The Fundamental Things Apply

As we look to 2014, many are reflecting on a very strong year for domestic stock markets. However, a key component that is missed by many investors and the media alike is the failure to appreciate how much (or rather how little) of that rally has been justified by an improvement in underlying fundamentals.

As has been a theme in our investment communication this year, there is a growing disconnect between expectations and reality. Most estimates suggest that only 5% of the 28% of stock market returns have come from improving fundamentals. Instead, the vast majority of the market’s appreciation has come from so-called multiple expansion, meaning investors are paying up for the hope of future profits coming through.

So much of the latter part of the rally since the lows of 2009 has been built on a tyranny of low expectations – a pernicious dynamic that has manifested in the last year whereby analysts continue to revise down earnings expectations, and companies have done just enough to jump over an ever-lower bar. Profit margins are up because of cost containment rather than top line growth. Eventually, that must start to appear in order to justify today’s prices.

From today’s level, unless there is a material improvement in such fundamentals, markets are now priced for lower expected returns. As Balentine Chief Investment Officer told the Atlanta Journal-Constitution, “the stock market is looking pricey, although it is still not in bubble territory.” That does not mean that a correction is imminent; it just means markets are more vulnerable to a disappointment if the hopes of fundamentals that have been baked into today’s prices do not come to fruition.

At Balentine, we counsel patience and advise our clients to be prepared for a lower period of returns from equities in the long-term. That is why we diversify strategies into other more attractively priced asset classes. For more on our long-term forecast of equities and other assets, be sure to download our 2014 Capital Markets Forecast, coming in January.

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