Market Commentary
by Byron Wien
 
05/30/2014

Better Times for the Economy Are Finally Here

The worst winter in the United States since 1995–96 has finally ended and the economy is responding favorably.  I never gave up hope.  I believed the housing recovery and energy production were enduring positives, but even those areas were experiencing setbacks.  Early favorable signs were the sharp increase in bank loans (up at an annual rate of almost 10%), which indicated improved business confidence, and a pick-up in rail car loadings, which reflected strong order books across a broad range of sectors.  First quarter real growth was down 1%, however, showing the economy was at stall speed, but the late Easter may have contributed to that.  Those cautious on the outlook point out that the harsh weather could only explain one percent or less of the overall Gross National Product shortfall, suggesting that the quarter was fundamentally weak without considering the weather factor.  I still believe momentum will build as we move through the rest of the year, and as a result we should see better economic growth and earnings.

The most significant change could come from capital spending.  Until now, the money that corporations have committed to capital equipment projects has gone to purchase labor-saving devices in both manufacturing and service industries.  Very few new plants have been built, which is understandable with operating rates at 79%.  We are now beginning to see evidence that capital expenditures are broadening to include new production facilities and this should result in a higher level of job creation.  Even so, the unemployment rate has dropped from 6.7% to 6.3% – although the decline in the participation rate has clouded the favorable aspect of this improvement.  Up to now, the conventional view has been that those dropping out of the work force were frustrated by the difficulty of finding a job.  Recent research has taken a harder look at demographics and concluded that “baby boomers” who are reaching retirement age are accounting for an important part of the decline in the participation rate.  In any case, the economy did create 288,000 jobs in the United States in April and that provided support for the optimistic view.  I am still looking for real growth to approach 3% by year-end, which should provide a favorable background for earnings and the equity market.  I also expect the unemployment rate to drop to 6%.

Meanwhile, we are five months into the new year and the Standard & Poor’s 500 has made little progress (up about 3%, so far).  Various reasons are given for this result.  Some valuation measures like that of Robert Shiller, which looks at normalized earnings over a decade, indicate the market is now overvalued at 25 times, a level high enough to warn investors that a decline is coming.  My model, which is based on operating earnings over the next twelve months, shows the market multiple to be slightly above the historical median at 16.3 times and well below the valuation levels of previous tops (25–30 times).  Others believe the excessive valuations of Tesla, Netflix, social media and biotech stocks are suggestive of a “bubble” and we all know what that means.  A third group likens the Ukraine situation to 1914.  A basically unstable world was thrown into a war because of the assassination of an archduke in Sarajevo.  While that might be a stretch, an event in Israel/Palestine, Iran or the South China Sea could turn worse at any time, disrupting oil shipments and world trade. 

Taking a hard look at earnings last year, revenue growth is clearly not the main factor contributing to increases.  Share buybacks net of share issuance were important.  A potential problem for earnings is corporate guidance, which is more cautious than at any point since 2009, according to International Strategy & Investment.  There have, however, been some recent improvements in earnings.  We experienced a similar period of negative guidance between 2005 and 2007, but earnings expanded more than 8% in those years.  We could be in a period where the fundamentals (the economy and earnings) improve and interest rates stay low, but the market makes little progress.  The reason could be related to sentiment, which is positive (a contrary indicator), and the fact that institutions are fully invested in equities as a result of the strong performance of the developed equity markets over the past two years.

Others believe that the market’s rise during 2012 and 2013 was fueled by the monetary accommodation of the Federal Reserve and now, with the Fed reducing its bond-buying program by $10 billion a month, the liquidity that was the driving force of equity performance will diminish with a resultant negative effect on stock prices.  One worry I have is that revenues will not expand fast enough for earnings to reach the S&P 500 level of $115 (or higher) that most strategists and economists are using.  If profit margins stay where they are at 10.2% of GDP (after an adjustment for inventory values) or 9.2% of sales, both all-time highs, revenues have to increase at close to 5% to achieve the earnings projections.  Right now revenues are increasing at about a 4% rate.  If the economy grows at a real rate of 3% and inflation is 2%, overall corporate revenues, which are nominal, should expand at a 5% rate, but we are running behind that rate now.

Another worry is that productivity is not increasing.  Earnings have been growing at 5% to 10% over the past few years even though the economy has been growing at less than 3%.  Low interest rates and modest inflation have helped, but productivity improvements as a result of technology and tighter management have played a role.  If productivity remains flat because those in charge don’t come up with new ideas to increase efficiency or technology advances are less impactful, profit improvements will be even more dependent on growth in the overall economy to produce increases.  All of these factors are on the dark side of the outlook.

