Tuesday, August 14th, 2012
by Seth Masters, Chief Investment Strategist, AllianceBernstein
While some people deem stocks expensive relative to 10-year trailing earnings, we take a forward-looking approach. It starts with the premise that the stock market is not a casino and stock prices are not pulled out of thin air: they reflect the intrinsic value of companies’ future earnings.
Let’s start with basics. Stocks represent an ownership claim on a share of company earnings. Hence, stock prices reflect (imperfectly, of course) the value of companies’ current earnings and potential earnings growth. In computing the expected returns for stocks, what matters is the starting price, earnings, dividends (the portion of earnings distributed to shareholders), earnings growth and changes in P/E. As you might expect, low starting prices, high earnings and dividends, high growth, and P/E expansion are all good for future stock returns.
The models we use when investing are complex, but a simple argument makes the point. The expected return for a Treasury bond held to maturity is equal to its yield. Similarly, the expected return for a stock equals its earnings per share (EPS) divided by its price—its earnings yield—if the company has no growth prospects and therefore returns all of its earnings to shareholders. If the company does have growth prospects, it would retain some of its earnings to fund growth. In that case, the expected return equals the dividend yield plus dividend growth. If the company pays out a constant share of earnings as dividends, dividend growth equals earnings growth.
Let’s apply this framework to the S&P 500 Index’s price level of about 1,300. Consensus forecasts call for the index to have $104 in earnings per share this year. If the companies in the index didn’t xpect any growth, they would pay out all their earnings as dividends, and earnings and dividends wouldn’t grow. The S&P 500’s dividend yield would be 8%, as the first row of the display below shows.
If the P/E remained unchanged, the total return would also be 8%, but both the S&P 500 and the Dow would stay at their current level. While a flat index price might be disappointing, we think most investors today would probably welcome an 8% return on investment.
Of course, the companies in the S&P 500 do retain a portion of their earnings to finance growth, so the index’s dividend yield is slightly above 2%, rather than 8%, as the second row of the display shows. What kind of earnings growth should we assume?
What About Growth?
Historically, earnings and the stock market have grown with the economy over time, although they can diverge for several years at a stretch, particularly if market euphoria drives stock prices to very high multiples of earnings or if gloom drives stock prices to low multiples. Nominal US GDP, which includes inflation, has grown 7% a year on average since 1947—and so have the S&P 500’s earnings and price. (GDP growth is more commonly quoted in real, or inflation-adjusted, terms. We use nominal growth here to match data for earnings growth and the stock market.)
The three key variables that drive both economic growth and earnings growth over the long term are inflation (which increases the nominal value of economic output), population growth (which boosts the number of people consuming and producing goods) and productivity (which increases the output per person or per unit of capital).
Inflation is widely expected to average about 3% over the long term; population growth, to average about 1%; and productivity, to continue to rise about 2% per year. Since 3% + 1% + 2% = 6%, 6% is a plausible long-term economic growth forecast; it is actually below both the postwar average and the International Monetary Fund’s projections for the next five years.*
So let’s assume 6% economic and earnings growth. With a constant dividend payout ratio, this would lead to 6% dividend growth. Eventually, this growth rate would probably make investors less gloomy, and the market would rise from its current low level of 12.5 times earnings.
If the S&P 500’s P/E rose to 15—halfway back to its average of 17.6 since 1970—the index’s expected return would be 9% per year. At that rate, the S&P 500 would reach 2,000 in five years. The Dow, which typically trades at about 10 times the S&P 500, would reach 20,000 in about five years.
But as discussed above, the market should arguably be trading at an above-average multiple, since bond yields are so low. If the S&P 500’s P/E rises to 20 times earnings as sustained growth in a low-interest-rate environment makes investors more confident, the Dow could reprice to 20,000 immediately, as the third row of the display shows.
Since most investors today would probably welcome an 8% or 9% return for the next five to 10 years (let alone an immediate market revaluation), the current limited appetite for stocks suggests that investors don’t believe in these scenarios. Most likely, they don’t believe in the consensus forecast of $104 in earnings per share this year or 6% economic growth. So let’s examine the implications for stock returns of lower earnings and slower economic growth.
What If Earnings Fall or GDP Growth Slows?
Many people expect earnings to decline because margins are far higher than usual. If corporate spending picks up from the unusually low levels of recent years, margins would fall, and that could drive down earnings.
We think it’s reasonable to expect margins to decline somewhat—although not necessarily to their historical average. But for the sake of argument, let’s look at what would happen if margins declined from 9.5% today to their long-term average of about 6.75%.
Even in this scenario, the S&P 500 would reach 2,000 and the Dow would reach 20,000 in about 10 years. Applied to current revenues, 6.75% margins would reduce S&P 500 earnings by about 30%—to $74, as the fourth row of the display shows.
While there would likely be a severe market pullback initially, if normal economic growth resumed and P/E ratios normalized, the S&P 500 would have a 5% total return and reach 2,000 in 10 years.
But the global economy is now weak, and the European sovereign-debt crisis could end up being a drag on economic growth for years. What if Europe and theUSenter a lengthy period of disinflation? That’s possible, particularly if policymakers are unsuccessful at addressing the world’s serious macroeconomic problems.
So let’s perform a stress test and assume inflation of only 1%, population growth of 1% and no productivity growth at all. That would give us nominal GDP growth of just 2%. A recent survey of professional forecasters said there’s less than a 10% chance that economic growth will be that slow over the next three years.**
What would these dismal economic forecasts imply about future earnings growth and stock returns? If we assume the S&P 500 earns $74 per share this year, 2% growth would still get us to a 4% annualized market return if the market P/E ultimately returns to average, as the fifth row of the display shows. At that rate, it would take 20 years for the S&P 500 to reach 2,000 and the Dow to reach 20,000. Such returns are hardly enticing, but they are still likely to exceed bonds.
Of course, stock-market returns could be worse than 8% (or 4%), particularly in the short term. S&P 500 earnings could fall below $74, and anxiety could cause market valuations to drop even further below normal; both happened in early 2009. Other market shocks are also possible. For example, very high inflation with slow growth could cause price-to-earnings multiples to contract.
But market returns could also be better. Our stress test incorporated draconian assumptions—a 30% drop in earnings plus no productivity growth at all, a very rare occurrence over a 10-year period. Human ingenuity has led to remarkably persistent and steady productivity growth in the postwar period. In recent years, new technology and globalization have driven productivity growth. In the future, these trends and others not yet imagined are likely to continue to drive it.
Faced with uncertainty and traumatized by losses in recent years, investors who are avoiding stocks appear to be assuming that the worst outcomes are highly likely to occur. Or, perhaps, they’ve just lost their stomach for market volatility and are prizing near-term stability over potential long-term gains.
In my next post, I will compare the likely range of outcomes for stocks and bonds.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.
