Welcome to Spring!

For those of us who really like spring, and those of us who are weather geeks, the “meteorological calendar” indicates that spring begins on March 1, not March 20 (as the solar calendar indicates).  This especially makes sense when you ask:  which period seems more like it should be in winter, December 1-20, or March 1-20?  Thank God for America, where we the people can actually choose the season!

Whatever season it is, the snow is melting, but leaving behind a lot of brown stuff along the sides of roads and parking lots.  Speaking of, has anyone ever dug into those mountains of crud-that-once-was-dirty-snow at Jefferson Pointe?  They seem to stay around until summer.  How do they retain their shape even after the snow melts?  Are they solid or porous?

Anyway, dirty snow reminds us a LOT of the sentiment in the market right now.  Fears of recession (meaning fears that we’re still in one, or we’ll soon be starting a new one) have melted away over the last 6 months, but it still looks kind of nasty out there.  Which is good, because as soon as everything looks rosy, and no one has a care in the world (like in early 2000), that’s the time to be the most concerned.

It’s still very easy to find doomsayers out there, although their emphasis has shifted as walls of worry keep getting knocked down.  Not many people believe we’re still in a recession anymore, but that doesn’t mean respite for the worrywarts.  The twin fears du jour are:

  1. An economy about to roll over under the weight of a struggling consumer, the eventual undoing of government programs supposedly propping up the consumer, and the threat of higher taxes down the road, and
  2. Hyperinflation, spurred by the budget deficit, which will inflame commodity prices and push interest rates up to finance the deficit spending.

Note that while these fears are both somewhat rational, they are completely incongruent, meaning that there’s virtually no way that both will happen.  And yet the fear still seems to be pretty well-balanced between the two.

What everyone would like to know is whether the economy is, for lack of a better term, “out of the woods.”  This could mean different things.  First, it could mean that the last recession is over (which it is).  Or it could mean that the economy is actually growing (it is).  Or it could mean that there is no foreseeable recession ahead of us.  That last declaration should never be made, no matter the time period.  Economies are naturally cyclical, so we will eventually be back into a recession at some point.

What we all wish we knew is, obviously, when?  If we expected recession in 2011, we’d be moving money out of cyclicals into defensive stocks as fast as we could.  If we knew we had a good 5-year expansion ahead of us, we’d be buying up a lot more cyclicals.  What we can say with a good measure of confidence is this:  as the economy keeps recovering, and turns into expansion, the number of believers in a “sustainable” expansion will grow exponentially.  And if that happens, we should start to wonder about the sustainability of the expansion.  Such is life in the wonderful world of economics.


Now that we have cleared that up, what is the current status of the economy?  GDP growth clocked in at +5.9% in the 4th quarter, which is a huge recovery from just 3 quarters prior (-6.6%).  Much of the change in growth from 1Q09 to 4Q09, however, was in the rate of change of inventories.  As we have explained before, production usually lags behind final demand by 2 quarters or so.  So, when demand was turning up in the 2nd quarter, businesses were still slashing their inventories.  This continued into the 3rd quarter.  During the 4th quarter, inventories fell $20 billion, but that was an improvement from a drop of $156 billion during the 3rd quarter.  The change in GDP captures the change of the change in inventories, so 4th quarter GDP benefited by $136 billion from inventory alone, which accounted for 3.9% of the 5.9% GDP growth, leaving final demand growth at only about 2%.  The 2% was a slight improvement from the 3rd quarter.

Keep in mind that this type of resurgence in GDP growth, led by inventories, is typical of every recovery.  The chart below shows how GDP growth is normally the sharpest in the early years of a recovery (2003, 1983, 1971), while the 1990s were an exception:

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And don’t forget, inventories haven’t even started to grow yet; they’re just getting depleted at a slower pace.  Adding to inventories (which are very low in some industries) will further increase the need for production to grow.

There is no doubt the consumer is still facing headwinds.  Consumer spending has, so far, been supported by government programs, although this, too, is typical.  Credit availability is either tight or nonexistent, depending on who you ask.  Consumer savings rates might be headed higher.  We are struck, however, by the resurgence of manufacturing, which has supported a huge boom in exports, which have increased at a 38% annual rate in the last 2 quarters.  Surveys like the ISM purchasing managers’ index show this will continue into 2010:


As a reminder, the ISM survey is a rare leading indicator into where the economy will be in a couple quarters.  Notice that ISM manufacturing typically peaks early in a cycle, and that drops in the index toward 50 don’t lead to recessions; drops well below 50 do.

The yield curve also continues to forecast strong growth ahead, as it is steeper than anytime in the last 35+ years:

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The most interesting part of this recovery is, prospectively, the possibility of a V-shaped recovery, especially in employment.  Yes, everything you hear from talking heads is that employment won’t be improving for years, and will be so meager that it’ll make the past 2 “jobless recoveries” (2002-03, 1991-92) look good.  However, two things are weighing in favor of a stronger labor market recovery this time:

  1. Unemployment got too high, much like production was cut too much.  Employers have realized they cut production too much, and some have already needed to add labor; more will follow.  Inflection points in hiring are usually a year after the inflection point on production, but we expect a shorter lag this cycle.
  2. This recovery will be led more by production than by services.  This is the opposite of the last 2 recoveries, which were led by consumer spending (fueled by mortgage refinancing and home wealth growth).  Manufacturing is more labor-intensive than the service sector.

