Since the axiom “Don’t fight the Fed” came into common parlance, we have all been aware that central bank policy is an important component of market performance. Most of us started out as security or business analysts and believed that fundamental factors like the pace of the economy, earnings growth and interest rates were the drivers of equity values. As we became more experienced, we began to understand the influence of psychology, which can be quantified by technical analysis. Since the end of the bear market and recession of 2008-9, and the fiscal stimulus and monetary easing that followed those tumultuous years, I have begun to appreciate even more the importance of central bank liquidity in determining the direction of equity markets. This is hardly a conceptual revelation, but I thought I would take a look at it quantitatively.
United States equities have tripled since the March 2009 low. The total capitalization of the Standard & Poor’s 500 has increased from about $6 trillion in March 2009 to $19 trillion today. Obviously this is not the total value of the entire U.S. equity market, because it leaves out much of NASDAQ and other peripheral markets, but most of the capitalization of U.S. public companies is captured by this index. Earnings have clearly driven a good part of that move; they have more than doubled from $417 billion in 2009 to $1.042 trillion in 2014. Since 2008, the Federal Reserve balance sheet has more than quadrupled from $1 trillion in 2008 to $4.5 trillion. It took the Fed 95 years to build up a balance sheet of $1 trillion and only six years to go from there to the present level. The Federal Reserve was providing this stimulus to improve the growth of the economy, but it is my view that three quarters of the money injected into the system through the purchase of bonds went into financial assets pushing stock prices up and keeping yields low. If I am right, the Fed contributed almost $3 trillion (some may have gone into bonds) to the $13 trillion rise in the stock market appreciation from the 2009 low to the current level, earnings increases explained $9 trillion (1.5 x $6 trillion) and other factors accounted for $1 trillion. You could argue that the monetary stimulus financed the multiple expansion in this cycle.
In Europe, a similar condition has taken place. The EURO STOXX index reached its low in the fall of 2014 with a total market capitalization of €8.1 trillion. The current market capitalization is €10.5 trillion, an increase of about 30%. The balance sheet of the European Central Bank in October 2014 was a little over €2 trillion. It is up about 15% from that level today at about €2.344 trillion. An improvement in the outlook for earnings and the European economy helped here as well as in the U.S., but liquidity played an important role in the rise in the market. Like indices for the United States, the EURO STOXX doesn’t capture the full market value of all European equities.
In Japan, the balance sheet of the Bank of Japan began to increase sharply after reaching about ¥132 trillion at the beginning of 2012. It is now ¥327 trillion, more than doubling the early 2012 level. The market capitalization of the Tokyo Stock Exchange increased from about ¥254 trillion at the beginning of 2012 to ¥587 trillion currently, again more than doubling. Earnings played a role here as well, but the monetary liquidity could explain much of the market appreciation. The concept of the central bank playing a critical role in market performance has been brought home this year with the relatively strong performance of Europe and Japan because of Mario Draghi’s explicit policy of aggressive easing and the accommodative strategy inherent in Abenomics. In contrast, the Federal Reserve is poised to tighten (interpreted as the withdrawal of liquidity) as soon as it becomes comfortable that the economy can handle higher rates. As a result, the U.S. equity market has made little progress this year, while Europe and Japan are up in double digits in local currencies, and Japan is up in double digits in dollars as well.
At this point, the prospects for both revenue and income growth for United States companies are not robust. Optimistic earnings projections for the S&P 500 show only a small improvement for the year, and even that would require a fair amount of financial engineering, including share buybacks, mergers and acquisitions and leverage. The current level of buybacks and mergers and acquisitions is less than 10% off the pre-crisis high, according to Strategas Research. The strong dollar and the decline in oil prices are negatives for near-term earnings improvement. In the face of these factors, it is something of a wonder that the U.S. market has risen at all this year.
One concept that may be helping the market is earnings yield. The 10-year U.S. Treasury is yielding 2.2%. Even if S&P 500 earnings are flat in 2015, the earnings yield (S&P 500 earnings divided by the price of the index) will be 5.5%, a healthy differential that is similar to the earnings yield in March 2009 when the market bottomed and the current upward move began. Earnings are likely to grow over time while the coupon on the 10-year is fixed. Although there is risk that earnings will fall in a recession, there is no recession currently in sight. The attractiveness of a 5%+ earnings yield compared to a 2% Treasury coupon is compelling to some investors.
There are also fundamental factors on the positive side. I have been counting on housing helping the United States economy move toward a 3% growth rate this year. Mortgage applications for purchase, sales of existing homes and the Case-Shiller home price index are all showing a positive trend. New home sales are, however, presently disappointing. Given that I am convinced that the favorable trends will continue, I expect the unfavorable data will reverse and housing starts will consistently exceed one million before too long. The increase in family formations resulting from improved employment in the 25–34 age bracket also gives me encouragement.