*World Economic Outlook: Growth Resuming, Dangers Remain, International Monetary Fund, April 2012
**“Survey of Professional Forecasters,” Federal Reserve Bank of Philadelphia, May 11, 2012
Copyright © AllianceBernstein
Tags: Alliancebernstein, Chief Investment Strategist, Company Earnings, Consensus Forecasts, Dividend Growth, Dividend Yield, Dividends, Earnings Growth, Earnings Per Share, Future Stock, Growth Prospects, Intrinsic Value, Premise, Price Earnings, Shareholders, Stock Market, Stock Prices, Stock Returns, Thin Air, Treasury Bond
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Tuesday, August 7th, 2012
Below are charts that show the change in default risk (5-year credit default swaps) over the past two and a half years for six of the most widely followed banks and brokers here in the US. Over the past week or so, these financial firms have seen a pretty big drop in default risk as their stock prices have moved higher.
Morgan Stanley (MS) still has the highest default risk at 322 bps, followed by Goldman Sachs (GS) at 247 bps. Bank of America (BAC) and Citigroup (C) are in the middle of the pack, while JP Morgan (JPM) and Wells Fargo (WFC) have the lowest default risk. Wells Fargo (WFC) is the only company with a 5-year CDS price below 100 bps, clearly establishing it as the “safest” of the big US financial firms.
Tags: Bac, Bank Of America, Banks, Bps, Citigroup, Citigroup C, Credit Default Swaps, Default Risk, Goldman Sachs, Investment Group, Jp Morgan, Jpm, Morgan Stanley, Sachs Gs, Stock Prices, Two And A Half Years, Wells Fargo, Wfc
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Thursday, July 19th, 2012
by Peter Tchir, TF Market Advisors
July 2007 to January 2008
These are the stock prices, “normalized” to 100 in July 2007. In the August swoon, JPM and C did the worst. Barclay’s eventually caught up in later August, while BAC did well. We briefly rallied on a Fed Rate cut in October, but then the swoon returned with C underperforming by far. It was down over 40% in that period. Barclay’s was in the middle, and JPM was actually the best performer, down only 11% by year end.
These are “normalized” CDS spreads. You can see that at first they moved in line, then Barclay’s underperformed, but returned to the fold by the time of the Fed rate cut, and then ultimately we saw a separation as JPM did the best (just like in stocks) and Citi did the worst (just like in stocks). But this overstates the divergence a bit. Looking at the outright spreads shows that Barclay’s actually started the period trading tight, and JPM was the widest, but by the end CDS markets viewed JPM, Barclays, and BAC as similar, but Citi was noticeably wider.
These are “normalized” LIBOR. All banks were submitting very similar rates. Then the stock market decline started and bank LIBOR increased. This was a function of credit spreads. Then as Fed programs kicked in (discount window) and then rate cuts were implemented, LIBOR moved down.
The outlier to me, is Citibank. Citi was the worst on CDS, the worst on stock, but actually did the best on LIBOR? Really? Was Citi really able to borrow from other banks at rates equal to or lower than BAC and JPM? Shouldn’t it have been closer to Barclays? There is the fact that Barclay’s was reliant on BoE rather than the Fed. That is one reason for Citi to more closely track JPM and BAC, but that close? CDS was relatively tame, so maybe the differential in 5 year CDS overstates the issue, but just doesn’t seem right.
August 2008 to January 2009
All the banks moved more or less in line at first. Then Citi, Barclays, and BAC underperformed. For one brief moment, Citi actually bounced and got back to JPM levels, then a long slow decline started. Barclays was for awhile the worst performer, but Citi took over, being down 80% at one stage and finishing down 65%. Those are big numbers. Citi, BAC, and Barclays all saw their stock price decline by 55% to 65%. JP was “only” down 23%.
On a “normalized” basis, it’s surprising to see Barclay’s CDS do better than anyone else’s at any time during the period. What is clear, is that on a “normalized” basis, Citi consistently was the worst name. One spike up with JPM, one with Barclay’s, and one big spike all by itself. But maybe like in 2007, the levels were low enough that the differences might be immaterial?
No, these moves in LIBOR are real. Citi started the crisis as the highest spread name, and maintained that “distinction” throughout the entire period. Barclay’s never traded as wide in CDS as Citi. JPM was probably the best, but BAC wasn’t too far behind (though it widened as noise about hidden ML losses came out). Barclay’s was surprisingly not as bad as I would have guessed. Citi though is just clearly the worst.
This is “normalized” and Barclay’s is a clear underperformer. You can tell when they were allegedly “told to catch up”, but throughout, they remained the high submitter. They underperformed through the entire crisis. Not quite consistent with stocks or CDS and may explain why they complained that others weren’t submitting “true” rates. Citi was somehow consistently able to submit LIBOR that was lower than BAC but was even lower than JPM on some days. By the end of the year, once Barclay’s was presumably fully in liar mode, they were similar to BAC and C. Maybe it’s the normalization process screwing up the data?
I’ve added the 3 month yield so you can get a sense of the Ted Spread, but it is clear that Citi felt they funded in line with BAC and at times with JPM. It is only at the end when we see Citi, BAC, and Barclay’s submit similar rates.
If Barclay’s said others were lying, who could it be? There were days the separation between the U.S. banks and Barclay’s was as high as 100 bps. 50 bps difference wasn’t uncommon. I can justify JPM trading that much better. The stock market performance and CDS of JPM would all be good explanations of why JPM was better than Barclay’s at funding. That much lower, is a guess, but it actually doesn’t seem unreasonable.
Citi in particular looks bad. Especially since BAC’s spikes in LIBOR coincide at least somewhat to times when their stock and CDS underperformed.
This is only one point in one curve. I have focused so far on 3 month USD Libor. That is the most important one in my opinion in terms of number of contracts that reference it. The 1 month has such short duration that I didn’t focus on it yet. The 6 month is interesting because it would have more credit risk and should reflect more differentiation. The same analysis would have to be done for every bank, every currency, and every spot on the curve to get a true estimation of how much LIBOR LYING was done. Determining, or guessing how much each bank lied would be critical to any lawsuit. Lawsuits will ultimately have to be tied to how much a bank lied, and how much of that lie impacted the LIBOR setting. The complex mechanism by which LIBOR is calculated means that not all (or possibly any) of a lie would impact LIBOR’s setting. In spite of Barclay’s rush to catch up, they were still being excluded from the LIBOR calculation on most days for being too high.
From this data, there is no way to prove anyone lied, or to prove by how much if they did.
I have spent more time focused on Barclay’s and their US issues. So far, it looks to me like they were submitting LIBOR more accurately than other and their claims that others were too low seem right. I have more work to do, but am getting to the point where the damage to Barclay’s stock price is worse than the risk.
Concerns over JPM’s exposure seem overdone as well. Yes, they were at the low end of submissions, but I think it would be hard to prove that is a lie without some real evidence. They had low submissions, but their CDS and stock performed the best. I do not think that they can be sued just because they have a large book of business if they didn’t have material amounts of “lying”. Again, I’m not concluding anything yet, but fears related to them seem overdone from all the work I’ve done.
