Equity Investment Outlook
April 2013
Every so often we write an Investment Outlook with conclusions that prove to be both accurate and worth repeating. Such is the case with our prior outlook issued in January 2013. In it we stated that “At the risk of sounding complacent, we believe that the fundamental trends that produced such favorable results in 2012 are still in place and should support another good year in 2013. We are not blind to the challenges and uncertainties that still face us, nor do we believe that the year ahead will be devoid of volatility. Rather, it is our view that the favorable trends now in force can ultimately prevail over the unfavorable.” We stick by this conclusion.
During the first quarter of 2013, the stock market, as measured by the S&P 500 Index, enjoyed a total return of 10.6%. First quarter U.S. gross domestic product growth appears to have been much stronger than expected, perhaps even topping 3%. Inflation remained tame at approximately 2% and corporate profits likely rose over 3%. The most recent economic data, however, point to slower growth and this could trigger a short term market correction.
Europe continues to lurch from crisis to crisis in what looks more like a long-running reality TV show than an existential threat. In the U.S., Washington continues to air its own melodramatic reality show, but frankly the viewing audience is apparently bored with the incessant wrangling and has switched the channel. In fact, when Congress unleashed the much feared doomsday machine – Sequestration – the market yawned. Sequestration is a blunt, ham-fisted way of controlling federal spending and could pare about 1.0-1.5 % from GDP growth. Sequestration is not the end of the world if we are correct that the private sector growth has finally shifted into higher gear. Sequestration may now force Congress to take seriously the need for real entitlement and tax reform, heretofore the third rail of politics.
In recent conversations with several politicians, we have the distinct impression that members of Congress are as tired of all the squabbling as the American people and are well aware of the low esteem in which they are held. The Republican Party is going through a period of mea culpa and self-examination more intense than anything we can remember. Perhaps our politicians, who have been acting like spoiled children, are finally growing up and realizing that all their constant bickering is a whole lot less productive than mature cooperation. Meanwhile, corporations have been behaving like grown-ups with mouths to feed and are going about the business of earning a living. As a result, the economy has continued to prosper despite all the dysfunction in Washington and across the pond.
We continue to believe that there are powerful trends that will support and drive economic growth in coming quarters and years. Housing has clearly bottomed out. From a peak of 2 million starts per year in 2005, housing starts fell to a mere 554,000 in 2009, but have since rebounded to a rate of 917,000 in February 2013.1 It is not unreasonable to expect further gains over the next few years. So after having been a drag on overall economic growth following the 2008 crisis, homebuilding could once again prove to be an engine of growth.
The banking sector, which was badly mauled by the housing collapse, has now largely cleaned up its collective balance sheet and has effectively de-leveraged to the point where it can start lending again. This is another former headwind turning into a tailwind.
The consumer has also de-levered both involuntarily through mortgage foreclosures, but also through the rebound in home prices and in equity valuations, which create a positive wealth effect. While not all segments of the population are seeing their prospects improve, as employment levels rise, consumer spending should also expand, eventually leading to a virtuous cycle.
Corporate balance sheets are in excellent shape. Companies with large amounts of debt have been able to refinance at significantly lower interest rates, thereby cutting their debt costs and freeing up cash flows for productive investment. Companies with low debt levels or no debt have amassed large cash balances. Some of this cash is being returned to shareholders in the form of higher dividends and share repurchases and some is being used for increased capital spending. Cash is also being deployed in increased merger and acquisition activity. All of these uses support economic growth either directly or indirectly.
