past 15 years.
However, if you look at it in terms of real purchasing power, it’s
not so scary. In fact, it appears we have just begun the next
secular bull market in real terms, suggesting this is not a time to
abandon US equities. More importantly, we believe it is likely
going to last longer than most expect with a few important
caveats. First, the rate of real returns since August 2011 is not
sustainable and is likely to decrease substantially from here.
Compared to steep initial increases from the 1942 and 1980
lows, today’s rate of increase is running ahead of those prior
examples. Second, painful cyclical bear markets are still going
Please refer to important information, disclosures and qualifications at the end of this material.
Nov. 18, 2014
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POSITIONING
Exhibit 2: Setting the Stage for the
EAFE Index to Outperform the S&P
Exhibit 3: Relative Earnings Revisions
in Japan, Europe Outpace the US
0.75
15%
MSCI EAFE Versus S&P 500
Relative Earnings Revisions Breadth Versus S&P 500
(three-month average) MSCI Japan MSCI Europe
10
0.65
-177% Relative Total
Return (1994-2001)
0.55
5
70% Relative Total
Return (2001-2008)
-67% Relative
Total Return
(2008-Present)
0.45
0
?
-5
0.35
-10
0.25
1992
-15
2004
1995
1998
2001
2004
2007
2010
2013
Source: FactSet as of Oct. 31, 2014
to occur around recessions, so we want to remain vigilant and
reduce our risk at the appropriate times. Nevertheless, the bigger
message is clear: The secular bear market has ended and it
wasn’t as long ago or as far away as you might think. There is
still a lot of time left and money to be made in real terms for
those who remain invested in US equities.
The Only Game in Town
A large part of my role as chief investment officer of Morgan
Stanley Wealth Management is to travel around the country to
meet with our clients and Financial Advisors. The objective is to
discuss current economic and market conditions and the GIC’s
outlook. One of the benefits is that I get a real-time read of our
clients’ greatest concerns. These concerns change over time, but
typically one or two dominate at any given moment. A few
years ago it was about QE and “how much gold should I own?”
Last year, it was about rising interest rates and “how can I
protect my bond investments?” Now, the concern I hear most is
about sluggish global growth and the question is, “why own
anything except the S&P 500 in my equity portfolio?”
One thing I have learned over the past few decades is that when
popular opinion gets this strong on any one topic, the trend is
close to having run its course. Does this mean the S&P 500 is no
longer a good place to invest and/or is about to have a major
correction? Not at all. Instead, the non-US equities investments
we have been recommending are likely to perk up—and perhaps
even outperform the S&P 500. While it’s difficult to know
exactly when this will begin, the Japanese equity market’s
recent run may be the beginning of this changing trend.
2006
2008
2010
2012
2014
Source: FactSet as of Nov. 13, 2014
S&P 500 outperformance has been and put it in context of prior
periods (see Exhibit 2). Those big relative performance swings
between the S&P 500 and developed international markets, as
represented by the MSCI EAFE Index, are more the norm than
one might think. Furthermore, they happen with consistent
regularity of approximately seven years—the same as this most
recent period of underperformance by MSCI EAFE.
Of course, market movements can remain extreme for a long
time. So what gives us confidence this is likely to move the
other way in the near term? First, in Japan the catalyst arrived
two weeks ago with the Bank of Japan (BOJ) and the massive
public pension fund working in concert to stimulate the
economy and the equity markets. Specifically, the BOJ has
increased its already sizable QE program by 25%, which will
allow the Japan’s Government Pension Investment Fund to
move a large part of its massive bond position to stocks without
a major disruption in the Japanese bond market. This shift in
pension-fund policy will provide a consistent buyer of Japanese
equities for the next several years—something that has been
absent for the past 20 years.
Second, and perhaps less obvious, the rate of change on
earnings revisions breadth in Europe and Japan is now
accelerating more rapidly than in the US (see Exhibit 3). This is
not surprising given how much earlier we are in the European
and Japanese recoveries. Nevertheless, it is supportive of these
equity markets, particularly on a relative basis. In the case of
Japan, earnings are also growing much faster than in the US—
an added benefit. If these trends remain in place into next year
as we expect, investors will take notice. 
Rather than just hoping for a turn, let’s look at some fundamental data to support our case. First, notice how dramatic the
Please refer to important information, disclosures and qualifications at the end of this material.
Nov. 18, 2014
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POSITIONING
Index Definitions
CONSUMER PRICE INDEX This index
examines the weighted average of prices of
a basket of consumer goods and services.
DOW JONES INDUSTRIAL AVERAGE This
is
a price-weighted average of 30 significant
stocks traded on the New York Stock
Exchange and the Nasdaq.
MSCI EAFE INDEX The Morgan Stanley
Capital International Europe, Australia, Far
East Index is a capitalization-weighted
index that tracks the total return of common
stocks in 21 developed-market countries
within Europe, Australia and the Far East.
MSCI EUROPE
This index captures large,
mid and small cap representation across 16
Developed Markets countries in Europe.
With 1,372 constituents, the index covers
approximately 99% of the free floatadjusted market capitalization across the
Developed Markets countries of Europe.
S&P 500 INDEX Regarded
MSCI JAPAN This
UNIVERSITY OF MICHIGAN CONSUMER
SENTIMENT INDEX Published monthly, this
index is designed to
measure the performance of the large, mid
and small cap segments of the Japan market.
With 1,134 constituents, the index covers
approximately 99% of the free floatadjusted market capitalization in Japan.
as the best single
gauge of the US equities market, this
capitalization-weighted index includes a
representative sample of 500 leading
companies in leading industries in the US
economy.
is based on 500 telephone interviews with
randomly selected US consumers. The
survey gathers information on consumer
expectations regarding the overall economy.
Risk Considerations
International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic
uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these
countries may have relatively unstable governments and less established markets and economies.
Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to,
(i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events,
war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence,
technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary
distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.
Physical precious metals are non-regulated products. Precious metals are speculative investments, which may experience short-term and long
term price volatility. The value of precious metals investments may fluctuate and may appreciate or decline, depending on market conditions. If sold
in a declining market, the price you receive may be less than your original investment. Unlike bonds and stocks, precious metals do not make interest
or dividend payments. Therefore, precious metals may not be suitable for investors who require current income. Precious metals are commodities
that should be safely stored, which may impose additional costs on the investor. The Securities Investor Protection Corporation (“SIPC”) provides
certain protection for customers’ cash and securities in the event of a brokerage firm’s bankruptcy, other financial difficulties, or if customers’ assets
are missing. SIPC insurance does not apply to precious metals or other commodities.
Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk.
Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date.
The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the
maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the
risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk
that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.
Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including
greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual
circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a
balanced portfolio.
Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and
market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and
domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied
economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These
risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in
countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.
Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.
The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the
performance of any specific investment.
The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan
Stanley Wealth Management retains the right to change representative indices at any time.
Please refer to important information, disclosures and qualifications at the end of this material.
Nov. 18, 2014
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