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 September 2004 Not Different, Just More Noticeable
So it's no wonder investors focus on the short-term, too. Investing used to be for the long-term while short-term trading was left to, well, traders. Now, however, even those who consider themselves investors act on every earnings or economic report. This, however, isn't the effect of 9/11 as it was well entrenched during the equity bubble of the '90s. If you'll recall, day-traders were the newest celebrities. Investors routinely expected quick riches from the first-day pop of the latest IPO. Long-term was the period from one cocktail party to the next. What has changed is the prevailing attitude. The investor of the '90s was the eternal optimist, only expecting the market to go up. Now every short-term development is viewed skeptically, suspected of being the beginning of the next pernicious trend. This short-term focus isn't new, it's just more noticeable. Indeed, that's the case in a number of instances. If you step back from the daily headlines, you'll notice that everything really hasn't changed, traditional cycles are simply playing out. Pumped UpThe spiraling price of oil has been almost everyone's concern. Not only does it hit the consumer at the pump, it cuts into corporate profits by increasing the cost of production. Together they reduce corporate profits and the outlook for equities.But spikes in oil prices aren't anything new or different. They're certainly more noticeable when prices at the pump exceed $2/gallon, yet even this isn't new. While it seems like uncharted territory in nominal terms, it isn't in real (inflation adjusted) terms. Depending on your preferred method of discounting, oil, which recently peaked just under $49/bbl, was selling at $69.51/bbl (based on the PPI) or $92.43 (based on the CPI) during the 1980's oil crisis.
What is different this time is the source of the problem. Up until now, all previous spikes have been from the OPEC cartel fiddling with supply. This time, however, prices are rising due to soaring demand. Americans' love affair with gas-guzzling SUVs does bear a resemblance to the preponderance of fuel-inefficient land yachts of the early 1970s, but this time there's another major source of demand: Asia. Unlike the struggling U.S. and European or moribund Japanese economies, Asia has suddenly reawakened and there, it's full speed ahead. Fully one-half of this year's oil consumption will come from Asia, with China alone accounting for one-third. Earlier this year the Chinese central government actually took steps to slow economic growth. Manufacturing and expanding infrastructure are two of the major factors driving the Chinese expansion, and both rely heavily on oil. A so-called "terror premium" is also adding to the price of oil. This arises from the uncertainty and extent of the next disruption in supply. No one can truly quantify what this adds to the price of a barrel of oil although many market watchers place it in the range of $5 - $9. Yet despite energy costs rising 2.3% and gasoline jumping 5.4%, July's PPI was up only .1% vs. June's .3% increase. Currently the PPI is projected to rise 3.4% this year and the CPI is expected to go up 2.8%. Both would be higher than last year (3.2% and 2.3%, respectively) and the greatest increase since 2000, yet both would still be below historical averages.
Still, it's hard to believe that a protracted run-up in oil prices won't eventually show up in inflation. Manufacturers and the consumer may be willing to absorb higher costs for awhile, but not for the long-term. Surprisingly, the Fed doesn't see this as a problem. "Inflation has been somewhat elevated this year, though a portion of the rise in prices seems to reflect transitory factors," according to the statement from the August FOMC meeting. "In recent months, output growth has moderated and the pace of improvement in labor market conditions has slowed. This softness likely owes importantly to the substantial rise in energy prices." Evidently the "substantial" rise in energy prices is one of the "transitory factors". History is on their side. Previous jumps in oil prices have often been followed by spikes to the downside. Of course that was the result of OPEC's hopeless attempts to micromanage prices. This time, with demand driven shortages, the problem may prove more chronic. Other inflationary factors have already become more persistent. Increases in the cost of drugs and medical supplies has far outstripped the overall CPI. This isn't a new development, it's been happening for more than 20 years. The difference is vividly illustrated below on Chart 2.
Education costs have had similar increases. Like jumps in medical costs, they aren't new, just more noticeable now that overall inflation has been so low. Fed UpThis hasn't escaped the Fed. Indeed, the reappearance of inflation is why they recently began raising interest rates.Actually that's another thing that really is different in more than just appearance: The lengths the Fed went to head off a deeper recession and possibly even a bout with deflation. By the time they were through, the Fed Funds rate stood at a mere 1%. Even with last year's CPI at 2.3%, the real (inflation adjusted) Fed Funds rate was -1.3%. Even now (late August), after two 1/4-point increases, the real rate is still unchanged at -1.3%. With inflation accelerating at roughly the same pace as the Fed's "measured" increases, they really aren't making any headway. That leads some to believe the Fed's already behind the curve in their effort to stave off inflation. Those in this camp are calling on the Fed to increase rates more aggressively and/or more frequently. The basic premise is that it's much easier to head off inflation before it gets a toehold than to root it out once it's entrenched -- at least that's been the case in the past. Others, however, charge the Fed has already gone too far. The rising cost of oil is already slowing the economy by diverting capital and reducing demand. Any additional monetary tightening risks derailing the already slowing economy. Supporting this view are data showing the economy slowed in the second quarter and continued decelerating in July:
This hasn't escaped the Fed, either. "While there has been weakness in June ... I might say that July seems to be somewhat better, even though we are going through a soft patch," Mr. Greenspan acknowledged in his July testimony before the Senate Banking Committee. Even so, in his estimation, "There is no real underlying evidence of any cumulative weakness here." Obviously Mr. Greenspan and the Fed don't believe June and July establish a trend and that underlying inflationary forces pose a greater threat. Time will tell, but history is on their side. The biggest gains typically occur early in an economic recovery. Then, as pent-up demand is quenched, growth moderates but it doesn't necessarily come to an end. Instead, this usually signals the begging of the expansion's second half, a period marked by moderate growth, rising inflation, and increased job creation. So maybe that's what the Fed sees ahead. Rather than seeing everything as different this time, they're betting on the traditional cycle. In the face of soaring oil prices there's no call for aggressive tightening yet it would be a mistake to completely neglect the threat of inflation. In this context, measured increases make sense. Mixed UpNot to be left out, equity investors are on edge, too. It's almost as if they can't believe their own good fortune.