For some reason I want to say something bad about BAC, and my gut tells me I’m right, but as of now, they seem reasonable. Their LIBOR moved with their stock and CDS. Maybe they were slow occasionally, but if anything they come out better so far than I would have guessed.
Citi. It is impossible to say they did anything wrong from the data I’ve looked at, but their submissions don’t pass an initial smell test. If Barclay’s is saying banks were submitting LIBOR that was too low, they strike me as a candidate for much deeper scrutiny. Their stock and CDS did the worst, yet consistently during those peak times, they submitted LIBOR closer to the better performers. Again, it could be a function that it is so short dated, and a function that Barclay’s was so high they were being excluded, but I would want to take a closer look at Citi’s submissions and would be nervous that their stock does not fully reflect the risk.
We are not lawyers, and have no access to actual interbank trades from the time, and this is not a recommendation to buy or to sell, but if the market is going to throw around lawsuit numbers in the $20 billion to $50 billion range and move prices based on that, figuring out how real those numbers are and who would bear the brunt of the burden is key. From all of our work so far, any “manipulation” prior to August 2007 would have had minimal impact as all the submitters were so close together and there really wasn’t a “credit” problem so the fluctuations of LIBOR seem reasonable, at least within a bp or two.
More banks to look at, more points on the curve, and more historical bond prices to dig up.
Tags: Barclay, Barclays, Boe, Citibank, Differential, Divergence, Fed Programs, Fed Rate, Jpm, Liar, Libor, Nbsp, Outlier, Pants On Fire, Stock Market Decline, Stock Prices, Stocks, Swoon, Tf, Year End
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Thursday, July 19th, 2012
by John Nyaradi, Wall Street Sector Selector
Investors are on their own and cannot count on the Federal Reserve to save their portfolios.
Global markets seem to be pricing in a new round of quantitative easing from the Federal Reserve. Dr. Bernanke and his colleagues will likely comply sometime between now and December. However, even with more quantitative easing, investors can’t count on the Federal Reserve to rescue the stock market and their portfolios. We are on our own, and here’s why:
1. Europe’s Debt Crisis
Europe is the crisis that just won’t quit, with Spain, Italy, Greece, ad nauseam , all running out of money. There is simply no solution to this problem as there is simply not enough money in Europe to save Italy and Spain. When the piper finally demands to be paid, no central bank on earth will have the firepower to stop the global financial avalanche that this crisis could trigger.
Second-quarter earnings season is shaping up as a weak affair with downgrades coming from most every sector. As we all know, stock prices eventually are based on earnings, and no amount of monetary policy, low interest rates or quantitative easing can add profits to corporate bottom lines. Monetary policy can set the stage for, but cannot create, demand.
3. Global Recession
This item is part and parcel of Items #1 and #2. Recession is quickly spreading across Europe. China’s economy, while still growing briskly by developed world standards, is rapidly slowing. The United States limps along with a 1.9% growth rate and recent GDP estimates have been sharply revised downwards. Like antibiotics for a sick person, Dr. Bernanke and his Fed can help but the disease must run its course and the patient must have the physical strength to survive on his own.
4. Diminishing Returns of Quantitative Easing
Each round of quantitative easing has smaller impact and brings greater risks for the global economy. Last week’s interest rate cuts by the European Central Bank, the People’s Bank of China and more quantitative easing from the Bank of England were largely ignored by global markets which, in the “good old days,” would have rallied hard on this sort of same-day global intervention. Like antibiotics fighting a virus, quantitative easing is losing its effect as the virus grows immune and mutates to offset continued attacks.
5. The Dreaded Fiscal Cliff
Dr. Bernanke has made it quite clear in recent testimony to Congress that the “fiscal cliff” coming up in December is too big for him to manage and that it needs to be resolved to avoid a significant economic shock. The hit to GDP from the fiscal cliff would likely trigger another recession in the United States (See Item #3)
ETF strategies for difficult days
So what are we supposed to do as we try to protect capital, prepare for retirement and secure our financial futures? Several options come to mind:
A. Cash: Cash is king, particularly in deflationary, depression-like environments. The U.S. dollar, represented by PowerShares DB Bullish Dollar ETF (NYSEARCA:UUP) is up some 5% since early May as capital seeks the perceived safety of the U.S. dollar. Cash doesn’t have to be U.S. dollars, either, as Swiss francs have been on a roll, along with the Japanese yen (NYSEARCA:FXY)
B. U.S. Treasury Bonds: Like the dollar, the U.S. is still seen as the safest harbor in an uncertain world and U.S. Treasuries are near record low yields and high prices as money flocks to the perceived safety of Uncle Sam. The biggest moves will probably come in the long end of the curve and iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT) is up some 14% since early April. iShares Barclays 7-10 Year ETF (NYSEARCA:IEF) has gained more than 5% in the same time frame. One day, the “short” bond trade will be the position of a lifetime, but that day does not look like today.
So now it’s summertime, but the living is not likely to be easy, at least for awhile. (apologies to George and Ira Gershwin, “Porgy and Bess”) We can’t count on Dr. Bernanke and his Federal Reserve to save us from what lies ahead but we can use the power and versatility of exchange traded funds to navigate through these challenging times. We are all alone.
Disclosure: Wall Street Sector Selector actively trades a wide range of exchange traded funds and positions can change at any time. Wall Street Sector Selector holds a position in (TLT)
Copyright © Wall Street Sector Selector
Tags: Ad Nauseam, Bernanke, Bottom Lines, Debt Crisis, Diminishing Returns, Downgrades, Earnings Season, Enough Money, Firepower, Gdp Estimates, Global Economy, Global Markets, Global Recession, Interest Rate Cuts, Italy Greece, Low Interest Rates, Physical Strength, Second Quarter Earnings, Sick Person, Stock Prices
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Wednesday, July 11th, 2012
Could “Confidence” Add 50 Percent to the Stock Market?
by James Paulsen, Chief Investment Strategist, Wells Capital Management
Fear (a lack of confidence) has dominated the economic and investment climate since the 2008 crisis. Indeed, excessive fears during the crisis likely accentuated the magnitude of the economic collapse far more than did poor economic fundamentals alone. Similarly, the inability to revitalize confidence since has also hampered both the economic and stock market recoveries.
A culture devoid of confidence has proved a chronic liability during the last five years. However, could a slow but steady revival in confidence soon become a primary asset driving stock prices higher? For a third time in the post-war era, since 2008, the U.S. stock market has traded below its long-term trendline level (that is, the level of the stock market if it rose through time at a constant pace equal to its long-term average return). While the slope of the stock market’s trendline tends to approximate the sustainable earnings growth rate, the degree to which the stock market trades above or below its trendline level has depended primarily on economic confidence. As shown below, should confidence simply rebound to a normal recovery level in the next several years, the return of the U.S. stock market may be boosted by 50 percent!
