Posts published in January 2014
This week we got two seemingly contrasting readings on the state of play in early 2014, and what may be in store for investors, businesses and households this year. The stock market pulled back, with the S&P 500 extending its loss for the year to date north of 4% by early Friday morning trading. The U.S. economy, on the other hand, produced another positive data point, with the first reading of 4Q GDP coming in at 3.2%.
This is less odd than it may seem, and very much consistent with our base case scenario for the year. The stock market is expensive, even with the recent pullback, and prone to potentially more bouts of selling. The fundamental economic picture, though, continues to show more promise than reasons for fear. That may not be enough to produce another year of double-digit equity returns. It may be enough, though, to make a good case against things getting too negative for long-equity portfolios.
GDP By The Numbers
A look at the chart below shows three consecutive quarters for GDP above the critical 2% level. Economists believe that the economy needs to grow at a clip of 2.5% or better to generate net new jobs (i.e. where job growth outstrips population growth). A string of readings above this level increases the potential for the unemployment rate to fall for the right reason – new job creation – rather than the wrong reason of decreased labor force participation. That wrong reason was the driving force in last month’s surprise fall from 7% to 6.5%.
Let’s look at where the growth came from, because there are some interesting storylets below the top line. The biggest contributor was consumer spending, accounting for 2.3% of the total. That’s unsurprising: in Shopaholic Nation, consumer expenditures typically make up about 70% of GDP. What is unusual is the next largest line item on the national account: net trade. The balance of exports over imports contributed 1.3%. This dovetails with the decreasing U.S. trade deficit we described in a previous Market Flash, but still is surprising given weakness in emerging markets and a stronger U.S. dollar. Net housing and business investment was up a modest 0.6%.
Take That, Government Shutdown!
So add up all those figures – 2.3%, 1.3% and 0.6% - and you get 4.2%. So why did GDP only grow by 3.2%? The wet blanket on the party was government spending, which subtracted 1% from the equation. Remember last October? The shutdown, the flirtation with disaster as posturing policymakers played chicken with the government budget and with the debt ceiling? That proved to be the weak link. The good news, though, is that even with this fiscal drag the economy was still able to grow by more than 3%. The even better news is that there is likely to be less fiscal drag this year than last. Congress managed to reach a budget deal by the end of last year, and this year even the partisan muckrakers may be a bit more tempered in their actions ahead of the November midterms.
Where Do All The Profits Go?
There are a couple cautionary notes in the generally positive picture, though. First, this reading is subject to revisions. That could impact the seemingly-too-rosy net trade numbers. Second, business investment results are not particularly impressive. Half of business investment came from inventories, as opposed to investment in new productive assets. Profits for U.S. businesses have been robust for many years, so what are they doing with all that money? Anyone who follows quarterly corporate earnings announcements knows the answer: it’s going back to shareholders in the form of share buybacks and dividends. The dividend payout ratio at a number of large S&P 500 firms is over 100%. That means the firms pay out 100% of their net earnings in the form of dividends and buybacks, and then borrow more money to pay out even more! Why not, the thinking goes, given today’s low interest rates?
Push Me, Pull You
Finally, this latest uplifting data point brings the Fed’s rate policy back into the picture. Short term rates soared after the Fed’s December meeting on doubts about whether the extended forward guidance target was realistic in a faster-growing economy. Then rates fell sharply after the surprisingly negative jobs report in early January. Now they may rise again, then they may fall again in a credit market version of push me – pull you. We need to keep a close eye on this. But on balance, we will prefer to see a stronger economic picture continue to take root. Heaven forbid, that might actually take us back to a world where equity fundamentals matter more than the word “taper”.
Bond yields plunging. Defensive, high dividend stocks holding firm as riskier exposures sharply weaken. Emerging markets bloodbath. If it were not for the frigid temperatures plaguing the East Coast, it might seem like we’re back in the summer of 2011, with investors scurrying into whatever safe havens they could find amidst the tempest. Is it Risk On / Risk Off version 2.0?
