Just Checking in

Looking back at our blog posts on the economy and markets in The Library, you could be forgiven for thinking that we only feel the need to get our thoughts out there when the market stinks.  While there is some truth to that, let this post prove that we are not just “defenders” of the market.  We can be “offenders” too!

Yes, we’ve had plenty of lean times in the last 4 years, plenty of times when investors were figuratively on their backs, looking up at market levels that once were.  In 2011, the S&P 500 was actually down for the year, but including dividends, the total return was +2.2%.  And the U.S. was one of the very few markets in the world which didn’t show painful losses for the year.  But even the S&P was down 21% at its worst, from the high on May 2 to the low at the end of September.  As the chart below shows, since then we have essentially returned to the previous May 2, 2011, peak.


What has changed in the past 4+ months?  Primarily, the market’s catalysts have been improved economic data and improved European bond markets.  This isnot to be confused with strong economic data and healthy European bond markets.  But lest we not forget that the market responds to changes in the rate of change. So when we’re talking about stocks being 23% higher now than on September 30, that corresponds with an economic mood that has progressed from “deeply concerned” to “guardedly hopeful.”

Our hopes for the economy’s transition from recovery to expansion have hinged upon business spending and hiring.  We have been talking about the 4 “legs” of the economic stool:  consumer, business, government, and exports.  Government is certainly going to be the weakest leg in the coming years, and without a pickup in hiring, consumer spending growth was close to exhaustion.  That left business and exports.  Relying on exports has always been a dubious proposition, lacking dependability despite our brightest hopes for American competitiveness.  One problem is that, during good economies, our imports always grow more than our exports.  The second problem is that relying on exports means relying on foreign demand.  Net-net, the current setup is still pretty good for U.S. exports, with emerging markets, Canada, and Mexico picking up the slack from a weakened Europe.

The leg that really matters, in our eyes, has been business expansion.  Without it, the stool has no dependable legs (again, without hiring, consumer spending can’t be relied upon).  So, our economy needs both business spending and hiring.  And right now, finally, we’re getting both.  Business spending has actually been rising since the 3rd quarter of 2009, and foreseeing this has been something of a no-brainer.  Spending was slashed during the recession.  Even maintenance spending was deferred, so there has been a lot of catch-up coming out of the recession.  Profits soared during the recovery and have been hitting new record highs, and cash has been piling up on corporate balance sheets as management teams have been so tentative in investing for the future.

But waiting for labor growth has been like waiting for Iran to stop developing nuclear weapons.  All the ingredients were present for companies to start hiring in earnest:  the labor force was stretched totally thin thanks to 2008-09 job cuts combined with growth in output, profits were through the roof, cash was plenty, demand was still rising, and the dollar was falling.  All that was seemingly missing was confidence.  It’s hard to come up with a compelling reason why (or if) confidence has returned, other than the absence of a catastrophe in Europe (see below).  Perhaps the recovery in Japan from the tsunami, perhaps warmer winter weather in the U.S., perhaps the delay of fiscal austerity by the federal government have all played a role.  But at least it proves that any increase in demand would need to be met with an increase in labor.

In Europe, Greece continues to stumble toward either another round of government spending cuts or a default on its borrowings.  Not much change there.  But an appetite for buying the bonds of shaky Eurozone members (Italy, Spain) has returned.  As we said at our Monarch lunch in December, the bond vigilantesare the guys with big guns who scare bond investors out of buying risky debt.  While they’ve been lurking around Europe since the end of 2009, they suddenly showed up in Milan and Madrid in late 2011, demanding sharply higher interest rates on newly issued bonds.  There is no pre-set level of debt burden or deficit level that triggers the arrival of the bond vigilantes.  They show up when they decide it’s time to show up.

Since then, these governments have scrambled to pass leaner budgets, while the ECB (European Central Bank) has increased its balance sheet to buy more government bonds of its members.  So the ECB is quasi-backstopping this sovereign debt.  Meanwhile, the Fed and China (among others) have coordinated with the ECB to essentially support the ECB’s backstop.  In addition, the Fed has signaled it intends to keep short-term rates low until at least 2014.  While the bond vigilantes have big guns, they look more like finger-guns compared to the central banks’ atomic bomb of monetary stimulus.  So, the added liquidity and the communication of support has worked to scare the vigilantes, which has sent a positive message back to global stock markets this year.

While the economy and the central banks have been the catalysts, the fuel for the rally in stocks remains the unprecedented spread in expected returns from stocks vs bonds.  This can be measured in many ways, but the old standby is the “Fed model” which simply compares the earnings yield of the market to the 30-year treasury bond yield.  As the chart below shows, even after the big rally, valuations of stocks are still so far away from bond yields that to say they’re not in the same ballpark would be an understatement.  More like not even in the same solar system.


Stocks and bonds have been trading in opposite directions ever since the financial crisis.  Whenever stock prices have fallen, a flight to safety boosts demand for U.S. government bonds, pushing their prices up sharply.  When the flight to safety subsequently turns into a flight to risk, stock prices rise and bond prices fall.  We would expect that if the historical relationship between stocks and bonds were to ever return to normal, it will be necessarily at much higher bond yields, and probably much higher stock prices.  Until then, look for them to continue to trade oppositely.  Thus, bonds should continue to be viewed as a source of safety, rather than return.

In fact, it has suddenly become a much-heralded investment “idea” to buy stocks as a source of income.  While this has been a principle of Monarch for forever, the ultra-low yields on bank deposits, CDs, money market funds, and bonds have started to push investors more into stocks.  In reality, only a modest amount of investor funds have gone into stock funds since last September.  Professionals have jumped the gun and pushed prices of high-yielding stocks up, in advance of what they expect to be a mad rush into them by individual investors.

We always treasure yield as a reliable source of total return in how we choose stocks in our portfolios.  We only caution that, at some point, prices might be pushed too high by an investor class who claims in unanimity, “We’re buying for yield; we don’t care whether the price rises or falls.”  This is easy to say now, but a little harder to swallow when prices do fall.  In the short-term, we expect the strategy to continue to work, as long as interest rates stay low.  In their defense, with the Fed “on hold” for 3 years, and with a potential new program for the Fed to buy more long-dated securities, it’s hard to envision rates risinganywhere on the yield curve.  But you never know when the bond vigilantes will return stateside, particularly if “budgets” like our President’s proposed “budget” come to fruition.