Post-War U.S. Stock Market vs. Trendline
Charts 1 and 2 compare both the U.S. stock market and U.S. corporate earnings relative to their respective post-war trendline levels. In each case, the trendlines are calculated by a simple regression of the (natural log) level of the stock market or profits against time. The slope of each trendline is a proxy for the average annualized growth rate over the entire period. Not surprisingly, since stock prices respond to earnings, the trendline slope of corporate profits and of the U.S. stock market are nearly identical at about 7 percent. And, 7 percent is very close to the annualized growth in nominal GDP—since 1949, nominal GDP growth has averaged about 6.7 percent overall. Essentially, over long periods of time, earnings cannot grow faster than overall economic growth and the buy and hold price only return from the stock market approximates the long-term pace of earnings growth.
Is Historic Earnings Trendline a Good Guide to Future?
In the post-war era, the annualized total return from stocks has been about 11 percent comprised by about 7 percent earnings growth and about 4 percent dividend returns. As shown in Chart 1, however, in the last decade, the stock market has significantly trailed relative to its trendline. Is the old trendline growth rate of about 7 percent still a reasonable expectation for the future?
Certainly, U.S. balance sheets are more leveraged today and the savings rate has been far lower in recent years compared to earlier in the post-war era. Moreover, aging U.S. demographics almost ensures slower labor force growth in future years (a moderating force for overall economic growth) unless immigration policy is considerably liberalized. Alternatively, in the last couple decades, the global economy has created a fabulous new economic growth booster—functioning emerging world economies! So far, these new economic entities have mainly augmented supply capabilities but several are on the cusp of becoming burgeoning middle class economies which should dramatically boost global demand and perhaps help maintain global economic growth rates even as developed economies age.
Most encouragingly, however, as shown in Chart 2, U.S. earnings continue to follow the long-term trendline established throughout the post-war era. Despite noticeably slower average GDP growth in the U.S. since 1985, earnings growth has continued to approximate its historic long-term trendline. Indeed, despite the pronounced and ongoing concerns surrounding the contemporary recovery, U.S. earnings bounced quickly above trendline after the recession and have since risen in line with trendline growth. Overall, earnings show no signs yet of breaking below long-term results suggesting the long-term trendline for the stock market may remain near post-war norms.
The Valuation of the Earnings Trend
Although stocks are ultimately tethered to earnings, in the short-run, the stock market often trades at a premium or discount to its trendline. As illustrated in Chart 1, the difference between the stock market and its long-term trendline is a good proxy for investors’ valuation of the long-term earnings trend. Since 2008, for the third time in post-war history, the U.S. stock market has traded persistently “below” its trendline. This also occurred after WWII until the mid 1950s, and again between the early 1970s until the late 1980s.
This is also illustrated in Chart 3. What causes investors to value the earnings trend sometimes at a 25 percent (or more) premium and sometimes at a 25 percent (or larger) discount? Certainly, multiple factors comprise this complicated valuation. During the late 1940s, the discount to trendline seemed to be driven by a post-war inflation surge, in the 1970s escalating inflation and interest rates appeared to lower valuations, and in the contemporary period persistent anxieties surrounding the potential for a global financial calamity have dominated. By contrast, the huge premium paid by investors for trendline earnings in the 1960s coincided with attitudes reflected in the “Camelot Kennedy Years” while the record-setting premium valuation reached in the late 1990s was a product of a “new-era” mania.
Confidence & Valuations
As shown in Chart 4, the discount or premium valuation of the stock market relative to its trendline is perhaps best explained by economic “confidence.” This chart overlays the percentage differential of the stock market relative to its trendline with the consumer confidence index. Although not a perfect relationship, the level of confidence has done a good job tracing changes in the “valuation of the earnings trend” during the post-war era.
Since at least 1950, premium and discount valuations of the stock market to its trendline have corresponded closely with periods of strong economic confidence and periods of broad economic fear. Currently, U.S. economic confidence is hovering in the lowest quartile of its post-war range and the U.S. stock market is about 25 percent below its trendline. This is not a coincidence. As was the case in the late 1940s, early 1950s, and again in the 1970s, early 1980s, a slow but steady revival in U.S. confidence could represent the biggest driver of stock market performance in the next several years!
An Investment Possibility?
The confidence index illustrated in Chart 4 has oscillated between about 60 and 110. With the exception of the late 1990s when the index briefly reached above 110, “normal” economic recovery confidence peaks have been around 100. Stock investors should consider what could happen should confidence slowly recover to normal again in the next five years eventually reaching a level between 95 and 100. Using history as a guide (reading across to the left scale in Chart 4), if confidence returns to normal, the stock market would likely trade at a 25 percent to 30 percent premium to its trendline level.
Of course, in five years, the stock market trendline level will also be higher. If the historic trendline growth rate remains a good guide for the future, the trendline (the dotted line) in Chart 1 would rise by about 7 percent a year in the next five years suggesting a trendline by 2017 of about 2425. However, to be conservative, assume in the next five years trendline earnings only grow at a pace of 3 percent, significantly “less” than the long-term trendline growth rate of 7 percent. Currently, the S&P 500 trades at about 1350 and its trendline level (from Chart 1) is about 1800 (i.e., 25 percent higher than the S&P 500 current price of 1350). With these assumptions, the stock market trendline would rise by 16 percent in five years to about 2100!
Finally, from Chart 4, assume confidence improves from its current level to about 95 boosting the investor valuation of the trendline from its current 25 percent discount to about a 25 percent premium in five years. A trendline target in five years of about 2100, combined with a valuation premium of about 25 percent implies a target price for the S&P 500 of about 2600—nearly a double from today’s level!
While we are not forecasting a doubling of the stock market during the next five years, this analysis does highlight the longer-term upside potential from stocks which exist today solely because of widespread cultural fears. Chart 3 shows the stock market has a historical tendency to oscillate between periods of glee and gloom.
The eventual impact of the Great Depression and WWII on investor attitudes kept the stock market selling at a discount until the late 1950s. By contrast, the cultural euphoria which swept the country during the baby-boom years kept stocks oscillating about a 25 percent premium between the late 1950s and the early 1970s. The stock market could be bought at a 60 to 70 percent discount in the 1970s when runaway inflation and interest rates destroyed confidence. Twenty years later in the late 1990s, investors could not buy stocks fast enough in the “new-era” even though they paid a 60 to 70 percent premium! Since 1945, two bouts of cultural glee (1960s and 1990s) subjected investors to significant risks while recurring bouts of cultural gloom have treated investors with three remarkable “fire sales”—1940s, 1970s, and “today”! Stock prices will continue to oscillate and scary sell-offs will occasionally feed fears, but don’t miss this sale!
