The financial markets are working on completing their second year of occupation…No, not Occupy Wall Street, actually Wall Street has been occupied by Europe. Hard to fit a huge region into a relatively small building at the corner of Wall & Broad, but little else has mattered to the day to day changes in the markets. I guess it could be called Preoccupied Wall Street. Not to take the problems of Europe lightly, as defaults by countries, writing down debt or severely curtailing economic activity all have global implications: from banking defaults to another recession that few countries are capable of fighting having spent so much fighting the last recession. The story is well-worn, although time seems to have clouded some of the exact reasons for the last recession, and so far, little has been done to rectify the financial system to reduce the chances of a repeat reoccurrence. Politics has played a very large role in both the domestic issues as well as those surrounding Europe, as the goal of every politician is to get re-elected and the election cycle as sprawled out to encompass the entire year – in effect there is always an upcoming election.
While many may argue my expertise on the economy, I’ll leave the politics to others that spend much more time in that arena. Taking a step through the top-down analysis to some meaningful investment conclusions has certainly been made more difficult by the events in Europe. As the US investor goes to bed with the SP500 futures modestly higher, they awake to find them down over 1% and scrambling to figure out what happened while they slept. The markets open down 1-2% and then trend sideways much of the rest of the day. Next evening the exact opposite occurs. It is almost better to flip a coin than to put forth any serious analysis of the markets these days. Very generally speaking, the data from the US economy is OK – not what would be expected at this point of a two to three year economic expansion. The big daddy, employment, can’t seem to get above 200k in new job creation and the weekly jobless claims remain around 400k on a weekly basis. Both show the economy is not the job creation machine that it has been in the past, but at least at this time, not rolling back down into recessionary levels. Manufacturing, as measured by the ISM data as well as the various regional Fed reports (NY State was yesterday) show modest expansion, but again, well below what would be expected at this point of an expansionary cycle. Finally a measure of the consumer – retail sales (instead of sentiment) are showing a consumer that is spending, but here too, not at robust levels as spending is constrained by very low levels of income growth.
The view from 50,000 feet is of an economy that is moving forward, almost imperceptibly so, but forward nonetheless. The concern is that this fragile recovery could easily be “broken” by even a mild shock or disruption. Never mind the storm brewing in Europe, the tsunami in Japan earlier this year did have a negative impact on US economic activity. Corporations are seemingly oblivious to the goings on around the world, as the quarterly earnings reports again showed the bulk of reports above expectations. (How hard is it really to beat low expectations!)? Digging below the reports, revenue growth was not terrific, as it is harder to fudge revenue than it is to show terrific earnings. Margins remain well above historic levels, indicating just how far companies have cut “non-essential” expenses and overhead to be as profitable as they are today. What has yet to occur is enough revenue coming through the door to encourage companies to realize they don’t have enough resources to handle the demand and begin an expansionary phase that would increase hiring and spending on plant and equipment. In many cases, companies are doing the bare minimum.
Based upon the most recent twelve month earnings on the SP500 of $87.24, the SP500 is selling at a relatively modest 14x earnings, slightly below the historical average of 15-16x. Herein lies the rub, IF the economy is (as some argue) or very soon will be in a recession, the market multiple could decline to nearer levels that have marked lows for stocks of 8-10x earnings, which puts the SP500 somewhere south of 900 from the current 1230. IF the economic engines do finally catch and we get a more robust economic expansion, then the market multiple could grow to 18-20x, putting the SP500 around 1750. What is the market indicating today is the more likely outcome? Based upon the market sectors that are performing better than the SP500, there is a pronounced leaning toward the lower ranges than the higher. Utilities have led the “charge” to unchanged, while the more economically sensitive parts of the markets (Basic materials and industrials) have been lagging for much of the year and do not yet show signs of regaining market leadership.
Having moved from the very broad and wide view of the economy (struggling) to the corporate level (good profitability, but historically high margins) to the market segments (defensive performing better than cyclical), where does this point to for the remainder of the year and into next? IF you are listening to the markets, playing defense in the already popular places in the markets make the most sense, although that opinion is getting rather common. Some parts of the market that have been performing better, including energy and technology, may allow investors to provide a bit of excitement in their portfolios without straying too far out on the risk curve. I would prefer to see persistently stronger economic data from the employment reports and manufacturing sectors before getting excited about making a stronger commitment to stocks, especially those tied more directly to the consumer and economic growth.
Finally a word or two on bonds, yields stink. Here too, the markets are pricing in a world that if not correct, returns will be very poor for those investing in the “safe haven” of the bond market. My argument is that we’ll not see significantly higher yields or even higher trending yields for quite some time. As outlined above, economic activity remains moribund, and while the Fed has tried nearly everything in the trick bag from nailing short rates at zero to twisting longer term rates lower, the economy has yet to respond. It is very likely that the Fed is “pushing on a string” meaning the economy is no longer responding to all the cheap money the Fed has made available, simply put the medicine the Fed is providing is not healing what ails the economy. The US economy, as well as the global economy, remains constrained by high debt levels. No amount of money being tossed into the economy will make it grow UNTIL the debt levels are worked down to manageable levels. Unfortunately, that seems to be still a long way off. As a result, bond yields can remain at these historically low levels, as they have in Japan, for quite some time – even beyond the 18 months that the Fed is ready to maintain the zero rate policy for short-term rates. It is for these reason bond investors should maintain their holdings in high quality bonds with maturities between 5-10 years. While the returns on bonds are not exciting, they have been providing positive returns vs. the equity market returns so far this year.
