Apr 03, 2012

The Disbelievers

One of my Ten Surprises was that the Standard & Poor’s 500 would reach 1400 sometime during 2012, and here we are at the beginning of the second quarter and it’s already there.  When I wrote that, my objective was to have the most optimistic estimate among Wall Street strategists.  I actually thought the S&P 500 could reach 1500 based on the generally achieved (but not last year) multiple of 15 times and operating earnings of $100.  Estimates have been trimmed somewhat, but, at this point, I still think 1500 is likely.  The real question is, “Why are investors so skeptical?” 

There are plenty of reasons to be negative.  West Texas Intermediate crude oil is over $100 and gasoline costs more than $4.00 a gallon at many American pumps.  Israel might strike Iran’s nuclear facilities, causing turbulence and instability in the Middle East.  The 10-year U.S. Treasury note has risen suddenly to 2.3% and the long era of depressed intermediate-term interest rates may be over.  Next January a major fiscal drag will begin:  the Bush tax cuts will expire, the automatic sequestering of funds for defense and health care resulting from the failure of the Congressional Super Committee to come up with $1.2 trillion in budget cuts over ten years will take place, the payroll tax holiday will end and the Obama universal health care program will start.  And there are other fiscal changes of lesser importance that will be implemented.

For the last two years the United States equity market has done well at the beginning of the year but has begun to run into trouble after March.  The age-old mantra of “sell in May and go away” has served investors well.  Why should this year be any different with the above negatives staring it in the face?  Some bears would argue that the only reason the indexes are where they are is because of the liquidity being poured into the market by central banks around the world.  In the United States, M2 has been rising exponentially and is up 10% year-to-date.  The European Central Bank has put over a trillion euros into the European economy to shore up the banking system there and to prevent a serious recession from taking place.  While much of this money has been absorbed into the real economy, clearly some of it has found its way into financial assets, driving stock prices higher.  Good weather has probably also been a factor, helping the troubled housing industry in the U.S. to stabilize and enabling retail sales to strengthen.  Quarter to quarter retail sales are up 5%.  Household net worth has increased 30% since last October, which has clearly helped both of these sectors.

Over the past few years the work of the Economic Cycle Research Institute has gained some respect.  Its index peaked in April 2010 and April 2011 warning of slower economic activity to follow.  The S&P 500 subsequently declined 15% in both of those years.  The index is currently rising and there are enough positive economic factors influencing it to believe that it won’t peak soon.  Of the 15 indicators tracked by International Strategy & Investment (ISI), 12 are gaining strength.  Let’s see if they continue their uptrends beyond next month.

At the beginning of the year most investors were cautious about the outlook.  The economic data was mixed week after week and the failure of the Congressional Super Committee to come up with a program to reduce the United States budget deficit underscored the perceived dysfunctionality of our political system.  The Republican primaries had not yet started but none of the many contenders for the nomination then was inspiring enthusiasm, and many Democrats were discouraged by President Barack Obama’s lack of leadership and his performance during his first term.  Measures of investor sentiment revealed that a pessimistic mood prevailed.

The economic news began to improve as we moved into the new year.  Initial unemployment claims moved lower almost every week and the unemployment rate declined as a result.  First quarter industrial production was up 9.5%, the strongest gain in 15 years.  Capital spending remained robust, with first quarter purchases of business equipment up 15%.  Much of this was for labor-saving devices; with operating rates below 80%, not a lot of new plants were being built.  In spite of this, manufacturing employment is increasing faster than service sector employment for the first time in 35 years. Small business optimism levels, a previous problem, have increased.  There is evidence that banks are lending again.  Job openings are up 17% from their level 2½ years ago.  Consumer confidence, another past problem, has improved considerably although it is still a long way from the pervasive optimism that existed prior to 2008.

At the beginning of the year, investors were also worried about a “hard landing” in China.  Unsold high-end apartments and non-performing loans on the books of the banks would cause the economy to slow.  While China has lowered its GDP growth forecast to 7.5% for 2012, this is still well above recessionary concerns. Other emerging markets are also off their peak pace, but they will still have growth rates substantially greater than those of Europe or the United States.  Among the developed markets the U.S., growing at better than 2% (I think 3% is possible), will perform better than Europe or Japan.  This is one reason the dollar is strong.

At the beginning of the year Europe was the big uncertainty.  Investors were concerned that the European Union would break apart and that Europe would enter a deep and prolonged recession that was sure to have a negative impact on economic growth in the United States.  There were new people in critical roles on the Continent and it was too early to assess their competence or how successful they were likely to be.  Mario Draghi as head of the European Central Bank has elected to provide substantial liquidity to strengthen the banking system and to offset the impact of the various austerity programs being implemented throughout the region.  In Italy, Mario Monti has proven effective in enlisting the support of former followers of Silvio Berlusconi and has introduced reforms that should prove positive for that economy going forward.  Italy and Spain have improved their economic prospects in the past several months, and this is an important positive change. 