There is other good news on the economic front. The Economic Cycle Research Institute’s Leading Index has turned up sharply. This index correctly forecast the slowdowns in the U.S. economy in 2010, 2011 and 2012. After a worrisome decline earlier this year, the index has turned sharply higher, supporting the view that the economy will improve in the remaining quarters. Investors became concerned recently when real Gross Domestic Product (GDP) growth was reported for the first quarter at .2%. Even this weak number may be revised downward because of the recently announced 43% increase in the trade deficit in the first quarter. The quarter was hurt by severe weather across the eastern part of the country, the strong dollar and the West Coast dock strike. First quarters in the U.S. have been significantly soft since 2009, and if the recovery pattern of the last six years follows, it is reasonable to assume real growth will be in the 2.5% to 3% range for 2015.
We are also seeing some signs of improvement in employee compensation. The Employment Cost Index was up 2.5% in the first quarter. This sharp improvement (it was as low as 1.5% in 2014) should help the housing sector. The recent increase in household formations (back to pre-recession levels) should also help housing. In addition, the willingness of corporate managers to borrow money reflects their optimistic outlook. In April, bank borrowing increased 8.3% on a year-over-year basis, matching the peak in 2009. Other indicators support a positive outlook for the economy: rail car loadings improved and consumer spending was up .3% in March.
Despite the positives, there are also some serious negatives, and assessing their significance is important. Productivity declined 1.9% in the first quarter of 2015 after a smaller drop in the fourth quarter of 2014. Because productivity is a key component of profitability, this is a reason for concern. Part of this may be attributable to slow revenue growth because of weather and other factors, but productivity improvement is essential to growth. Technology has been a major force in increasing productivity, and we may have reached the point where the incremental benefits of using equipment and processes to increase the output per worker may be taking a rest. Given that revenues going forward are likely to increase slowly, this negative trend in productivity must be reversed.
On the jobs front, the April employment report came in slightly below target at 223,000. The previous month was revised downward to 85,000 from an already disappointing 126,000. Average hourly earnings increased 2.2% year-over-year. The unemployment rate dropped to 5.4% and the participation rate increased to 62.8%. The construction sector was strong, reflecting the improved weather, but manufacturing was disappointing, only adding 1,000 jobs. As expected, most of the jobs were created in the service sector, which tends to have a lower rate of compensation. While I would have preferred to see a stronger report, nothing in the data would indicate that the economy will not show reasonable growth as we move through the year. Looking at the labor report from a broader perspective, however, there is reason for concern. According to David Malpass of Encima Global, the labor force only grew 166,000 in April, 1.1% year-over-year, which was disappointing. The employment to population ratio is 59.3%, which is 3%-4% below the 2000–2010 level and 5% below the level in the 1990s. What is troubling about this data on the trade balance, productivity and the employment report is that it suggests that there is unlikely to be a major increase in capital spending. According to the Commerce Department, capital investment was down 3.4% in the first quarter. The U.S. industrial stock is 22 years old, an all-time high, but operating rates are below the 80% where companies begin to plan major capital expenditures. Much of the money that has been spent has bought labor-saving equipment that has enabled companies to deliver goods and services with fewer workers.
An important driver of recent capital spending has been energy, and the sharp drop in oil prices over the past year has had a major negative impact. Now that the price of oil has risen from $43 per barrel (West Texas Intermediate) to over $60, energy capital spending should pick up, assuming current prices will hold. The pending nuclear agreement with Iran, while eliminating a major geopolitical risk, does change the supply / demand balance. If this were signed over the next few months and sanctions are lifted, one million barrels of incremental oil could come into the world market and crude prices could decline again. Right now, the negotiations seem to be running into serious difficulty, so I still expect a pick-up in energy capital expenditures as we move through the year.
I am occasionally questioned about the possibility of a bubble forming in the NASDAQ as a result of the strong performance of technology and biotechnology stocks in the current cycle. Investors clearly have not forgotten the excesses of the 1999-2000 period. Looking at the data, however, there seems to be much less froth this time around. For example, the price-earnings ratio (excluding companies with negative earnings) was 49 in 2000; it is 25 now. The dividend was negligible in 2000; it is 1.13% now. The price to sales ratio was 12 in 2000; it is 3.5 now.
The U.S. market has been long overdue for at least a 10% correction. It has been three years since the last one. Sentiment among investors is optimistic or complacent, not a condition conducive to a sustained upward market move. I still maintain a positive outlook for the S&P 500 for 2015, but perhaps we have to endure a little pain first. By the second half of the year, the market mood may be more subdued and the fundamentals of the economy may be better, providing a more favorable environment for stocks to move higher. I still expect the S&P 500 to rise 10% or more by the end of the year, but it will have to get there on the basis of fundamentals without the help of liquidity provided by the Federal Reserve.
The views expressed in this commentary are the personal views of Byron Wien of Blackstone Advisory Partners L.P. (together with its affiliates, “Blackstone”) and do not necessarily reflect the views of Blackstone itself. The views expressed reflect the current views of Mr. Wien as of the date hereof and neither Mr. Wien nor Blackstone undertakes to advise you of any changes in the views expressed herein.
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