More to the point, the following chart shows the ISM employment index.  This is one component of the overall ISM composite index, which gauges employers’ outlook for adding (or reducing) staff.  Check out the huge bounce in the last few months.  This level wasn’t reached in the last cycle until 2004 (3 years past the recession), and it never was reached in the 1990s.  It is more like 1983, when the bounce came shortly after the end of the recession.


Don’t misread our short-term bullishness on employment for long-term bullishness.  Long-term employment recovery will obviously depend on the durability of the expansion of our economy.  And that, in turn, will depend on how gracefully our economy can weather the removal of government stimulus, as well as higher interest rates and higher taxes.  Our friends at Strategas call this being “bullish until the bill comes due.”  There is actually some possibility that the economy can negotiate all the troubled waters and stay afloat (i.e. avoid recession), but it requires a Goldilocks economy (not too hot, not too cold), and the government extricating itself from the economy little by little.  It’s for the last reason that most people have little faith in the expansion, but it’s educational to see how, historically, the market has magically taken care of even the biggest problems.

Let us also remember that when you own stock in an American company, your payout is not U.S. GDP growth; usually, it’s much better.  Right now, it would seem that the scale has never been slanted more in favor of the global operators, compared to the U.S. economy, because:

  1. They have access to faster growth from faster-growing economies;
  2. When sales are rising, generally sales grow faster than costs.  This is called operating leverage, and the result is wider profit margins.  Right now, the difference is enormous, as U.S. companies continue to benefit from falling labor costs in the U.S., a continued shift in production toward low-cost geographies, and savings from permanent cost cuts taken during the recession.  In fact, productivity in the 4th quarter was +8.3% from the 4th quarter of 2008, which is the fastest growth ever for a 4-quarter period.
  3. Borrowing, for growth and for acquisitions, is still cheap.
  4. Free cash flow is high and rising, a result of the rapidly expanding margins (see #2 above), along with balance sheets that haven’t been this healthy in decades.

Earnings Update

Now that the 4th quarter earnings season is pretty much over, the twin themes of renewed sales growth and controlled costs came shining through.  On average, earnings for the core stocks rose 26% compared to the 4th quarter of 2008 (an admittedly easy comparison), with all but 2 companies (GE, Northern Trust) showing growth.

A much broader perspective can be gained by looking at how earnings have fared coming out of the recession.  With the market sitting 30% below its high in October, 2007, it is still verboten among market watchers to ask any questions that relate to a return to peak levels.  Even pondering the thought will get the ponderer into deep trouble.  Same goes for earnings; nobody is predicting a return to peak earnings anytime soon.  If there was a consensus expectation on this, it would probably be 2013, but with the caveat that we don’t endure a double-dip recession before then.

The core stocks, however, are a considerably brighter group.  For 9 of the 26, earnings never fell in a calendar year.  For another 7, earnings will hit a new peak this year; we have just added Cisco to this group!  Intel’s 2010 earnings are currently expected to fall 1 cent short of their previous peak, which was in the year 2000, and given the company’s current momentum, we should soon be putting Intel into this group.  That will mean that all 4 of our tech stocks are either already hitting new record earnings, or will be this year.  For a historically cyclical sector, that’s amazing, and speaks to how well-managed they are, and how strong the nascent recovery in capital spending really is.  4 more core stocks will see new peak earnings in 2011, and 6 will be thereafter.  Of those 6, 3 have a reasonable shot at seeing a new peak during 2011 instead of after 2011.

What’s the difference between the average company and the core stocks?  First, the core stocks are a little less cyclical than the average.  So, their earnings didn’t fall as hard in the recession.  Second, they are well-managed global machines.  Thus, they are not reliant upon demand from sectors that will take a long time to recover.  This would include geographies, as well as business lines.  While Coke’s U.S. volumes still aren’t growing, its overseas growth is over 30% in some countries!  J&J’s stent business is way off its peak, thanks to new competition in the drug-eluting stent market, but its orthopedics business keeps pounding out strong growth.

Dividend Update

We are very pleased to report that companies are starting to demonstrate some optimism.  We have been showing, at our seminars and lunches, a table of the core stocks, broken into 3 categories:  those who have continued to raise their dividend every year, those who have stopped raising it, but have been maintaining it (for more than 4 quarters), and those that have cut their payout.  As of last fall, the “serial raisers” list was 15 long, while there were 4 “maintainers” and 4 cutters.  Now, 2 of the maintainers have restarted dividend growth—Intel and Home Depot—and 1 of the cutters increased its dividend (Pfizer).  While the dividend cuts in late 2008 and 2009 were painful, we expect that 2010 dividends will prove to be higher than their 2008 peak.

Whatever concern you have, or anecdotal evidence about the economy, we’d be happy to hear from you!

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