New Expectations For A New Year

OCEAN CITY — With interest rates at historic lows, resulting in lower income from bonds, achieving investment goals has brought about a shift in portfolios that has tilted them toward equities. This raises the importance of understanding the drivers of equity returns over the near term.

Three components drive total returns of equities: dividends, earnings growth and valuation changes (for example, changes in the price/earnings (P/E) ratio).

In the past few decades, the S&P 500 dividend yield has averaged around 2.5% and has been fairly stable. We anticipate 2014 will see more of the same: dividend yields of 2%. We believe it is more important to focus on the other two, more volatile factors — earnings growth and changes in valuation. The former — earnings growth, like dividends — has been surprisingly stable since 2011.

Looking at 2013, the S&P 500 Price Index has risen nearly 25%, the largest annual price increase in a decade. The majority of the returns are due to rising P/E ratios.

After two years of multiple expansions, greater confidence is now more discounted by fairer valuations. As such, we believe that the expansion in the P/E ratio this year is likely to be more muted for several reasons.

First, U.S. and global gross domestic product (GDP) should accelerate in 2014. In the U.S., the private sector looks set to be the engine for higher nominal GDP growth, driven by a combination of stronger household and corporate spending.

Fiscal headwinds should be lower as well. Activity indicators over the previous months are showing that the U.S. economy is ending 2013 with healthy momentum, and we are confident that it will carry over into next year. Globally, nominal GDP also looks set to increase, helped by an improving Europe and a resilient Japan. Bank of America Merrill Lynch (BofAML) Global Research has forecast U.S. and global nominal GDP to increase from 3.2% and 5.8%, respectively, in 2013, to 4.0% and 6.7% in 2014, and up to 4.7% and 7.0% in 2015.

Second, the commitment of the Federal Reserve (Fed) to keep policy rates at historically low levels, combined with a stronger U.S. economy and an eventual Fed tapering, is leading to steeper Treasury yield curves. In our view, these steep yield curves are likely to persist through 2014, and history shows they presage acceleration in earnings growth.

Third, profit margins are likely to remain resilient in 2014. BofAML Global Research forecasts S&P 500 earnings per share to grow by 7% next year. This growth rate is entirely in line with average earnings growth over the past 50 years. In fact, Savita Subramanian, BofAML Global Research’s Chief Equity Strategist, notes the risk to this 7% earnings growth forecast is to the upside: In non-recessionary years in the U.S., earnings growth has averaged over 10%.

But this optimistic view on earnings comes with a caveat: Investors need to moderate their expectations for U.S. equity returns, especially compared to what they have seen in 2013. The S&P 500 Index is no longer undervalued. The majority of equity market valuation metrics point either to a fairly or slightly overvalued market. Furthermore, an additional re-rating of U.S equities is unlikely to occur at the same pace as in the past few years, in our view.

That is not to say we are bearish on U.S. equity markets. On the contrary, we remain constructive on equities going into 2014; however, our return expectations are more in line with long-term equity returns on the S&P 500.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)