Revisiting the Law of Round Numbers
Last fall we wrote a piece on the weird magic of round numbers: namely, the S&P 500 and the Down Jones Industrial Average breaching the nice round figures of 1800 and 16,000 respectively. We noted that oftentimes, indexes take a while to reach escape velocity after breaking through a round number resistance level. So while 1800 and 16,000 were resistance barriers in autumn 2013, they are playing the role of support level today. As of this writing the Dow is flirting with 16,000 while the S&P 500 is trading around 1805. By the time we post this, we will see whether the support level has held or been breached. That could give us some insight into what might be happening in the days ahead.
Death, Taxes and Market Corrections
From our perspective, having been in this business for several decades, periodic market pullbacks are as dependable as those other two more well-known inevitabilities. Considering that the S&P 500 gained over 32% in 2013, a correction of sorts is not the most surprising thing in the world. Right now the market is about 2% off its December 31 high. Corrections of between 2-5% are typical of pullbacks in a larger growth market environment, whereas a range of 10-20% is more indicative of a building bear trend. Sometimes, though, the bear doesn’t gain traction. Looking back to that turbulent summer of 2011, U.S. indexes did retreat by about 20%, but rallied strongly from the October 1 trough to recover all the lost ground by early 2012. There have been no 10% or more retreats since, and only a handful more than 5%.
A January Effect?
One thing vexing the bulls is the timing of this pullback. January has a history of being a more active than usual month both in terms of volume and market direction. The first month of the year saw price gains of 5% in 2013 and 4.3% in 2012, while the 5% drop in January 2000 and 6.1% retreat in the first month of 2008 were the canaries in the coal mine for the dismal periods to follow. Of course, it doesn’t always work that way. A 3.5% drop in the S&P 500 in January 2010, and negative 2.5% reading in 2005, were followed by positive performance for the full calendar year. Still, it’s a good idea not to completely discount notions like the January effect, because human behavioral quirks around calendars are as hardwired into the markets as those round number oddities.
Watch the Earnings
It’s still relatively early in earnings season, but the general tone is more negative than positive. Large names like IBM and Procter & Gamble have disappointed, while positive “surprises” – when companies release earnings that beat analyst expectations – are fewer in number and less in scale than in recent quarters. We remain of the opinion that markets are expensive at current valuation levels, but not in bubble territory. A 2-5% pullback may be all it takes to shake a bit of froth out and then stabilize. But we need to remain vigilant and let the data inform what we do (and do not do) in the coming days and weeks.
If there were an equivalent of People magazine’s “Sexiest Person of the Year” award for macroeconomic statistics, the trade balance would never be it. Unemployment, GDP, consumer spending…these are the celebrity metrics whose fortunes and failings we love to follow on Twitter feeds. The trade balance is sort of an afterthought. If we mention it at all it is usually to express the misguided notion that trade deficits are bad, while trade surpluses are good. That’s a shame, because there are some useful insights to be gained from a study of recent trends in the U.S. trade numbers. They are insights that go beyond trade to argue why the overall American economy currently may be in its strongest condition for some time.
A Shore Thing
Since 2005 the current account deficit has fallen from 6.2% of GDP to 2.2%, the lowest level it has been since 1998. One of the prime movers is an increasingly favorable position for the U.S. in tradable goods – basically, tangible things produced in factories. For decades now U.S. production has been the victim of “offshoring” – the export of manufacturing to places like China and India with comparatively attractive wages and tax regulations. That has been reversing as of late. For example Whirlpool, a U.S. appliances manufacturer, recently “onshored” one of its signature Maytag production plants from overseas to Ohio. If you buy a Maytag washing machine now you are not contributing to the trade deficit, but rather adding a few hundred dollars to the domestic personal consumption expenditure line of the GDP account.
