Market Surveillance: The Bull’s Horns

Fri, MAR 30th, 2012

There is never a shortage of public opinion, and the stock market is no exception. An exhaustive search it ain’t to find a pundit standing on a soapbox … with a strobe light … and a megaphone.

With all of the bull/bear battles in the public square, we thought it prudent to cut through the noise and clearly outline the thinking. In this blog, we will examine the bull’s viewpoint.

Encouraging Economic Data

Figures in the U.S. are certainly firming up, especially in the labor market where less people are being fired while more people are being hired. Housing, while still in the trough, is beginning to see early signs of recovery [new builds/permits, inventory declines, lower foreclosure rates, improving job market, low rates, improving sentiment, etc.]. In Europe, the situation surely isn’t good, but it has improved. While it is true that the euro zone economies are likely in a zero-growth recession, the primary fear the equity market had was the threat of a contagious liquidity and banking crisis. Solvency was never the real issue, nor is it currently. The market doesn’t take that long-term of a view. The European leadership did right by creating the EFSF and ESM facilities, and that in conjunction with the ECB LTRO program acted as effective stop-gaps in extinguishing the crisis, for now. Sovereign yields have come down and sentiment has improved.

Finally, emerging markets. Yes, China and other key emerging markets are seeing a slowdown in their growth trajectory, but they are still growing at a fantastic clip. In addition, many of these economies boast strong balance sheets and are awash in liquidity. Recently, we were given assurance by the Chinese government that a soft-landing of at least 7.5% [GDP growth] would be achieved in 2012. In other key frontier markets, we are seeing a softer stance by central bankers in terms of interest rate policy after a small cycle of tightening. As this pertains to China, with the property market cooling significantly and inflation in a more manageable zone, looser monetary and/or fiscal policy may be deployed to make up for a slower export market.

Attractive Market Valuation

Stocks are still attractively valued, even after the latest rally with the current market multiple around 14. We are still below the long-run mean [approximately 15.5], and especially when compared to bonds the market looks cheap. Some argue that we need a resurgence of “animal spirits” to bring the market multiple back to these levels, and these spirits will not develop with so much uncertainty [Europe, U.S. political/fiscal imbalances, oil, scars of recent crises, etc.]. However, it is worth noting that this historical average P/E typically runs along-side much higher interest rates [10 year Treasury] — more in the 6-10% range. In the post-WWII era, however, when rates are low-to-moderate [under 5%] the mean market multiple is often closer to 17-18. This is an important distinction that many investor overlook. Given that our condition is presently the latter, the market looks even cheaper and may not need animal spirits to take it higher. If true animal spirits were to return it may drive this market exponentially higher [to that 17-18 P/E].

Succinctly, “animals spirits” may not be required to deliver that long-run multiple of 15.5.

Low Interest Rates

With such elevated bond prices, when interest rates begin to rise money will flee current bonds/bond funds [with dismal yields]. As bond prices fall from this early selling wave, more people will sell in effort to avoid capital losses. Investors need a return on their money; presently, fixed-income is not providing it. The dearth of return is even more drastic when you tack on inflation leaving negative real yields. This relentless punishment of savers is evident up through ten years on the Treasury yield curve.

So, if investors leave bonds where else are they going to go? In short: this money will be in search of a new home. Until [10 year] rates move north of, say 4%, the most reasonable place this money river will wind up is in stocks as they provide the best return profile. There is one caveat, however. When Bernanke shifts his monetary flight path from a dove to that of a hawk, it will cause transitory ripples in the market. History illustrates that when the Fed begins its tightening cycle the stock market can retrace briefly before continuing the bull rally [in some cases up to five more years].

A side effect of this reversed money flow will be increases in market rates. Yet, rates going to 3% or even 4% are unlikely to derail the bull market. Indeed, this 2-4% range may well be the sweet spot where investors, pushed out of bonds, conclude that yields aren’t high enough to compete with stocks. This type of market action will continue until bond yields are pushed up enough to more effectively contend with stocks.