Manufacturing is returning to the U.S. There is a legitimate debate as to how fast and to what extent but the driver here is the rise in Chinese (and other developing nations) wages that has far outstripped the rise in U.S. wages. As a result, our wage cost disadvantage is narrowing. In addition, vast unconventional gas and oil reserves discovered in the U.S. and Canada have given us an enviable energy cost advantage. All of this has spurred a massive investment boom in energy infrastructure such as pipelines to move gas and oil from the well head to the point of consumption. Likewise, it has sparked a boom in new domestic petrochemical plants designed to take advantage of the new low cost fuel stocks. Finally, it is causing railroads to invest very aggressively to update and modernize in order to move more goods across the country. According to the Wall Street Journal, “North America’s major freight railroads are in the midst of a building boom unlike anything since the industry’s Gilded Age heyday in the 19th Century – this year pouring $14 billion into rail yards, refueling stations and additional track. With enhanced speed and efficiency, rail is fast becoming a dominant player in the nation’s commercial transport system and a vital cog in its economic recovery.” 2
Lastly, as two economists at GE recently pointed out, we are now entering a third wave in innovation and change that could have profound implications for productivity and economic growth. The first wave was the Industrial Revolution that started about 1750. It involved the substitution of machines for human labor and led to the rise of large industrial enterprises able to gain significant economies of scale. The second wave was the Internet Revolution of the 1990’s that through knowledge and information was able to drive down costs across vast sectors of the economy. They are calling the third wave the Industrial Internet - the application of intelligent devices (e.g. sensors), intelligent systems, and intelligent decisioning to drive down costs in many key industrial and service sectors. Whether this is truly a third wave, or simply act II of the Internet Revolution, is not as important as the fact that it holds the promise of vastly more efficient production, distribution and services.
The beauty of technology and innovation is that it unfolds independent of the business cycle and can have profound implications for how businesses operate, what industries grow and are displaced, and ultimately how fast the aggregate economy grows. The downside is that for a time we may have more structural unemployment as workers are displaced by automated innovation. Over time, new skills and the workers that have them will be employed to oversee these processes.
Taken together all these and other factors should support growth in the U.S. economy. Perhaps the growth rate will not be as robust as in previous decades because of demographic shifts that we can discuss in subsequent outlooks, our large fiscal debt or potential shocks such as another euro crisis or Washington impasse. But even subdued growth is growth nonetheless. And just moderate growth complemented by relentless pursuit of efficiencies is sufficient to propel corporate profits at a rate far in excess of the broader economy. This can be seen over the past four years, during which the U.S. economy has expanded only 6.6% from the recession low in 2009 yet earnings for the S&P 500 have rebounded by approximately 68% or about ten times as quickly as the broader economy.
As corporate profits continue to grow, equity prices should benefit. Many market observers have recently sounded the alarm that the major equity indices have finally recovered back to their prior highs. Too many of these market commentators tend to fixate on the expansion of the Federal Reserve’s balance sheet as the primary driver behind the stock market’s strength over the past four years. Often ignored is the astounding recovery in corporate profits as noted above. Not only have profits recovered smartly from the recession lows four years ago but profits jumped to new all-time highs in 2011 and continued to grow in 2012 (Figure 1). If the consensus estimates hold for 2013, S&P 500 profits may be nearly 30% higher in 2013 as compared to the last time the S&P 500 peaked in 2007.
Figure 1:
Source: Bloomberg, Bureau of Economic Analysis
Figure 2:
Source: Bloomberg
To us, this means that stocks are not currently expensive by historical standards. While not dirt cheap either, equity valuations are reasonable. When looked at through the prism of a classic dividend discount model, stocks are quite cheap based on the current interest rates. Said another way, stocks seem to be looking beyond the current low level of interest rates and anticipating higher interest rates. Since higher interest rates are most likely to occur in response to better economic growth and lower unemployment or a pickup in inflation, they would be associated with growth in corporate profits. Therefore, within bounds, we do not think that higher interest rates will necessarily drive the stock market lower. Rather, they may well correlate with higher stock prices.
1 Source: Bloomberg
2 Source: Wall Street Journal, Boom Times on the Tracks: Rail Capacity, Spending Soar, March 27, 2013
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Past performance is no guarantee of future results. This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The S&P 500 Index is an unmanaged index which is widely regarded as the standard for measuring large-cap U.S. stock market performance. This index includes the reinvestment of dividends. The index does not incur expenses and is not available for investment.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
P/E Ratio is the valuation ratio of a company's current share price compared to its per-share earnings.
Correlation is a statistical measure of how two securities move in relation to each other.
© Osterweis Capital Management
© Osterweis Capital Management
