January 24, 2014

Two years ago, the carnage of the 2008–2009 financial crisis had not receded from investors' minds, but economies were slowly mending, corporate balance sheets were strong, consumer saving rates were way up, and Brian Rogers was talking about "irrational exuberance."

Rogers, T. Rowe Price chairman and chief investment officer, was not speaking of an irrational exuberance for stocks as former Federal Reserve Chief Alan Greenspan had in 1996 when he coined the phrase. Instead, he was describing the "2011 variety, the illogical and widespread quest for safety" that had investors shying away from stocks.

Since then, global stock markets—with the exception of emerging markets and Asia outside Japan—have turned in consecutive strong years. Over 2012 and 2013, the S&P 500 Index of U.S. large-cap stocks delivered a total return of 53.6%. U.S. small-cap stocks did even better, and European and Japanese stock performances weren't far behind. (See chart below.)

Back-to-Back Strong Years for Stocks Around the World

Note: Chart represents total annual returns for the following: S&P 500 Index of U.S. large-caps; Russell 2000 Index of U.S. small-caps; MSCI EAFE Index of international developed markets; and MSCI Europe, Japan, Emerging Market, and Asia Ex-Japan indices.

Sources: T. Rowe Price and MSCI.

By the end of 2013, the gains had extended the current U.S. bull market that began March 9, 2009, to almost five years in length and to total returns for the S&P 500 Index of 203%—a bull as long and strong as the average bull going back to the 1930s.

But now Rogers is talking about "irrational exuberance" again—only this time he's referring to Greenspan's original sense of the phrase to urge caution.

"As investors have begun to gain more confidence in the economy, in the value of their houses, in their jobs, money has begun to move into riskier asset classes," he says, noting such signs of potential froth as rising interest in initial public offerings of stocks, speculation in the virtual currency Bitcoins, record margin debt used for investments, and giddy headlines hailing the bull.

"Today, looking at markets, asset class opportunities, and where we've come from since the tremendous valuation opportunities of 2008 to 2010," Rogers says, "it makes sense to be a little bit careful when it comes to equities and fixed income and maintain prudent return expectations."

Nothing's Cheap

A core problem for global investors is that stock valuations have risen in most markets.

U.S. small-caps are now valued more richly than their historical median, based on their forward price/earnings (P/E) ratio. U.S. large-caps' forward P/E ratio now is roughly at its historical median.

International stocks offer better value. European stocks are roughly at their historical median forward P/E ratio, but Europe is just emerging from recession and remains far from its peak earnings. And Japanese stocks still lag their historical median P/E. (See chart below.)

"What do you do as an investor if nothing's really cheap?" asks Bill Stromberg, head of equity. "Right now, there are very few pockets of opportunities, very few big pricing anomalies."

It's time for investors to rebalance their portfolios, recommit to their long-term investing program, and "wait for things to happen," he says.

While Stromberg says global economies are gaining strength and a recession in the United States is unlikely, he says a "nonrecessionary correction" is possible this year—a potential market drop of 5% to 20%.

Another reason for T. Rowe Price's "yellow light" is tepid corporate revenue growth accompanied by historically high profit margins, says John Linehan, head of U.S. equity.

He notes that the key driver for U.S. market growth since the fall of 2011 has been P/E expansion, the price that investors are willing to pay for stocks as a multiple of corporate earnings. Since then, he says, corporate earnings are only up 13% for the S&P 500 while P/Es expanded more than 40%.

Absent significant revenue growth, a key factor will be how corporations deploy the record amount of cash on their books, Linehan says. "If companies funnel cash into dividends or share repurchases," he says, "that could be a very powerful driver of the market."

U.S. Themes

Among U.S. stocks in 2014, two major themes stand out for Linehan.

One is the recent revolution in North American energy production, the result of the new drilling technology hydraulic fracturing or "fracking."

U.S. oil and natural gas production are both up by about 40% since 2008, he notes, providing opportunities in more cost-efficient exploration and production companies. Moreover, expanding supplies means lower energy costs for varied sectors, from high energy users—such as refiners and chemical firms—to household product makers.

This energy revolution—which could result in the United States essentially achieving energy independence—is just "in the first or second inning," says Shawn Driscoll, manager of the New Era Fund.

Linehan's second major U.S. investing theme is the prospect for a U.S. manufacturing renaissance from both falling energy prices and rising labor competitiveness.

U.S. labor productivity has been significantly increasing relative to the rest of the world, he says. And workers' wages have risen so fast in emerging markets—while U.S. wage gains have been muted—that the United States is newly viewed as a competitive manufacturing base for many products.

"It's definitely happening—but slowly," says Peter Bates, manager of the new Global Industrials Fund. "The prime beneficiaries are North American small-cap companies. But there are broad implications for retail firms, homebuilding, and autos, so it's really that U.S. GDP [gross domestic product] growth will have a bit extra kick."

Adds Brian Berghuis, manager of the Mid-Cap Growth Fund, "If the '90s belonged to technology and the last decade to materials and commodities, then there's a good probability that the next decade will belong to industrials.”

International Recoveries

At the same time, T. Rowe Price asset allocation portfolio managers have increased the overweighting of their diversified portfolios to non-U.S. equity markets as expectations for better U.S. growth are offset by more attractive valuations abroad.

But they also have continued to trim their overweighting to emerging markets in light of these markets' slowing growth and the threat to their currencies from Fed tapering.