Perhaps the most impressive aspect of the current economic environment is the increase in merger and acquisition activity.  In the past 111 days there have been 206 deals amounting to $1.7 trillion, a level comparable to 2007.  There are two ways to look at this level of activity.  The optimists would say that corporate executives and their boards are more confident about the outlook and are more willing to make substantial commitments to strengthen their strategic position.  A more cautious investor would say that this is yet another sign of the animal spirits that usually precede a market decline.  Since there are so many other factors on the positive side, I am siding with the optimists.  The Institute of Supply Management manufacturing and service indexes have been rising steadily.  Consumer credit is increasing, initial unemployment claims are declining, small business operators are becoming more optimistic and hotel revenues are strong, all signs of business confidence.  Rising stock prices and house values have increased consumer net worth to more than $82 trillion, well above the $70 trillion peak of 2007.  Critics would argue that too much of this increase has accrued to the already rich (the inequality problem) but there are signs that the broader population may be benefiting as well: more jobs are being created and average hourly earnings look like they are starting to rise.

Another favorable sign is vehicle production.  So far this year the seasonally adjusted annual rate has increased from 10.5 million units to a recent record of 11.6 million.  Some of this may reflect the aging fleet of American cars, and a peak may occur at some point, but right now this is one of the clear positives.  The rig count is also picking up, which is a good sign.  In 2010, 2011 and 2012 the economy slowed down during the summer and the stock market declined in sympathy.  Some investors are worried that we could experience a similar circumstance, prompting a recall of the mantra, “sell in May and go away.”  A shift in monetary policy took place in each of those years, however, and that doesn’t seem likely in 2014.  The Economic Cycle Research Institute Index correctly forecasted the second half slowdowns in the U.S. economy in 2010, 2011 and 2012.  It indicated the economy would not have a slowdown in 2013 and we didn’t have one.  The index has moved up sharply recently, which provides reassurance that the current favorable economic signs will continue.  My view is that economic momentum is about to increase, so the background for higher equity prices is favorable.

I am hearing rumblings of a controversy about housing, which has been improving since 2008.  Both new and existing home sales are off their peaks, but improving recently, and some investors are worried that the best part of the residential construction cycle is behind us.  Since housing has been a source of jobs as well as a positive factor in other aspects of the economic recovery, that would present a problem.  Home ownership in the United States has dropped from 69% in 2007 to 65% now, but we know that the high pre-crash level was a result of irresponsible behavior by both lenders and borrowers.  The lower level may be more normal.  A new concern is that there are some secular forces that could cause home ownership to move toward 60%, which would be an economic negative.  This would be caused by a lower level of family formations as young people choose to get married later or not get married at all.  The new generation may also want to maintain maximum flexibility in their lifestyle and rent their residence so they can change jobs and locations easily.  At this point, however, identifying this as a major trend is premature. 

One of the reasons people are not buying homes is not mortgage interest rates.  A 30-year mortgage yield is 4.2%, which is very attractive.  In fact, interest rates around the world are low.  To almost everyone’s surprise, the 10-year U.S. Treasury yields less than 2.6% and rates abroad are similarly depressed.  Spain can borrow money at 3% and Greece at 6%, a long way from the double-digit yields during the European crisis of 2010 when these countries were having trouble obtaining funds at double-digit rates.  Why are rates so low?  Part of the answer may be the need for institutional investors to rebalance their portfolios since equities have done so much better than bonds over the past two years.  Another reason is the abundant liquidity that has built up around the world as a result of improved corporate profitability in the economic recovery.  A third reason could be some apprehension over geopolitical instability around the world and the desire to “park” funds in safe instruments until there is more clarity on the outlook. 

While investors in the United States may be relatively complacent about the unsettled conditions in Ukraine since February, their counterparts abroad have been much more concerned.  That’s why Vladimir Putin’s decision to move troops back from the border of Eastern Ukraine (as yet unimplemented) could be important to the equity markets.  I believe three factors contributed to his decision.  First, the conflict between Russian separatists and Ukrainian nationalists was likely to erupt into widespread bloodshed and world leaders would hold him responsible for that situation.  Second, the integration of Crimea into the Russian federation was proving difficult and it would be important to accomplish that successfully.  Third, sanctions were hurting the already weak Russian economy.  Putin therefore decided to scale back his aggression for now and wait for a more favorable time to make his move.  The Ukrainian election took place with a minimum of turbulence.  Many polling places were closed in Eastern Ukraine to prevent conflicts between the nationalists (of varying allegiances) and the separatists.  Petro Poroshenko won a majority and the turnout was strong.  Now let’s see if he can bring the country together and develop a harmonious relationship with Moscow.  Putin has said he will accept him as Ukraine’s leader.  In another major geopolitical event, the outcome of the election in India was favorable and reform may at last be on the way in that complicated but important country.  In contrast, events in the South China Sea seem to be heating up.  China has had a confrontation with Vietnam over offshore oil drilling rights, which as of now is unresolved.   

I continue to believe traditional economic factors like economic growth, earnings and interest rates will drive the equity markets this year and that geopolitical events will be background rather than central factors.  Everyone involved has too much to lose by not taking advantage of the worldwide expansion underway, but we have to get used to unsettled geopolitical conditions involving Russia and China continuing to influence the investment environment. 

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