It’s a Gas
Another development having a major impact on trade is the rise of domestic hydrocarbon production, much of which has to do with the extraction of natural gas and oil from non-traditional sources like shale. In the last five years the share of total U.S. energy consumption produced domestically has increased from 70% to 89%. That has come at the expense of traditional overseas suppliers like Saudi Arabia and Russia, whose fleets of tankers have long filled the tanks of our Esplanades and run up our import bills.
Trading Places (of Employment)
There are other sources of U.S. competitive advantage in trade that have been around for awhile: royalties and licenses from domestic intellectual property, for example. But what is notable about the more recent contributions of manufacturing and energy is that they create lots of jobs. Some of the frontier towns in the North Dakotan wilds, where shale oil production is in full swing, offer a near-guarantee of employment to visiting job seekers – not just in production but in the service economy that supports it. Despite the lackluster reading in the latest jobs report, there seems to be a case to make that unemployment may continue falling for the right reasons (more jobs as opposed to fewer participants).
Trade and the Global Economy
The Economist Intelligence Unit estimates that the U.S., Japan, Britain and Germany will contribute more to the global economy this year than will Brazil, Russia, India and China. Growth prospects are still rosier in China or India than France or Japan, to be sure. But the same trends that are having a positive impact on the U.S. trade balance are favoring sources of economic advantage in the developed world over those in emerging markets.
None of this necessarily foretells another blockbuster year in equity markets, which may slow down or pull back after last year’s torrid pace. But the fundamental economic picture appears stronger today than it has for some time. That may keep secular market trends oriented more towards the bulls than the bears.
Just when you thought it was safe to go back into the water…
One of the overriding narratives of the past several months has been a building case for stronger than expected economic growth. The headline numbers – GDP, employment trends, housing and consumer confidence to name a few – were pointing in the right direction. This morning, that narrative took a body blow with the release of the December employment report. It remains to be seen whether this is an outlier, a case of bad data that missed heightened seasonal variables, or a sign that those green shoots are not putting down roots as strong as we thought. In the meantime, we may be seeing lots of confusion in the markets and lots of false signals about directional trends as investors try to make sense of what this means for the economy, for the Fed, and for different asset classes.
Here are the key data points from today’s report in chart form.
Some Very Opaque Tea Leaves
The Wall Street Journal’s monthly jobs report liveblog captured the Zeitgeist perfectly. In the minutes before 8:30 a.m., the numbers being tossed around ranged from 200,000 to 300,000 for the payrolls, with a general consensus for the headline rate staying around 7%. As the bell tolled on the half hour, there was a microsecond of stunned silence, and then a chorus of “huh?” and “what the…?” filled the ether. Why did only 74,000 payroll jobs get created in what is normally a busy hiring month? And how did such a weak reading actually bring down the unemployment rate?
That second question is the easier one to answer. The rate came down because fewer people are actively looking for jobs. The labor participation rate is 62%, slightly down from where it was a year ago. That means that very few people are coming off the sidelines and back into the labor force. Unless there is some unexplained cultural phenomenon to account for that, it means that job creation levels are not yet strong enough to be putting a larger percentage of the population back to work.
Anomaly or Bad Data?
There is a sizable contingent of opinionators questioning whether the BLS data are believable, given how far from the consensus they turned out to be. Of course, dismissing the validity of a data point is a tried and true Wall Street dodge for predictions gone egregiously wrong. Still, there is a distinct possibility that the December numbers will be substantially revised when the next reading comes out in early February. Last fall’s government shutdown threw a wrench into the monthly reporting rituals, and while that should not still be causing problems, there may be something to the idea that the data are not all that robust.
One thing the BLS did note in its report is that 279,000 people did not work in December on account of the weather (it was unseasonably cold in much of the country during the month). That would partially explain some of the lower-level findings, like the 16,000 jobs lost in construction. But it doesn’t shed much light on why, for example, the healthcare sector lost 7,000 jobs against an average monthly increase of 13,000 for 2013 overall.
