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Thankful or Not?

Fri, 29 Nov 2013

Markets editor Jeremy Glaser sizes up the thank-worthiness of the Fed, health-care spending, market valuations, and more.

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Video Transcript

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five, our special Thanksgiving edition.

This week: thankful or not? Five factors for consideration. We'll see where Morningstar markets editor Jeremy Glaser comes down.

Jeremy, thanks for joining me.

Jeremy Glaser: You're welcome, Jason.

Stipp: What do you have for The Friday Five this week.

Glaser: We're going to talk about the Fed, Congress, health-care spending, valuations, and finally, Europe.

Stipp: The Fed transition, going from Bernanke to Yellen: thankful or not?

Glaser: We're thankful for that so far. Earlier this year we saw what could happen when Fed messaging gets a little bit out of control, or they're not really able to completely control the message, and we had the so-called "taper tantrum," when rates moved up very rapidly, much faster than the Fed had really predicted, because there were worries about when the quantitative easing programs were going to slow down.

I think the fact that the transition from Bernanke to Yellen has been so smooth so far really shows that there is going to be a lot of continuity of policy. The [fact that the transition] hasn't caused a lot of ripples is something to certainly be thankful for.

Now, that doesn't mean that some of the issues the Fed faces are going to instantly disappear in any way. She's still going to have to deal with, when do you back out of these quantitative easing programs? When do you start thinking of raising short-term rates? That might be many years down the line, but you have to start potentially laying the groundwork for that beforehand. Those issues still remain.

But at least in terms of the transition, I think we've been thankful to see it going without a lot of drama.

Stipp: For number two, Jeremy, I'm just going to go ahead and say it: not thankful for Congress.

Glaser: I don't think there are a lot of people thankful for Congress right now if you look at their approval ratings. It's really been a tough couple of years for Congress and for investors who are trying to keep their eye on the long term.

Instead of passing any kind of long-term legislation, and giving some clarity on what tax rates are going to look like, and what entitlements are going to look like, Congress and Washington in general just keep kicking the can down the road with these short-term deals and setting up all of these different cliffs and debt-ceiling debates and things that are just adding a lot of short-term noise and a lot of short-term uncertainty. That's making it difficult for investors and businesses to make solid decisions.

We've been lucky so far that nothing has completely blown up. We've ended up with policies that, although, they might not be ideal for what you would want fiscal policy to look like, they have been OK so far, and have kept the economy growing. But there is really no saying when that streak of luck is going to run out.

I think also as we focus on what hasn't happened, Congress could have looked at other pieces of legislation that could be helping things--like doing some serious tax reform that could really try to get people investing in businesses again. Or thinking about different ways to reform mortgage financing, for example: What happens with Fannie and Freddie? Putting some clarity around that could provide even more support in the housing market.

You look at the issues that you've had with all the short-term deals and all the brinksmanship, combined with all the legislation that they haven't passed and the uncertainty there, and it's very difficult to be thankful for what Congress has done.

Stipp: Number three, Jeremy, the rate of health-care spending is obviously a very important issue to lots of folks out there. Is there some glimmer of hope to be thankful for health-care spending, though?

Glaser: I think we are cautiously thankful on what's happening with health-care spending right now. It's actually looked pretty good. We've seen a 2.4% increase over the last year; that includes drugs and other health-care services. That compares to the 5.9% average we've seen over the last 65 years, and it's looked good enough that our director of economic analysis Bob Johnson says it even has the patina of a story that's almost too good to be true.

Health-care spending is so important for two reasons. First, it's a big part of what people spend their money on, particularly retirees. So, having that spending inflation come down a lot is helpful for them. But for the country as a whole, as we think about these larger deficit issues, a big driver of that is health-care spending. It's spending on Medicare; it's spending on Medicaid. And if we could see that inflation really is much lower than we've seen historically, or what we're projecting out, when we're thinking about deficits, it makes those [issues] much easier to solve. The issue is still there--we still need to reform entitlements--but it makes it that much easier.

The reason it's cautious, though, is that we're not really sure what's driving these health-care costs lower right now. It could just be that because consumer spending is somewhat weak with the recession and with the anemic recovery, we just haven't really gotten back to a steady state of health-care spending. People have put off whatever they wanted to spend money on and put off procedures, and those could come back online if the economy starts to look stronger again, and this will just be a temporary blip.