Tags: Chief Investment Strategist, Corporate Earnings, Corporate Profits, Earnings Growth, Economic Collapse, Economic Confidence, Economic Fundamentals, Investment Climate, Lack Of Confidence, Post War, Simple Regression, Slope, Steady Revival, Stock Earnings, Stock Prices, Third Time, Trendline, Trendlines, U S Stock Market, Wells Capital Management
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Thursday, June 7th, 2012
by Dr. Ed Yardeni, Yardeni Research
What’s the difference between a correction and a bear market? The conventional definition is that the former is a drop in stock prices that falls short of a 20% decline. Anything beyond that is a bear market. A correction tends to be caused by falling valuation multiples (P/Es), triggered by fears that earnings will drop. If earnings remain stable or continue to rise, contrary to expectations, then the P/E rebounds and the bull market resumes. If earnings do fall, then P/Es may continue to do so too, resulting in a bear market. So corrections are panic attacks that aren’t validated by the fundamentals. We had a nasty correction two years ago and another one last year. It is happening again this year:
(1) During 2010, the S&P 500 forward P/E dropped 22% from a high of 14.7 on January 11 to a low of 11.4 during August 26. However, forward earnings rose all year. So the 16% correction in the S&P 500 from April 23 to July 2 was reversed by the end of the year, with the P/E ending at 13.1.
(2) During 2011, the P/E fell 25% from 13.6 on February 18 to 10.2 on October 3. Forward earnings rose during the first half of the year and remained mostly flat during the second half at a record high. So once again, the market recovered and closed higher by the end of the year with the P/E rebounding to 11.7.
(3) During 2012 so far this year, the P/E peaked at 13.0 on March 26. It was down 11% to 11.6 yesterday, just about matching the 2010 low, which was 11.4. The S&P 500 is down 9% from its high on April 2, which is still just a garden-variety correction. Meanwhile, forward earnings rose to a new all-time record high of $111.27 during the week of May 31. At this level, a retest of last year’s panic low P/E of 10.2 would push the S&P 500 down to 1135, which would be a 20% decline from the year’s high on April 2.
As you can see in our Earnings & Valuation: S&P 500 Blue Angels, the market’s volatility is attributable almost entirely to the volatility in the P/E. Earnings expectations tend to change more slowly and smoothly. The one exception is during recessions, when both variables take a dive. During the bear market from October 9, 2007 through March 9, 2009, the P/E plunged 32% from 15.1 to 10.2, with forward earnings diving 29%. The P/E actually bottomed at 8.9 on November 20, 2008.
Today’s Morning Briefing: Corrections vs. Bear Markets. (1) P/E times E. (2) Corrections are driven by P/E. (3) Bear markets caused by earnings recessions. (4) A review of recent history. (5) Just another correction? (6) Earnings and valuations plunged during Great Recession. (7) A relatively optimistic outlook for revenues. (8) Profit margin going nowhere for a while. (9) Corporate cash flow hit by smaller depreciation expenses. (10) Wisconsin’s winner. (11) PATCO for public employee unions. (More for subscribers.)
Tags: Amp, Bear Market, Bear Markets, Blue Angels, Conventional Definition, Decline, Dr Ed, Earnings, Ed Yardeni, Fears, Garden Variety, Nbsp, Panic Attacks, Rebounds, Retest, Second Half, Stock Prices, Time Record, Yardeni Research, Year 1
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Wednesday, May 2nd, 2012
Is it Déjà Vu all Over Again?
April 30, 2012
by James Paulsen, Chief Investment Strategist, Wells Capital Management (Wells Fargo)
After nearly six months of persistently better-than-expected economic reports and a regularly rising stock market, metrics on the economy have turned a bit more mixed lately while stock market prices have struggled in recent weeks. This has caused many to wonder whether the economy and the stock market are headed again toward another “spring swoon” like those experienced during 2010 and 2011.
Spookily, conditions do seem remarkably similar today to those which preceded the last two spring thaws. In 2010, the stock market peaked on April 23 and in 2011 it peaked on April 29. Well, it’s April again and stocks are struggling? Moreover, in each of the last two years, just like this year, the spring stalls were preceded by improved economic reports and by a surge which carried stock prices to new recovery highs. Finally, rising gas prices have again played a dominant role in recent months as they did leading up to both of the last two spring swoons.
So, is everyone best advised to simply “Sell in May and Go Away”—something which worked well in each of the last two years? Although similarities to past swoons are troubling and while the recovery will inevitably “ebb and flow,” there are several critical differences evident this year which should help keep the economy and the stock market out of “swoon’s way” during the balance of 2012.
Economic Policies are More Accommodative
Economic policies are notably more accommodative today compared to either 2010 or 2011. In 2010, the pace of the M2 money supply had slowed to a restrictive 1 percent annual pace, and in early 2011 it was only rising at a very modest 4 to 5 percent pace. By contrast, today, the annual growth in the M2 money supply has persisted about a robust 10 percent clip since last fall!
In both early 2010 and early 2011, the 30-year national average mortgage rate (Chart 1) rose above 5 percent prior to the spring swoons. Today, the mortgage rate is near an all-time record low below 4 percent! Significant accelerations in consumer inflation ravished household real incomes prior to both the 2010 and 2011 economic stalls. As illustrated in Chart 2, the annual rate of consumer price inflation jumped from -2 percent (deflation) in mid 2009 to about +2.5 percent by early 2010. Similarly, the annual inflation rate rose from about 1 percent at the end of 2010 to about 3.5 percent by 2011 springtime. These spikes in consumer prices significantly reduced real household income gains. Today, by contrast, real incomes are being boosted by a decline in the consumer price inflation rate from about 4 percent last fall to 2.7 percent currently!
While the Japanese tsunami had ravished U.S. manufacturing supply chains last year, today the “Japan bounce” is helping revive U.S. industrial activity. Finally, global economic policy officials are almost universally accommodative today. Until last fall, euro-zone officials refused to ease interest rates or expand the ECB balance sheet. Recently, however, both policies have been eased significantly! Similarly, until late last year, most emerging world economic policy officials were attempting to moderate recoveries by tightening policies. Now, nearly all of the emerging world is easing conditions to reaccelerate recoveries.
In both 2010 and 2011, economic policies were decidedly more restrictive and probably played a significant role in the resulting economic and stock market swoons. Today, however, much more accommodative global economic policies should bring a more favorable outcome.
U.S. Economic Recovery More Mature
The spring swoon in 2010 hit before the economic recovery had even reached its first anniversary. Today, the recovery is much more mature and therefore less vulnerable to swoons than it was in either 2010 or 2011.
Several recent economic reports portray a maturing economy. In the first quarter, average monthly job gains were in excess of 200 thousand for the first time in this recovery. Initial weekly unemployment insurance claims have finally fallen below 400 thousand and the unemployment rate is enjoying its most persistent decline of the recovery. Additionally, the present situation consumer confidence index (Chart 3) has risen to a new recovery high, the economy has enjoyed the most robust retail spending of the recovery, auto sales have again recovered to about a 15 million annual pace, and an array of recent housing reports suggest the greatest level of housing activity since the industry collapsed. Finally, bank loans (Chart 4), absent during much of the first two years of this recovery, have risen steadily during the last year!
While the economic recovery has not yet surged ahead with strong momentum, many of the traditional engines of growth which often suggest a sustainable recovery (e.g., job creation, consumer and business confidence, improvement in big ticket spending propensities on cars and homes, and better bank lending) are now increasingly evident. With the economy simultaneously firing on so many more cylinders than it was in early 2010 or early last year, it appears much better equipped to weather adversities.