Over to You, Chairwoman Yellen
How markets react to this news in large part depends on what consensus emerges about the Fed’s likely moves when it meets later this month. Bear in mind that this is the maiden Board of Governors meeting for incoming Fed Chairwoman Janet Yellen. Last month the Fed decided to begin rolling back its $85 billion monthly bond buying program known as quantitative easing. With QE tapering off, the policy tool du jour is forward guidance on interest rate policy. The Fed extended its forward guidance, saying that it would keep rates at zero percent until “well past” the time when unemployment reaches 6.5%.
Immediately after that announcement, short term interest rates shot up. That seemed to indicate doubt among investors as to whether extending the historically low Fed funds rate that far ahead, possibly into 2016, would be possible if the economy really were catching fire more quickly than expected. Part of that doubt concerned exactly the issue that is front and center today: the labor participation rate. If unemployment reaches 6.5% mostly because people are still dropping out of the labor force, then the Fed has more leeway to keep rates down. If the rate comes down for the “right reasons” – i.e. more actual job creation – that could create upward pressure on prices and force the Fed to act sooner.
So if the December reading is in fact not an anomaly, but a sign that things aren’t as rosy as they have been looking recently, then look for more dovish overtures from the Yellen Fed, and maybe even a pause in the QE taper. If this is a one-off, or bad BLS data that gets revised upward next month, perhaps the old narrative continues. At this point we don’t know, but we do expect the fog of uncertainty may complicate the market’s direction over the coming weeks.
Temperatures in much of the northern U.S. are well below freezing, so it would seem that melting fears are not weighing on the minds of our citizenry. In the climate-controlled offices and trading floors of investment houses, though, the topic is very much in the discourse. The new buzzword is “melt-up”, as in a market that goes into a frenzy of speculative buying and pushes assets into bubble territory. Of course, the logical result of a melt-up is that which we know all too well, the meltdown. As 2014 gets underway, the punditry wants us to consider whether this will be the year of the Big Melt – first up, then down.
What the Numbers Say
We prefer to study the data before arriving at any conclusions about what the market might, or might not, do in the near future. What the numbers are telling us now is that equities are expensive at current levels, but not in bubble territory. The twelve trailing months P/E ratio is 16.5, which is higher than it has been for more than three years, but still nowhere near record highs.
The Case-Shiller P/E ratio, which presents the data on the basis of cyclically adjusted earnings, is currently around 26. That level shows equity markets to be overvalued – but again, it does not make a definitive case for a clear and present bubble. It’s not a great time to be scooping up underpriced stocks, as there aren’t many bargains to be had, but in our opinion there is nothing particularly compelling out there to say that the market is ripe for either a melt-up or a meltdown in the immediate future.
One indicator we focus on in our research is Return on Equity (ROE). ROE is a good metric because it tends to show mean reversion over long economic cycles. What ROE measures is a company’s earnings over a period of time relative to its average net book value (assets minus liabilities) over the same time period. Think of equity, or net book value, as what the company has invested in to make money (net of its debt and other obligations). So ROE tells you how productive those investments have been.
Now, in any given industry, a company earning a high ROE will attract competitors eager to get in on the action. The rational expectation would be for average ROE to go down as the total pie gets sliced into smaller pieces. Eventually some competitors will go out of business, and those left behind will enjoy higher ROEs from the spoils they grab…and so the cycles go.
What’s the point of this digression into financial statements analysis? Simply that, at present, the ROE for the S&P 500 is about 15.4%. That’s a bit higher than its historical average of about 14.9%, but lower than the 16% level it breached two years ago. In a word, inconclusive. It leaves us drawing the same conclusions as the P/E analysis: namely that the market is expensive, but not inordinately so.
The Earnings Season Catalyst
We do believe, though, that the upcoming earnings season will be an extremely important factor in influencing the market’s near to medium term direction. In particular, we will look at top-line sales numbers as a barometer of whether the recent promising macroeconomic data points are showing up on income statements, or whether the recovery may be on shakier ground than the current consensus holds. That – along with what the tea leaves reveal as the new Yellen Fed gets underway – could hold clues about whether some variation of the Big Melt will become a reality.