Barron’s Article ~ “The Yes-Yes Stock Market”
It is a pervasive, skeptical opinion among investors that the Fed is largely responsible for the +100% bull run in stocks. Surely the Fed has played a big role in helping to instigate, even incentivize, asset price inflation. Prices of virtually every asset class have risen since the bottom in March, 2009: stocks, treasury bonds, mortgage bonds, junk bonds, commodities. Notably absent: real estate, although low interest rates have probably helped a great deal in supporting something of a floor in real estate prices.
However, this skepticism ignores corporate earnings, which are now at record levels. Can the Fed actually increase corporate profits? Not directly. But the recovery in asset prices can abet a recovery in demand, or at least stop it from dropping. While this has surely happened, we note that most sales growth from corporate America can be attributed to overseas demand. The linkage between Fed liquidity and foreign demand is even less direct.
Our belief is that some, not all, government programs, did their job in getting a tourniquet onto the bleeding arm of our economy. From there, consumers and businesses realized that they had been cutting and deferring spending for too long, and started buying again. Overlay sales growth from emerging markets, and we’ve seen decent sales growth for 1 ½ years now. And we’ve been producing more with fewer people: at its worst, U.S. employment was down 8 million from its peak; now it’s down close to 7 million. That combination is what has been responsible for record profits.
The recovery in U.S. domestic demand growth, as well as employment growth, have both been meager to say the least. Now consider that demand for two humongous industries, autos and housing, are still running below scrappage rates. That means that, despite the recovery in car purchases, more cars are still being scrapped (or, less delicately, thrown away) than new cars are being bought. So, consumers continue to own fewer and fewer cars. Similarly, growth in household formation (the sum of population growth and people deciding to move out into their own residence) continues to far exceed new home purchases. So, the home ownership rate continues to fall.
Rather than spin this as a negative, the upside is that our economy, despite operating now at record levels, has hardly recovered. This means that, barring an economic apocalypse, it can’t really fall too much. When new home sales were running over 1.2 million annually, there was a LOT of room to fall. At 0.3 million, not so much. As for labor, businesses can hardly afford to let employees go because they’re stretched much thinner than they were 2 years ago.
Our base case is that business spending, and hiring, are still the “way out” for our economy. As this Barron’s article rightly points out, companies have the cash, and cash flow, to increase spending. Banks are suddenly willing to lend again. All the ingredients are present, save for confidence on the long-term of our economy. We’re surprised that hiring hasn’t picked up so far in 2011 as much as we had anticipated. We viewed the 2010 Congressional elections as a morale boost to corporate executives, and believed it would translate into a pickup in spending and hiring, in fairly short order. We still believe this is the most likely outcome. Slowdowns in peripheral Europe and China and commodity price declines are concerns. But we still believe the most likely case is that they are temporary, and most leading indicators (yield curve, ISM surveys, junk bond spreads) are still flashing expansion. Federal budget austerity, whatever its shape, is still a major headwind for our future economy although we don’t foresee major effects until after 2012.
The Barron’s article, as well as Jason Trennert’s piece, also posted in the Library (5/6/11), corroborates our opinion that NOBODY is all that bullish. Most strategists are sticking to a “chicken bull” outlook, which seems nice and safe and comfortable. Kind of like making mashed potatoes: it’s pretty hard to royally mess it up. Most of us would probably be satisfied with a high single-digit return (i.e. +7-9%) in 2011, given the bear market that still looms in our memory, but we’ve already achieved most of that return this year. The bottom-line is that the door to the bull party is wide open, and there’s still plenty of room inside. The economy will surely dictate the path for the stock market. But even a tough, slogging, Goldilocks expansion should be good enough for stocks to keep moving forward.