Household Fundamentals Much Improved
The U.S. household is also much less vulnerable to shocks compared to earlier in this recovery. Consumer fundamentals have improved markedly in the last year. The job market has finally come to life, consumer confidence has risen to its highest level of the recovery, and real wages and salaries are rising by about 2 percent in the last year compared to a negative growth rate in early 2010. The U.S. personal savings rate has averaged 5.1 percent in the last four years which represents the highest persistent savings rate in more than a decade, and the U.S. household liquidity ratio (cash holdings as a percent of net worth) has been hovering about a 20-year high since the start of the recovery. Moreover, despite virtually no recovery yet in housing prices, households have already regained almost two-thirds of the loss in net worth experienced during the crisis.
Tags: April 29, Chief Investment Strategist, Critical Differences, Dominant Role, Economic Policies, Economic Reports, Investment Outlook, M2, Market Metrics, Money Supply, Pace, Rising Gas Prices, Six Months, Spring Thaws, Stock Market Prices, Stock Prices, Swoon, Swoons, Wells Capital Management, Wells Fargo
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Wednesday, April 25th, 2012
Today’s report of Consumer Confidence for the month of April came in at 69.2, which was slightly weaker than expected (69.6) and down modestly from last month’s downward revised reading of 69.5.
One interesting aspect of the Consumer Confidence report is the spread between those Americans making more than $50K per year and those making between $35K and $50K per year. It is no surprise that Americans with higher incomes are typically more confident than Americans with lower incomes. What is noteworthy, however, is the growing divergence in confidence between the two groups. Although the current six month average reading is down sharply from last May’s record high reading, since the early 1990s there has been a clear trend higher in this spread.
The two charts below show the historical levels of the percentage of Americans expecting higher and lower stock prices and interest rates. Currently, 35.7% of those asked expect stock prices to rise, while 29.1% see stock prices falling. For those looking for comparisons to last year, this marks the second straight month where more people expect stock prices to rise than decline. The last time this occurred was back in April 2011. The lower chart shows the percentage of consumers expecting higher and lower interest rates. Just as more Americans expect higher stock prices than lower prices, more Americans also see interest rates rising versus falling. It has now been 36 straight months that at least 40% of consumers have been expecting higher interest rates. The last time this number was less than 40% was back in April 2009 when the 10-Year US Treasury was yielding about 3.2%. Today the 10-year is yielding under 2%.
Tags: 35k, Consumer Confidence Report, Consumer Report, Consumers, Decline, Divergence, Early 1990s, Incomes, interest rates, Last Time, Month Of April, Stock Prices, Surprise, Treasury
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Tuesday, April 24th, 2012
“Dow Direction Dictates”
by Jeffrey Saut, Chief Investment Strategist, Raymond James
April 23, 2012
“The absolute price of a stock is unimportant. It is the direction of price movement which counts.”
During major sustained advances in stock prices, which usually occupy from five to seven years of each decade, the investor can complacently hold a list of stocks which are currently unpredictable. He doesn’t worry about the top because he knows he is never going to sell at the top. He knows that the chances are overwhelming in favor of the assumption that he will get far better prices by waiting until after the top is passed and a probable reversal in trend can be identified than he will ever get by attempting to anticipate the top, and get out on the nose.
In my own experience the largest profits we have ever taken have come from stocks purchased while they were making a new high in a market which was also momentarily expecting the top. As I have already pointed out the absolute price of a stock is unimportant. It is the direction of the price movement that counts. It is always probable, but never certain, that the direction of the price movement will continue. Soon after it reverses is time enough to sell. You should sell when you wish you had sold sooner, never when you think the top has arrived. That way you will never get the very best price—by hindsight your individual transactions will never look daring. But some of your profits will be large; and your losses should be quite small. That is all that is necessary for a satisfactory, enriching investment performance.
Stock Profits Without Forecasting – by Edgar S. Genstein
These are two of the most important paragraphs I have encountered in 45 years of studying markets. DO NOT read them just once. Go off to a quiet spot that invites contemplation and READ THEM SEVERAL TIMES. Then reflect on all of the mistakes you have made in trading and investing. Bells will ring, and curses will be uttered, if you are truly honest with yourself. My advice is to keep this quote handy, read it over, and study it every time you get ready to make an important buy or sell decision; especially if your emotions reign.
Obviously, I agree with Mr. Genstein’s advice, but over the years have added a “twist” to his sage strategy. That twist has been to be a scale-up seller in select stocks that have appreciated when I think I should raise some cash. This does not mean I sell the entire position if I continue to find the fundamentals to be favorable. But, scale selling partial positions accomplishes a number of things. Firstly, it allows capital gains to accrue to the portfolio (sometimes long-term capital gains and sometimes not). Secondly, it rebalances said stock position back towards the original portfolio weighting intended. Thirdly, it tends to give me the “margin of safety” mentioned in Benjamin Graham’s book “The Intelligent Investor.” To wit, this strategy allows me to hold some of my original investment positions until I “wish I would have sold them sooner.”
I revisit this topic this morning after spending last week in Colorado speaking at several events and seeing institutional accounts. Unsurprisingly, most of the institutions have had a difficult time over the past few months. As one portfolio manager put it, “While we make money in one position we give more than that back in another.” Indeed, since the “buying stampede” ended on January 26th it has been a market in which it has been pretty easy to lose money. For example, at the intraday high of January 26th the D-J Industrial Average (INDU/13029.26) traded at ~12842. Last Friday the senior index closed at ~13029 for a 12-week gain of 0.015%. Meanwhile, many individual stocks have fared far worse. As for retail investors, my presentations to them last week found most frozen like a deer in the headlights of a car buffeted by the recent decline and the negative “spin” from the media; so let me address the recent action.
Recall that we advised raising some cash following the cessation of the “buying stampede” in anticipation of a 5% – 8% pullback in the major averages. That said, our mantra was, “You can be cautious, but do not get bearish.” Some took that “raise cash” advice, but most did not, imbibed by the Dow’s 14.3% rally from mid-December, and its 23.4% rally since the October 4, 2011 “undercut low” that we actually recommended buying. Now, however, the Dow’s 4.4% decline from its April 2nd peak into its April 10th reaction low has brought back memories of last year’s May to August angst, which lopped 17.6% off the Industrials. While the recent news backdrop is less appealing than that of October – February, it is still not a reason to believe we are going to see another May through June swoon of over 17%. Let’s examine why.
In the last tactical bull market of October 2002 through October 2007 (60 months) there were nine such 4% or greater pullbacks, yet stocks traded higher after each correction. In the current tactical bull market of March 2009 to present (37 months) there have already been eleven 4% or greater pullbacks and each time stocks have also subsequently traded higher. Clearly the frequency of corrections/pullbacks has increased in the current cycle likely driven by memories of the Dow’s 54.4% massacre between October 2007 into the March 2009 bottom that at the time we deemed would be similar to the “nominal” price-low of December 1974 (that was the “nominal” price low of that wide-swinging, trading-range 1965 – 1982 affair). More recently, we have likened last year’s October 4th “undercut low” to the valuation-low that occurred in August 1982 since valuations last October were at levels not seen in decades. Whether we have begun a secular bull market like that of August 1982 – January 2000 is debatable, but we doubt last October’s low will be violated.
