Is Weak Growth Extremely Bullish For Stocks?

Is Weak Growth Extremely Bullish For Stocks? You’ve been a bull on U.S. stocks over the last few years, a view that has paid off. What factors underlie your continued bullish thesis for U.S. stocks?

Jonathan Golub: My starting point is that we are in a secularly weaker economic environment. Economic growth is going to be more difficult to come by. That may sound quite negative, but if you actually look at the ramifications of that, you reach some interesting conclusions.

The first and most important impact is on the economic cycle, which, let’s say on average is something like seven years. Because of the weaker growth environment, we’ll probably have a much more extended cycle that goes 10 years or 12 years.

As a result, investors who get into the market now aren’t getting in at year six of the seven-year cycle; they may be getting in at year six of a 12-year cycle. That means they have much longer to participate.

It’s important to note that what drives markets down are recessions. Markets don’t fall apart because they get too expensive, or because people get tired or anything else. It really is recessions that cause these problems. And as we aren’t likely to see a recession for quite a number of years, that’s extremely bullish for stocks.

The second point to consider is that in an environment where the economy is weak, corporate revenues are weak. That again sounds like a negative, but what companies do in that environment is manage the bottom line much more aggressively and maintain real controls over cost.

Investors continue to be surprised by how strong the margins are getting. Many people are saying margins can’t keep going higher, but they’ve been saying that for the last three years. In fact, I think margins will continue to surprise to the upside for several years or longer.

The third point is that in a weaker environment, there tends to be far less inflation. You’re going to see inflation stay low, and that allows central banks to continue to provide very accommodative monetary policy. That’s an interesting idea. A weaker growth environment can actually counterintuitively lead to a longer bull market for stocks.

Golub: As long as growth is not at a recessionary level. A 2-2.5 percent growth rate for GDP is a very comfortable sweet spot. Another thing you mentioned is that valuations aren’t much of a concern, and that stocks aren’t going to fall apart because they get too expensive. But how do you see valuations; are stocks expensive right now?

Golub: The question is, “What’s your comparison?” For me, stocks should be valued based on their discount rate, their cost to capital. If you use the cost of capital for corporate bonds, stocks should be trading at somewhere between 18 and 21 times forward earnings. Right now, they’re trading closer to 16. So they look pretty cheap based on that metric.

Golub: Based on that. Now if you asked, “How are they valued compared to the long-term average?,” if you look at the long-term range, valuation in the last 40 years has been between a price-earnings ratio of 6 and a P/E of 24. That’s an extraordinarily wide range. The average has been a little over 14, and we’re about 16 right now.

Are we more expensive than average? Sure, but the point is that you’re clearly in the range around normal that should not raise alarm bells. If you get to a valuation in the low 20s, or even the high teens, then you can start questioning it. But right now, stocks are closer to average than we are to some type of a bull market extreme.

Moreover, you have to consider that interest rates are much lower than the historical average, thus valuations should be higher. Stocks are less volatile now than normal. That also suggests higher valuations. And thirdly, companies are carrying less debt now, which is another reason they should have a higher valuation. What’s your year-end price target for the S&P 500, and what’s your longer-term outlook?

Golub: My target for the S&P 500 is 2,325. As for my longer-term outlook, I think that we’re in a low-double-digit stock market environment where you’re going to get somewhere in the neighborhood of 7 percent earnings growth and something in the neighborhood of a half a multiple point P/E expansion.

We could see the market P/E go from 16 to 18 or 19 over the next four or five years, which is about half a multiple point a year. Half a multiple point translates into about a 3 or 4 percent return.

You add that to the 7 percent EPS growth number, and you’re in the low double digits for annual returns. A lot of investors keep saying it doesn’t make any sense, that the economy is not strong enough to deliver those kinds of numbers. But that’s exactly what it’s been doing for the last five years. What sectors or specific areas of the market do you like the most?

Golub: Long term, the strength is going to come from secular growth plays. These are companies that outperform without the need for economic strength. What do they have in common? These are generally new-economy success stories. Those can include new restaurant ideas like Starbucks and Chipotle. I’m not recommending those individual stocks, but companies that have been successful in terms of being able to grow in this kind of environment are doing so not because of the economy, but because people like their products and services.

It could also be technology, but specifically new tech. It’s Apple; it’s Google; companies like that.

If you look at health care, the majority of health care names are growing by more than 10 percent. Those are very strong numbers in a weaker growth environment.

I’d also add that you’re far more likely to see these types of companies in the United States than you do elsewhere. That sounds like a reason to be overweight the U.S.

Golub: It very much is. What are your thoughts on sectors that have underperformed, such as energy?

Golub: Areas like energy and materials are going to be under pressure. I have them as a neutral, but I think they’re going to face head winds in this environment, such as weaker growth from China. You talked about how a recession is the only thing that could really make the market fall apart. What tends to cause the recession? Is it usually high interest rates, a financial crisis or some black swan?

Golub: Recessions don’t tend to happen from black swans. If the Earth gets hit by a meteor, sure it would cause a recession, but in general, what happens is that as the economic cycle goes on, you run out of spare capacity.

That’s the point where the economy is running at full employment and factories are being fully utilized. Therefore, to grow the extra unit, you start pushing up the cost of labor and you start pushing up the cost of commodities. Businesses are forced to spend more money on capacity and you start to see inflation rise.

Then the central banks get engaged and they see too much inflation, and they try to slow the economy down. More often than not, they drive it into recession. That’s the traditional recessionary pattern. That’s not necessarily what happened in the last recession, but in general, that’s what it looks like.


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