Chris Alderson, head of international equity, is optimistic about international markets based on their valuations and liquidity from global central banks.

He says Europe "is past the worst of its financial crisis," such that its recovery is starting to be self-sustaining. The Japanese market also has passed a positive inflection point, he says, brought on by Prime Minister Shinzo Abe's reforms and monetary and fiscal easing.

International risks include the receding possibility that Europe will slip back into recession, that central banks' liquidity will not fend off deflation, and that the Chinese banking system "harbors lots of nonperforming loans that come home to roost," Alderson says.

But in Europe, Dean Tenerelli, manager of the European Stock Fund, says, "Everyone last year was worried about the potential breakup of the euro, but we're now worried about its growing strength. It shows you how far things have come."

Euro-area governments are now running their highest current account surpluses in the last 15 years, he says, because of budget cuts, competitiveness, restructuring, and labor and pension reforms. In Europe now, Tenerelli says, "the downside is pretty limited. There's not much fluff, neither in the numbers nor the valuations."

The recovery hasn't yet been fully expressed in European corporate earnings, but that has started to happen, he says.

While half of European firms' revenues come from outside Europe and they thus can provide effective access to global trends, particularly in emerging markets, Tenerelli now is finding more opportunities with domestically exposed European firms. For example, he's had a focus on the Spanish banking sector, where the survivors have benefited from consolidation.

In Japan, where stocks have soared after years of floundering, impetus for change has been catalyzed by China's ascent, globalization pressures, and a desire to become competitive again. Monetary easing has weakened the yen, helping Japan's world-class exporters. But the most painful aspects of economic and corporate restructuring haven't occurred.

"Japan is slowly improving," says Ray Mills, manager of the Overseas Stock Fund. "But there are huge vested interests. Japan is behind the world on profitability and returns. Corporate governance isn't always as good as in other developed markets. So there's still a lot more room for improvement."

In the meantime, managers favor certain Japanese plays on improving consumer confidence, possible mergers and acquisitions, and real estate.

Last, the international recovery theme is much less clear when it comes to emerging markets, where returns lagged last year with falling growth rates, stubbornly higher inflation and interest rates in some markets, and the threat of Fed tapering.

A range of T. Rowe Price managers are invested in companies in emerging and developed markets benefiting from the rise of middle-class consumers in the developing world, and they say that long-term trend remains.

While emerging market valuations remain attractive on a historical basis, managers say equity prospects are widely dispersed, with commodity producers suffering from the Chinese growth slowdown (Brazil and Russia, for example) and markets heavily reliant on foreign capital (India, Indonesia, and Turkey) most vulnerable to potential Fed tapering.

"Emerging market stocks are down, and currencies are down," says R. Scott Berg, manager of the Global Growth Stock Fund, which had more than 23.3% in those markets at the end of 2013. "When skies are cloudy, that's when you want to be buying. Once you see the catalysts, it's too late."


Internationally, small-cap stocks also provide potential opportunities.

U.S. small-caps, having returned more than 38.8% in 2013, are now at the high end of their historical valuations. (See chart below.) "I'm finding a lot of companies that are interesting," says Preston Athey, manager of the Small-Cap Value Fund, "but not at their stock prices today."

Stock Valuations Around the World Rose Sharply Last Year
Except in Emerging Markets and Asia Outside Japan

This chart shows the forward price/earnings (P/E) ratios of various equity markets at the end of 2013 compared with the end of 2012 and with their historical medians over various time periods (described in the note below).

  Forward P/Es
  12/31/12 12/31/13 Historical Medians
U.S. Small-Caps 14.6 18.9 14.2
U.S. Large-Caps 13.0 15.4 14.8
Japan 12.2 14.5 16.4
Europe 11.4 12.9 12.7
International Developed Markets 11.9 13.3 15.2
Asia ex-Japan 11.6 11.4 12.1
Emerging Markets 11.0 10.8 11.0
Note: The forward P/E ratio is the current stock price divided by industry analysts' estimates of corporate earnings for the next 12 months. The chart uses the following indices with the varying time periods on which their historical medians are based: the S&P 500 Index of U.S. large-caps (9/30/1989–12/31/2013); the Russell 2000 Index of U.S. small-caps (12/31/1978–12/31/2013); the MSCI EAFE Index of international developed markets (12/31/1995–12/31/2013); and the MSCI Europe (5/31/2001–12/31/2013), Japan (5/31/2001–12/31/2013), Emerging Markets (5/31/1995–12/31/2013), and Asia Ex-Japan (5/31/2001–12/31/2013) indices.

Sources: T. Rowe Price Quantitative Equity Group and MSCI.

International small-cap valuations have risen too, but not by as much as U.S. small-caps.

Tenerelli notes that many small- and mid-cap European companies are attractive in part because they remain family owned. "They manage their businesses with a very long-term perspective," he says. "They are willing to invest in downturns, and they're not afraid of missing numbers to generate long-term returns."

And Justin Thomson, manager of the International Discovery Fund, sees small-cap possibilities all around the world—from a British fashion retailer expanding to the United States, to certain Chinese Internet stocks, to a German supplier to the global auto industry.

"Opportunities can come from all sorts of places," he says. "If Europe accelerates in 2014, small-caps there could be a good play. If some inflation returns in Japan, it could have a profoundly positive impact on small-caps. And emerging markets small-caps now are relatively cheap."

International investing is subject to market risks and risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad. Emerging markets investments are subject to the risk of abrupt and severe price declines.