Nevertheless, since the beginning of February there have been a number of gleanings that left us in cautious mode. The parade looks like this: an upside non-confirmation by the D-J Transports (TRAN/5234.25), the small-caps also failed to confirm the upside with the Russell 2000 (RUT/804.05) subsequently experiencing a 7.5% decline, weakness in the market-leading Financial SPDR Fund (XLF/$15.18), worsening Advance/Decline and New High/New Low figures, a 90% Downside Day on April 10th, waning Buying Power, an exhaustion of the stock market’s weekly internal energy, softening economic reports, and the list goes on. On the positive side: the stock market’s daily internal energy has a full charge of energy, an 8.53% drop in the price of gasoline last week, an earnings reporting season that has so far seen 72% of companies beating estimates and 70% beating revenue estimates (more importantly, after two quarters of reducing guidance companies are now raising future earnings guidance), late Friday the IMF announced it has raised another $430 billion to be used if Euroquake worsens, a U.S. dollar that looks like it is breaking down (read: a positive for stocks), and hereto the list goes on. All of this continues to leave us chanting, “You can be cautious, but do not get bearish!”
This week we will see more major companies reporting earnings. From our research universe, stocks that are favorably rated by our fundamental analysts and appear positive on our proprietary algorithms are: Brinker (EAT/$27.90/Strong Buy); Baidu (BIDU/$144.91/Strong Buy); Pultegroup (PHM/$8.37/Outperform); and Caterpillar (CAT/$107.73/Outperform – covered by Raymond James Ltd.).
The call for this week: For the past few weeks I have wrongly suggested that my sense is the S&P 500 (SPX/1378.53) will remain mired in the 1385 – 1425 consolidation zone. As paraphrased:
I think the SPX needs to convalesce in the 1385 – 1425 zone while the short-term overbought condition is alleviated and the market’s internal energy is rebuilt. Interestingly, while my daily internal energy indicator now has more than a full charge of energy, the weekly energy indicator is nowhere near being fully recharged. The implication is that the downside should be contained, but the SPX is also not likely to breakout above 1425 without spending more time consolidating. … Importantly, all of the pullbacks in the SPX this year have been between 25 and 35 points. Accordingly, measuring from the recent reaction high of ~1419 produces a level of 1394 for a 25-point correction, and 1384 for a 35-pointer. Hence, anything more than a 45-point pullback would put the SPX below the bottom of our 1375 – 1385 support zone and suggest something has changed, potentially bringing into view the 1320 – 1340 zone.
Subsequently, the SPX dropped below that envisioned zone, yet has rallied back into the 1375 – 1385 zone, which has now become an overhead resistance level. And for these reasons we counseled for caution before leaving for Colorado last week. Our advice was not to sell short, not to add to existing long positions, not to raise cash since we have already raised cash, but rather to sit tight because the downside should be contained in the 1320 – 1340 zone. Confidence that downside objective will be achieved grows if the April 10th intraday low of 1357.38 is violated. And this morning that pivot point looks like it is going to be tested with the preopening futures off some 14 points. Indeed, “The absolute price of a stock is unimportant. It is the direction of price movement which counts.”
Copyright © Raymond James
Tags: 45 Years, Assumption, Bells, Chief Investment Strategist, Contemplation, Curses, Dow, Edgar, Hindsight, Investment Performance, jeffrey saut, Nbsp, Paragraphs, Performance Stock, Quiet Spot, Raymond James, Saut, Seven Years, Several Times, Stock Prices, Stock Profits
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Friday, April 13th, 2012
by Neel Kashkari, Head of Equities, PIMCO
- Stock prices today are anchored on strong profits, hence investors’ intense focus on the sustainability of those profits. If they fall, stock prices are likely to follow.
- No doubt individual companies and individual sectors will face margin pressure. But for the equity market as a whole, our central scenario is for corporate margins to remain strong in the near future.
- As always, we are buying individual companies we like based on our analysis of their own fundamentals in the context of the economic environment they are operating in, and we are keeping one eye focused on managing downside risks.
We’ve all heard the story of Sir Isaac Newton sitting in his garden pondering the universe when an apple fell from above and supposedly smacked him in the head. It is said to have been a Eureka! moment when Newton first asked the fundamental question: Why? Why did the apple fall? For centuries people had seen objects fall, but Newton was the first to question what the rest of humanity had just accepted for thousands of years. Today Newton’s question seems obvious – but the most powerful ideas are usually obvious after someone points them out. Newton’s ability to see through the common beliefs of those around him and spot something important is a trait shared by scientific visionaries over the centuries – and one that the most successful investors have occasionally exhibited.
Newton’s questioning of nature led to his development of fundamental laws of physics that have transformed our understanding of the universe. Indeed, in many ways Newton’s ideas have become our own common beliefs similar to those that Newton so brilliantly looked past in his own time. Newton’s Laws, as they are called, are taught in introductory physics classes worldwide:
- A body at rest tends to stay at rest. A body in motion tends to stay in motion.
- Force is equal to the product of mass times acceleration.
- For every action there is an equal and opposite reaction.
These simple rules permeate our beliefs about how the world works and we often don’t realize it. When people say “what goes up must come down,” they are implicitly referring to Newton’s Second Law: In the presence of earth’s gravity, a mass will always accelerate in the direction of that force. Hence, an apple thrown in the air (or grown on a tree) will eventually fall to the ground.
These Newtonian beliefs also affect how many people think about investing. “Mean reversion” is the investment world’s version of “what goes up must come down.” It’s usually a pretty good rule. Mean reversion suggested that the extraordinary price to earnings multiples of technology stocks in the late 1990s couldn’t last; they would eventually revert to historical average valuations. Similarly, mean reversion suggested that house price increases in the U.S. in the mid-2000s weren’t sustainable. They didn’t last either.
But is mean reversion always right? In 2000 mean reversion would have suggested the bull market for bonds would be over. Interest rates couldn’t stay low, let alone fall further, could they? But here we are in 2012 and we’re not predicting a bear market any time soon.
In tension with mean reversion is Newton’s First Law: A body at rest tends to stay at rest. In investment parlance there needs to be a catalyst to force the system to revert to the mean. Left alone, it may continue in its elevated state for a long time.
The timing of that reversion matters: Just because someone can identify a bubble doesn’t mean they can make money from their insight. People who shorted tech stocks too early may have lost a lot of money while the bubble kept expanding.
Today many equity investors are asking whether corporate profit margins can stay strong. Coming out of the financial crisis, many large corporations, especially multinationals, have enjoyed record profits. This is counterintuitive given the low growth much of the developed world has experienced during this time. Corporations responded to the financial crisis by paying down debt and cutting costs, positioning them for strong profit growth as their end markets slowly recovered. Figure 1 is a chart of corporate profit margins, earnings multiples and the overall level of the S&P 500.