Second quarter earnings were again stellar. As in the prior two quarters they ultimately exceeded analysts' expectations. Comparable quarter comparisons exceeding 20% were the rule, not the exception. Yet many investors were spooked by the fact that some companies showed declines in earnings growth. Others issued warnings or tempered guidance for the coming quarters. Could this be the beginning of the end? Somehow investors have come to expect earnings growth to accelerate in each and every quarter. This, of course, is yet another holdover from the 1990s when companies made sure -- one way or another -- that profits constantly grew at a rising pace. Investors came to associate that with the bull market, so now it's assumed to be a necessary element. But just as trees can't grow to the sky, earnings can't accelerate forever. Logarithmic growth is simply not sustainable. Yet even if earnings growth has peaked, that doesn't mean profits can't continue to grow for quite some time.
This is an important distinction and deserves a little elaboration. Earnings growth has generally tended to peak in the first half of previous economic expansions, but earnings have continued to grow long after, albeit at lower rates. In other words, the second half of the expansion is marked by slower earnings growth, but still growth. There are indications that that's exactly what's happening now. Chart 3 shows the 2003 and year-to-date performance of the ten S&P sectors. As you'll notice, last year was dominated by the aggressive and cyclical sectors, yet this year they've fallen behind the more defensive ones. This is the typical mid-cycle rotation from riskier high growth stocks into those with lower yet more predictable earnings. This transition is already captured in analysts' estimates for the coming years. Chart 4 shows actual and projected earnings growth rates for the five-year period ending in December 2006. If its projected estimates are correct, profit growth will indeed peak this year. Nevertheless, analysts still believe earnings will continue to rise through 2006. If earnings drive share prices -- and we believe they do -- then stocks can continue to climb for at least another two years, just at a slower pace. There's nothing "different" about this pattern, it's the historical market cycle. It's certainly very noticeable -- especially if earnings growth declines from 18% to 8% -- but it's certainly not a sign of the apocalypse. Those who cut their investing teeth in the 1990s learned to see everything as either bullish or bearish, black or white with no grey areas in-between. But the markets have never been like that and never will. The economy's movement through a market cycle is punctuated with grey areas. This one is no different than those that have gone before. Of course with investors expecting everything to be different, they trade as if it is. To a degree, this can become a self-fulfilling prophecy, but for the savvy investor it can also spell opportunity. One other factor hanging over the market is the prospect of a Democrat returning to the White House. If one believes the polls, this is a distinct possibility as the race looks like a dead heat. Part of the concern stems from the uncertainty surrounding a change of administration. Part of it comes from the fact that Kerry administration would certainly turn a harsher eye toward the market. One of Sen. Kerry's prime targets is President Bush's tax breaks "for the rich." Interestingly enough, this promise (threat?) may have actually worked to investors' benefit, spurring Microsoft to finally return $32 billion to its shareholders before the dividend tax rate has a chance to go back up. At any rate, if history is a guide, a Democrat in the White House may actually be a good thing for the market. According to Ned Davis Research, from 1901 through April 2004, the Dow Jones Industrials averaged annual gains of 7.2% under Democrat presidents and 3.7% under Republicans. Democrat partisans will attribute this to the superior economic policies of their presidents while Republicans will suggest theirs had to pay the price of their Democrat predecessors' "tax and spend" tactics. Whatever. In the shorter-term, the latter part of an election year has generally been favorable for stocks. For the period extending from the end of the last convention through December 31st, the Dow has risen an average of 3.7%. The only fly in the ointment is when the incumbent (of either party) loses. Then, the Dow averages a 1.4% loss following the last convention. Even under this scenario, a Kerry victory wouldn't necessarily subject the market to a steep slide. Perhaps the most heartening thing is the fact that it's highly unlikely that the Democrats will regain control of Congress, possibly impeding Sen. Kerry's attempts to undermine market-friendly economics. If you'll recall, the economy had a long, prosperous run in the 1990s when a Democrat president and Republican Congress resulted in fiscal gridlock. It could happen again. Search this site! Just enter you key word or words:
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VER SINCE 9/11, THERE'S been a perception that everything's changed. Americans' sense of security has certainly been rocked. Periodic alerts keep the focus to potential future attacks. It's as if everyone's waiting for the next shoe to drop.
