Monday, April 2, 2012

“The Market – Like Goldilocks’ Porridge, Neither too Hot, Nor too Cold”

Sydney M. Williams

Thought of the Day
“The Market – Like Goldilocks’ Porridge, Neither too Hot, Nor too Cold”
April 2, 2012

There is risk in today’s market. But there always is.

The 12% gain for the S&P 500 represents that indices best gain for a first quarter since 1998. The gain in NASDAQ’s first quarter (+18.7%) was the strongest since 1991. As the old ad for Virginia Slims went, “You’ve come a long way, baby!”

Since the lows were reached in March of 2009, the S&P 500 has gained 113%, or a CAGR of 28.4%, making the market look expensive on that metric. However, that rise was off of a very low base. When one takes a longer horizon of ten years, the same index has compounded at a nominal rate of 2.7%, making stocks – again, using that metric – appear inexpensive. Going back further, twenty years, the S&P 500 compounded at 6.5%, suggesting the porridge is neither too hot nor too cold, but just about right. The twenty-year numbers represent one very strong decade, followed by a weak one. As a believer in trends reverting to the mean, it is difficult to get overly excited about equity prices, but neither should one be unduly negative.

At 13.7X a consensus earnings estimate of $103 for 2012, the S&P 500’s valuation, given interest rates, looks reasonable, but not exceptionally appealing if rates start backing up, as I suspect they will over the next several years. (However, between 1945 to 1968 interest rates rose modestly, and stocks did very well.) Should the economy continue to gradually improve, as I believe it will, and if corporations persist in improving productivity, as they should, the market’s future gains should approximate corporations increase in earnings. However, following the snap-back in earnings after the recession, the rate of gain should moderate.

In comparison to other assets, stocks, despite their move, appear attractive. U.S. Treasuries have been correcting, but yields still appear too low relative to inflation expectations. Spreads between Investment Grade Corporates and Treasuries have narrowed from 411 basis points on December 31, 2008 to 167 basis points today, suggesting that the bond rally may be nearing its apex. The spread between Corporates and high yield bonds, over the same time, has narrowed from 1108 basis points to 325 basis points. It may not go higher, but gold is four times higher than it was ten years ago, indicating that there are a lot of believers in the metal.

There are some statistics that are eye-catching. Cash on corporate balance sheets approximates two trillion dollars (including cash held overseas), but almost one quarter of that is held by ten companies, with three companies – Apple, Microsoft and Cisco – accounting for just under $200 billion, or ten percent of that cash. Corporate pretax profits now account for 12.5% of GDP, the largest share since 1950, while wages and salaries account for the smallest share of GDP (54.9%) since 1955. According to the Financial Times, capital expenditures are surpassed by internally generated cash flows at a quarterly annualized rate of $200 billion. However, the FT quotes RBC in noting that corporate buybacks and dividends combined are now outpacing earnings.

Offsetting those somewhat Panglossian statistics, however, is the uncertainty surrounding both the Affordable Care Act and the fate of the Bush tax cuts. As we all know, the market does not like uncertainty, despite that being a constant condition whenever one is contemplating the future. Nevertheless, these two issues loom large. The good news is that both will be settled within nine months; the bad news is that we don’t know what the outcome will be. I would argue, though, that to the market, in the near term, resolution is more important than the outcome.

The S&P 500 closed at 1408.47 for the quarter, and has been flirting with the 1400 level for the past two weeks. Twice, in the past thirteen years, that index has closed above 1400. The first time was in July 1999 and the second time occurred in November 2006. In both cases, the index continued to do well for about a year. It peaked in March 2000 at 1553.11 and in October 2007 at 1576.09. Perhaps the lyrics to the song will be auspicious: “Third time lucky and you’ve arrived.”. On the other hand, we know it took Robert the Bruce’s spider seven attempts to attach its web.

Morgan Stanley had a comment on the market that Jeff Somers discussed in his column in Sunday’s New York Times. As a small fish, it’s always interesting to read what the “big guys” are thinking. They conclude that “macro conditions are vastly different than in 2006 (to which I say ’Duh!’) and largely worse,” to which I ask ‘Really?’ They point out that GDP has been weaker and that inflation has been stronger today than in 2006. They point out that unemployment is higher today, “shockingly steep” is the way they put it, and that the trajectory of profit growth is flattening. They note that corporate balance sheets are in generally better shape, but that the Federal Reserve’s balance sheet has tripled to $3 trillion. However, they neglected to point out that in 2006-2007 we were on the cusp of the largest credit crisis the monetary system had confronted since 1907 and about to enter the worst recession since the Great Depression. Retrospect tells us that there was a good reason for the market to fall sharply from 2007 to 2009. Nobody knows what the next five years will bring, but I wager it will not be as bad as what we experienced.

Having written that, there is a lot that worries me. The size of government debt is one, and the decision by the Fed to keep rates abnormally low permits spenders in Congress to not have to face the full consequences of their prodigal ways. Combined, according to Bloomberg, the fifty states have promised their employees retirement healthcare benefits of $627 billion, of which only four percent is funded. Unfunded state and municipal pension liabilities amount to as much as $4 trillion. For the last ten years, the U.S. has pursued a policy of dollar depreciation. During that time the U.S. Dollar Index has dropped 31.6%. The Middle East is in turmoil, but when has it not been? Many have counted on China to be the engine of global growth, and they seem to be struggling. Europe reflects the failure of socialism, but there is nothing new in that. The President seems determined to expand the size of government relative to GDP, with the result being reduced freedom and opportunities for individuals. But none of these concerns are new. The market has been studying them for years. The negatives are, as Laszlo Birinyi, has said, as prominent as the nose on one’s face – Mr. Birinyi’s Cyrano principle.

Thirteen years ago (the first time the S&P 500 was in this realm), the markets were completing an eighteen year period during which S&P 500 compounded at 16.3% on a price basis – the largest gain for that period of time in the history of the stock exchange. What we have been doing is digesting the extraordinary gains of the past. The python swallowed a horse; he has stopped eating; the question is, how far along the python’s alimentary canal has the horse traveled?

I conclude where I began. The market has enjoyed a good three years. Unfortunately money flows into equity mutual funds suggest a lot of people missed the rally, as flows have been negative and continue to be so into March. In contrast, flows into bonds have been positive. Markets, in their diabolical fashion, have a tendency to do what is inconvenient and least attractive to the most people. Equity investors should not be frightened by continued outflows, in fact, that should be placed on the positive side of the ledger, as they weigh options. Consumers, very recently, have increased spending at a rate higher than incomes, diminishing savings. That should go on the negative side. Keep in mind, this has been a highly correlated market, which should provide opportunities to stock pickers. Valuations, in general, look ok to me – not great, but not terrible – a lot like the porridge Goldilocks chose, just about right.

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