It's also difficult to talk about health-care spending without talking about the Affordable Care Act. That act both tried to expand coverage and control costs. We've seen what's happened as we've tried to roll out this expanded coverage over the past couple of months. It's really been a disaster in terms of getting the website working, getting people signed up, and we haven't even started on the cost-containment parts yet. And the cost containment, these are more trials. It's much more cautious than the coverage expansion. We haven't really seen those take hold yet. So we don't know what impact any of those trials would have on the potential longer-term rate of inflation, and it's that longer-term rate that really drives that deficit and drives the potential good news.

So far, so good, but I think we're going to be watching this story for probably decades to see if health-care spending really can be brought down to a manageable inflation level.

Stipp: Number four, market valuations. I might be thankful when I open up my account statements here at the end of November, but what about looking forward?

Glaser: It's hard to be super-excited or super-thankful for market valuations right now. This week I had a chance to talk to both Josh Peters, who is our DividendInvestor editor, and Sam Lee, who is our ETFInvestor editor, about valuations. They both approached the subject from different ways. Sam prefers to look at the Shiller P/E, which looks back over the last 10 years trying to find more of a normalized earnings rate. Josh prefers more of a short look-back period. But both of them really see the market as being fully valued or a little bit overvalued, and that jibes with what our market fair value graph says. When you compile all the fair value estimates from all the companies we cover from our analysts, the market looks about 5% overvalued.

All those things in agreement do point to a slightly overvalued market. You just aren't seeing the kind of values you saw as recently as maybe 2011, where we were at a 20% discount to fair value, where there were lots of great opportunities.

Even though we're not seeing a huge plethora of options to put money to work, and that makes you a little bit unthankful, I think there are two important things to keep in mind.

First is that, even though we're looking a little bit overvalued, it's really impossible to predict what the short-term path of the market is going to be. It could continue to rise from here. We're at record levels. We could continue to hit record levels. Or we could see a pretty major correction in the relative near term. But trying to make those short-term predictions is a losing game, and trying to time the market like that is going to be incredibly challenging. So even if you do see the market as being a little bit overvalued, it's difficult to really make any big moves right away, given that uncertainty.

The second big one is that we still think you're going to get a fair return from stocks over time. It's not going to be a spectacular number. It might not look like it did in the past. It might be relatively modest, but it's still going to be a fair return. It's probably going to be other asset classes that don't look as poised for great returns--things like bonds or maybe cash.

That means that there is still a case for holding your full allocation of equities. Obviously, that has to make sense in your asset allocation mixture: You should have your short-term money in short-term assets, and [stocks are] really the money you're going to have for the long term. But we still think over that longer horizon, stocks still make a lot of sense.

Stipp: One of the hurdles that stocks got over in recent times that had held them back before was Europe. The crisis in Europe seems to have cooled down a little bit. So what would you say, thankful or not for the situation over there?

Glaser: I think we can be thankful that Europe hasn't had any big blowups recently. With the exception of Cyprus earlier this year, which was a very brief flare-up, things have been pretty quiet in Europe. A lot of it has to do with what's happening with the politics on the continent and also with growth.

On the politics, we had a German election that was actually pretty quiet. Angela Merkel returned back to be chancellor again. That gives her the opportunity to keep with their stable policies, continuous policies, and probably is a vote of confidence that Germany will be there as a backstop when you have some of these issues flare up. We've seen a little bit more political flexibility in terms of potentially changing agreements or making agreements more palatable to make sure they stay in place.

Growth--although still looking very, very anemic--has returned, and the recession does appear to be over. Even if we're not having explosive growth, having just that little bit of growth really does help the situation a lot. That's what you really need--growing economies in order to completely solve the crisis.

On the other hand, it's not over yet. A lot of the underlying issues, the idea that fiscal policy is being set by individual member countries, but monetary policy is not--that's still a major issue that's going to take some time to work out in order to keep this from flaring up years down the line. Things like making sure that the central banking regulations make sense, that you don't have more of these banking crises, you know what that bank-resolution process is, need to be figured out as well. But it seems like they've now created a base to solve these problems and are slowly making progress, and I think that's a good thing for investors.

Stipp: Well, I'm thankful to have you in the chair every Friday for The Friday Five, Jeremy. Thanks for joining me again.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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