Strong Corporate Earnings and Cash

Earnings in 2011 for S&P 500 companies clocked in around $98/share, the best on record. For 2012, earnings are expected to grow around 6% to $104/share. Coming out of the recession, the growth rate for corporate earnings has been well above trend. Nevertheless, this rate has slowed year-over-year each year. This is to be expected as 15-40% growth rates cannot be sustained in perpetuity. In 2012, this trajectory is, again, anticipated to slow. However, given the stock market’s aforementioned historically low valuation and stubbornly low interest rate environment, we don’t need much earnings growth to push the market higher because earnings have been so good compared to prices. Indeed, S&P 500 EPS growth around the historical mean of GDP plus a couple percentage points could be enough to expand the market multiple as investors weigh the anemic investment alternatives.

Likewise, cash on corporate Americas’ balance sheets — both with and ex-financial firms — are at multi-decade highs. Cash as a percentage of total assets is similarly hitting high watermarks. We are beginning to see some signs that this mound of cash is being put toward more effective uses, like hiring, increased capital investment and direct returns to shareholders [e.g. buy backs and dividends]. The economic utility of these uses are certainly more compelling than overworking the corporate treasury department in the quest for yield on cash.

Undeniably, this strong corporate health underpins stocks and, theoretically, provides a tailwind for a continuation of the bull market.

The Friendly Fed

Operation Twist is still in effect [expires this June]. As we’ve seen three times now [QE1, QE2 and Twist], as the Fed accommodates markets with liquidity and promotes low interest rates stocks move higher as investors seek greater returns. Bernanke & Co. has been quite clear that the Fed will remain accommodative as the recovery searches for firmer footing. What’s more, read-through on recent Fed language suggests that any material down-tick in the economy or across markets will likely be met with Fed action. All of this liquidity has a way of floating stock prices as the economy heals.

Sentiment and Participation

Investor, consumer, and business attitudes have markedly improved as of the past few months. The chief reasons are higher stock prices, progress in the labor market, less downbeat news headlines [especially out of Europe] and lower volatility *more on this in a minute*. It is a virtuous cycle, higher stock prices and an improved job picture boosts market confidence, which then further helps the economy and stocks. But, while there has been a strong move higher in sentiment many investors are still not participating in this market. Technical measures like market breadth, depth and general volume trends during this rally suggests that this market is still under-owned. That gives the rally more fuel as an increasing number of people “left out” finally cave and buy stocks. Those who haven’t enjoyed the move up are likely to buy the dips in order to put some money to work. This, too, may well provide support to this market.

Many Bears, Many Worries, Many Thanks

Europe’s economy is soggy and its debt burden is heavy; oil prices and, by extension, gasoline at the pump have risen markedly taxing both businesses and the consumer; China and other emerging markets have slowed a bit; U.S. economic data, while decent, has paused in surprising to the upside; U.S. fiscal imbalances are worrisome and those at the switch seem more focused on political brinkmanship in the name of partisan ideologues; the labor market recovery is more a reflection of declining productivity growth not real increases in the demand for labor power; the warm winter weather has pulled forward economic activity therefore we are poised to slow soon. These are the arguments favored by the bears in explaining why this rally cannot continue. But, contrary to what you might think, this opposition represents a useful balance as healthy bull markets typically climb a wall of worry. Those who are still bearish offer stocks an available pool of buyers as they begin to capitulate one-by-one as things improve.

Suppressed Volatility

Market turbulence has significantly abated in 2012, demonstrated by the VIX’s inability to reach higher than 25. While this could be the calm before the storm, for the time being it is plainly saying that investors are paying less insurance to protect against the threat of a market decline. This has helped quell the market’s once irrational fear of everything and may well bring some additional market participation into the fold, bidding prices higher. This serene stock market can be especially alluring to retail investors who feel they have been burned in past years by wild volatility, black swan events and the Wall Street pump-and-dump racket.

Performance History

After 10+ year periods of lagging equity performance — a box we can absolutely check — past evidence shows that equities usually outperform for a sustained period. It is a function of the whole secular bear/bull market cycle.

So what of the stock market’s recent pause? Bulls call this consolidation, and its a healthy and crucial step in the continuation of an uptrend. In fact, many would like to see a near-term correction of 3-4% before we continue the path up.

We agree.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200

About Albion Financial

Established in 1982, Albion Financial Group is an independent, fee-only financial planner and investment manager located in Salt Lake City, Utah.