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, earn-
ings 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 percent and has been
fairly stable. We anticipate
2014 will see more of the
same: dividend yields of 2
percent. 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 per-
cent, 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 expan-
sions, greater confidence is now
more discounted by fairer valua-
tions. As such, we believe that the
expansion in the P/E ratio this year
is likely to be more muted for sever-
al reasons.
First, U.S. and global gross do-
mestic product (GDP) should accel-
erate in 2014. In the U.S., the pri-
vate sector looks set to be the en-
gine for higher nominal GDP
growth, driven by a combination of
stronger household and corporate
spending.
Fiscal headwinds should be low-
er 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, nomi-
nal GDP also looks set to increase,
helped by an improving Europe and
a resilient Japan. Bank of America
Merrill Lynch (BofAML) Global Re-
search has forecast U.S. and global
nominal GDP to increase from 3.2
percent and 5.8 percent, respective-
ly, in 2013, to 4.0 percent and 6.7
percent in 2014, and up to 4.7 per-
cent and 7.0 percent in 2015.
Second, the commitment of the
Federal Reserve (Fed) to keep poli-
cy rates at historically low levels,
combined with a stronger U.S.
economy and an eventual Fed tap-
ering, is leading to steeper Treasury
yield curves. In our view, these
steep yield curves are likely to per-
sist through 2014, and history
shows they presage acceleration in
earnings growth.
Third, profit margins are
likely to remain resilient in
2014. BofAML Global Re-
search forecasts S&P 500
earnings per share to grow
by 7 percent next year. This
growth rate is entirely in
line with average earnings
growth over the past 50
years. In fact, Savita Sub-
ramanian, BofAML Global
Research's Chief Equity
Strategist, notes the risk to this 7-
percent earnings growth forecast is
to the upside: In non-recessionary
years in the U.S., earnings growth
has averaged over 10 percent.
But this optimistic view on earn-
ings 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 lon-
ger undervalued. The majority of
equity market valuation metrics
point either to a fairly or slightly ov-
ervalued market.
Furthermore, an additional re-rat-
ing of U.S equities is unlikely to oc-
cur 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 con-
trary, we remain constructive on eq-
uities going into 2014; however, our
return expectations are more in line
with long-term equity returns on the
S&P 500.
Brian Selzer
Special To The Dispatch
(A Merrill Lynch Wealth Man-
agement Advisor who can be reach-
ed at 410-213-8520.)
New Expectations For A New Year
Page 28
January 17, 2014
The Dispatch/Maryland Coast Dispatch
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