It now appears that the European Union will hold together at least for a year or more.  Greece remains a problem but its sovereign debt holders have agreed to a severe restructuring of their holdings and the liquidity being provided by the European Central Bank should soften the impact of declining government expenditures.  Whether Greece will be able to meet its deficit and debt-to-GDP targets remains unclear. Draghi seems to be emulating the United States decision made during the sub-prime real estate crisis of 2008, namely to provide the funds necessary to keep the system from melting down.  This represents a total reversal from the previous policy of the Bank, which was to focus on controlling the rise in inflation through a restrictive monetary policy.

The combination of generally better economic data and an improved outlook for Europe has reassured investors.  Over the past three months the pessimistic mood has changed to optimism.  Most investors have been slow to put their money to work and, as a result, many hedge funds and long only investors are lagging behind the performance of the major indexes.  Ordinarily, optimistic sentiment readings presage a market correction, but there are so many investors looking for an opportunity to increase their exposure that even a minor downdraft gets cut short by a flood of buyers.  This could continue for a while. 

That is not to say that the market outlook is devoid of problems.  The price of oil at over $100 a barrel is one of them.  That does not seem to be hampering consumer spending, however, indicating that perhaps people have resigned themselves to driving less and paying more to do it.  In the past President Obama’s approval rating has tracked the price of oil pretty closely, but over the past several months his approval rating has risen while the price of oil has moved higher.  The economy was improving during that period and the adversarial Republican primaries were taking place, and that may have had more to do with how those polled felt about the President.

Another factor investors are concerned about is the possibility that Israel will conduct an air strike against Iran.  The view is that Iran will soon be at a “zone of immunity” which means that they will be so far along in the development of a nuclear weapon that no effort to stop them will be possible.  That point will, according to various projections, occur later this year so, in this view, Israel must strike soon.  I believe that President Obama assured Israel’s Prime Minister Benjamin Netanyahu on his recent trip to the United States that we would support Israel in preventing Iran from having a nuclear weapon, but wanted to be patient to see if sanctions and other forms of intervention worked.  If Iran was attacked and the price of oil moved into the $150–$200 range, that obviously would be an important market impediment.  I remain of the view that the weapons program in Iran has already been weakened by assassinations and sabotage, and that while the rhetoric of the clerics is fierce, their willingness to engage in conflict is less threatening.  The people of Iran want economic opportunity and the sanctions are holding them back.  Most of them don’t understand why the country is pursuing a nuclear weapon.  I don’t think we’ll see an attack on Iran this year.

The recent increase in the yield on the 10-year U.S. Treasury note may be the beginning of something important.  Intermediate term interest rates historically have reflected the nominal growth rate of the U.S. economy which today is about 4.5%, so the current level of 2.3% still remains a bargain rate for the Treasury to pay to borrow to finance our deficit.  The low rate results from so many investors around the world seeking a safe place to park their money and the United States, with a strong military and the ability to print money, meets their test.  Now, however, as the positive performance of equities everywhere continues, the appetite for taking on additional risk is increasing.  The movement away from defensive assets has caused the price of gold to decline.  I continue to view gold as a kind of insurance policy against a calamity in financial assets. Because of that I would maintain positions even as the price of equities moves higher. 

The intermediate-term Treasury yields could “normalize” to the nominal growth rate.  How long this will take is hard to estimate.  I have been forecasting higher rates for some time and been wrong.  I do believe that we have reached an inflection point and that 10-year Treasury rates will move higher between now and year-end, perhaps reaching 3%.  The question is what impact that will have on the equity market.  For a good part of my career I maintained a “dividend discount model” similar to the so-called Fed Model (mine came first) that related the fair value for the S&P 500 to the 10-year Treasury yield.  The model served me well into the late 1990s when it showed the market to be egregiously overvalued.  In the new millennium, however, when fear around the world drove the 10-year yield to what I considered aberrationally low levels, the model broke down.  Whether it ever becomes operative again is uncertain.  Based on the principle that stocks compete with bonds, it would argue that today the S&P 500 should be over 2000.  There is an overarching view among investors that the market is mean-reverting, so perhaps the model will someday work again, but I am skeptical.  I think the future will be different than the past and that we are in for a prolonged period of slow growth and deleveraging while the federal deficit is brought down.  That may mean more modest returns for equities in future years, but for 2012, I still believe we have higher highs ahead of us.  Apple paving the way for a greater focus on dividends will help the indexes move ahead.

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