Global equity markets have climbed 6.5% year to date (source: MSCI World Index through 11 April 2012). With record profits, earnings multiples still seem reasonable at 14.5 times. Stock prices today are anchored on strong profits, hence investors’ intense focus on the sustainability of those profits. If they fall, stock prices are likely to follow. To assess the vulnerability of profit margins, let’s review several possible catalysts for profit mean reversion and consider how likely they are to occur:
1. Increase in Cost of Labor
Labor costs are about 70% of the total cost of production for corporations, according to Federal Reserve research. There is no question that if competition for a finite labor pool increased, this could put immediate pressure on corporate margins. However, in the U.S. unemployment remains high, stuck at 8.2% as of March 2012, with 14.5% of Americans either out of work or looking for more work (source: Bureau of Labor Statistics). Obviously individual industries and companies may experience wage inflation due to scarcity of workers with specialized skills, but until unemployment falls closer to more normal levels, corporate margins do not appear vulnerable from a spike in unit labor costs. Last week’s disappointing jobs report highlights labor’s slow recovery.
2. Economic Slowdown or Recession
Clearly if the U.S. or world economy were to meaningfully slow or fall into another recession, corporate profits and stock prices would suffer. Our base case continues to be a muddle-through scenario of low growth while avoiding recession in the U.S. and globally (though we do forecast a recession in Europe due to their fiscal crisis and policy response). Certainly a disorderly unraveling of the eurozone, an oil price shock or a hard landing in the emerging markets could tip the global economy into recession, but that is not our central scenario.
3. Dollar Strengthening
Strong appreciation of the dollar would make U.S. exporters less competitive, which would certainly affect their margins. But companies producing goods and services abroad for sale in America would benefit. Our base case scenario is for a long-term secular decline of the dollar, which assumes continued strengthening of emerging market economies and a Europe that muddles through its fiscal crisis. If either proved incorrect, they could trigger a global recession, which would have a larger impact on corporate margins than dollar strengthening alone.
4. Cost of Capital Increase
If costs for corporations to borrow or to raise equity capital increased substantially, corporate margins would be vulnerable. Corporations today on average have low net leverage with record cash of some $2.23 trillion, according to Federal Reserve data. Climbing rates could pressure corporate margins. They could also push companies to grow more slowly or even contract their activities. Again, this is not our central forecast. We believe the Federal Reserve will stick to its forecast of maintaining exceptionally low rates until at least late 2014, and we believe the European Central Bank will be forced to continue aggressive monetary stimulus to combat its fiscal crisis. It is worth noting that corporations could in fact increase their net leverage from today’s conservative levels, which could actually boost corporate margins.
5. Increased Corporate Taxes
If the federal government increased effective taxes on corporations their net margins would obviously fall. But this appears highly unlikely in today’s political environment. Both Democrats and Republicans are advocating various policies to boost job growth, including pro-growth corporate tax reform. The most common tax reform proposals are revenue neutral, lowering marginal corporate tax rates in exchange for eliminating loopholes and deductions. Policy theory suggests a simpler, fairer tax code should encourage investment and enhance economic competitiveness. While political winds can change direction, as long as unemployment remains high, politicians will be cautious about increasing barriers for corporate investment.
None of these catalysts for profit mean reversion appears likely in the near future, though each is impossible to rule out. Given the importance of corporate margins on today’s stock prices, it is worth taking this review further and also considering a macroeconomic perspective on margins.
Some investors have used the Kalecki profits equation to break corporate profits into its fundamental macroeconomic elements, specifically:
Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends
From this equation, investors can see that corporate profits have expanded to such a large share of GDP due to large government deficits. Therefore, if the government implemented a deficit reduction plan, corporate profits could suffer.
Let’s explore this scenario in more detail. We know that Washington D.C. is currently dysfunctional and that large deficit spending is ultimately unsustainable. However, if Republicans and Democrats can agree on anything, it is to keep spending. This is the reason Washington hasn’t produced a new Federal budget in three years – they have simply agreed to extend the status quo. Hence the dysfunction of Washington suggests no meaningful deficit reduction agreement in the near future. Don’t forget that President Obama and both Congressional Republicans and Democrats were united in their dismissal of the serious Simpson-Bowles deficit reduction plan.
Let’s say the tone in Washington does somehow change and consensus is reached to bring the Federal budget into balance. Policy analysts of both parties know that long-term deficits are being driven by demographic changes and the long-term expansion of entitlement programs for our aging society. As with Simpson-Bowles, any major deficit reduction agreement would almost certainly phase in slowly, over many years. Even though current law prescribes a fiscal cliff at the end of this year due to last year’s temporary budget and debt ceiling extensions, Washington will almost certainly agree to delay this deadline. It is hard to imagine an abrupt fiscal adjustment happening in the near future.
If there were a long-term grand bargain, it is true federal government deficits as a percentage of GDP would likely fall, but such a scenario would almost certainly be a net positive for confidence in our economic and political systems and provide a strong tailwind to economic activity. Even if corporate margins fell as federal budgets gradually came into balance, it is easy to imagine corporate profits continuing to grow. It is ultimately the dollars of profit, rather than margins, that drive the value of companies. It is hard to see corporate profits, or stock prices, falling because of long-term fiscal discipline.
These considerations all suggest corporate profits are not on the verge of collapsing. In fact, we are optimistic corporations, on a case-by-case basis, can even continue to improve them through the adoption of new technologies. As always, we are buying individual companies we like based on our analysis of their own fundamentals in the context of the economic environment they are operating in, rather than buying sectors or the market as a whole. No doubt individual companies and individual sectors will face margin pressure. But for the equity market as a whole, our central scenario is for corporate margins to remain strong in the near future. Profits are strongly correlated to nominal GDP. The Federal Reserve’s commitment to lowering unemployment through aggressive monetary stimulus should support both nominal GDP and corporate profit growth.
As we’ve written in the past, we are keeping one eye focused on managing downside risks in our equity portfolios. Serious risks from Europe remain, and at some point the Federal Reserve will have to end its aggressive easing policy. We are still living in a bimodal world, but we are finding good companies today at attractive values that are selling into higher growth markets. We prefer those with strong balance sheets that are paying healthy dividends.
Given the investment analogies of Newton’s First and Second Laws, you may be wondering if there’s an investment analogy for Newton’s Third Law: For every action there is an equal and opposite reaction? Yes: There is no free lunch. That’ll be the subject of a future Equity Focus. In the meantime, be wary of predictions of falling apples (I’m talking about the fruit).
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.
Tags: Accelera, Apple Fall, Body In Motion, Downside Risks, Economic Environment, Fundamental Laws, Fundamental Question, Individual Companies, Intense Focus, Introductory Physics Classes, Isaac Newton, Laws Of Physics, Margin Pressure, Margins, Mass Times, No Doubt, Own Time, Sir Isaac Newton, Stock Prices, Visionaries
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