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 March 2005 Chugging Along
Bulls have been expecting consumers to pass the spending baton to businesses, unleashing a new wave of capital. They're also expecting job creation to pick up along with corporate revenues and profits. According to this rosy scenario, stocks will regain some upward momentum in the latter half of the year while bonds will hold relatively steady. On the other hand, bears expect the economy to slow, bogged down by rising deficits, the falling dollar, and decelerating profit growth. As the Federal Reserve continues to tighten credit to forestall inflation, the cost of capital will increase squeezing corporate earnings. At the same time, the rising cost of oil will pressure consumer spending, the main driver of the current economic expansion.
But so far the economy hasn't supported either prediction. Instead, it's just plugged along at a steady pace. Like professional prognosticators, investors are understandably confused as they try to gauge the direction of the financial markets. Fortunately, there are ways to make sense of all this. Most of them draw on history and how markets have reacted under similar circumstances. The Cost of SuccessContrary to the bears' current expectation, most bull markets haven't simply run out of steam, they've flamed out in a flurry of inflation. In a sense, inflation has been a cost of success. As the economy moves forward with strong demand for production, costs tend to escalate to the point where they begin to erode real purchasing power.Inflation -- at least at the wholesale level -- did show signs of heating up in 2004. Driven by the jump in oil prices, the Producer Price Index (PPI) rose by 4.1%, the greatest increase in 14 years. Core PPI which excludes volatile food and energy prices rose by a more modest 2.2%. Even so, it was still the sharpest increase since 1998.
January's figures were reversed with the headline number climbing 0.3% while core PPI jumped .8%. For the latter, that was the biggest monthly increase in 6 years and was attributed to higher tobacco, alcohol, and automobile costs. So far, these wholesale increases have yet to be passed on to the consumer. The Consumer Price Index (CPI) was up 3.3% in 2004. The core index was up 2.2%. For January, the monthly increases were .1% and .2%, respectively. Crude oil prices moved back over $50/bbl in February. Given the ongoing high levels of U.S. consumption, this one commodity will continue to have a major impact on the inflationary outlook. Continued instability in Iraq and OPEC's growing desire to keep oil over $40/bbl will add to inflationary pressures. This is all part of the bears' case for an economic slowdown. What they haven't anticipated. however, is the Fed's ability to head off inflation before it starts. Perhaps more precisely, what no one anticipated was how effective the central bank would be in communicating its intentions. Prior to Alan Greenspan's reign, the Fed was primarily reactive. Changes in the direction of monetary policy tended to occur only when economic conditions required, causing the Fed to often overreact. Now, however, the Fed has become more proactive, attempting to blunt developing trends before they're carried to extremes. This approach, as opposed to those of the past, has the potential to be much more effective in maintaining price stability. The current Fed has done a good job in telegraphing its intentions through post-meeting announcements and speeches by its governors. Minutes of each FOMC meeting are now released well in advance of the next, a change from prior policy. So it was no surprise when the Fed began tightening short-term rates last June. Since then, there have been a total of six 1/4% increases, pushing the Fed Funds Rate to 2.5%. The markets have weathered this remarkably well, again thanks to the Fed's candor. Nevertheless, real short-term interest rates are still negative -- in other words, they're still lower than the annual inflation rate. In the past, this would be reason to panic but the Fed's "measured" pace instills a great degree of confidence. In his February Congressional testimony, Mr. Greenspan was reassuring, "People experiencing long periods of relative stability are prone to excess. We must thus remain vigilant against complacency." The upshot? Over the near-term interest rates have further to climb, but over the longer-term the Fed has a good handle on inflation. There's not much here to support the bull or bear case, unless one is willing to question the Fed's ability to pull this off. To date, that's been a losing argument. A ConundrumHistorically, the prospect of rising rates has hurt the bond market. The value of existing bonds goes down as current rates go up. After all, who would want to buy an existing bond at par when they could buy a new one with the same maturity but a higher yield?Inflation can drive up prevailing yields, but so can the Fed. Given the latter's promise to remain vigilant, you'd expect bonds to be under more than a little pressure. But that's not the case. Instead, bond investors are amazingly sanguine. This is at least partially due to the Fed's communication effort: Bond investors weren't taken off-guard as in the past. In addition, they believed the Fed unlike 1994 when they ignored the warning and suffered significant losses. Nevertheless, "For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum," according to Mr. Greenspan. Long-term yields are actually the source of his puzzlement. Back on June 29, the day before the Fed's first rate increase, the 30-year Treasury Bond yielded 5.37%. Following six short-term increases totaling 1.5%, the long bond has traded as low as 4.37% on February 8. That's not supposed to happen. Usually when the Fed tightens, rates move up across the board. In fact, if inflation is an immediate concern, yields of longer maturities rise faster than those of shorter-term instruments to compensate investors for the greater degree of risk in longer holding periods. As a result, the yield curve, which graphically illustrates the yields at all maturities, typically gets steeper as long-term yields rise faster than short-term.
But that hasn't happened this time. As Chart 2 indicates, long-term yields have fallen while short-term yields have climbed, resulting in a flatter yield curve. We would suspect this odd behavior is due to the fact that bond investors don't see inflation as a long-term threat. In essence, it's a vote of confidence in the Fed. It's also a tribute to the Fed's successful communication effort. By clearly relaying their intent, they've taken some of the risk out of holding longer-term securities so investors aren't demanding such a large spread over shorter-term bonds. Could this be a bit of support for the bulls' case? "Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience," cautions the ever circumspect Mr. Greenspan. Serious HeadwindsUp to this point the Fed's tightening policy hasn't negatively impacted stocks. Of course it may be too early to tell as there's usually a 6-9 month lag between a Fed move and its impact on the economy. With the first rate increase in June 2004, we're only now arriving at that point.The bears argue that the higher cost of capital along with rising commodity prices will compress margins and ultimately reduce corporate profits. If so -- and if you believe as we do that earnings ultimately drive share prices -- stocks may be in for a rough 2005. The falling dollar doesn't help, either. Freshman economics textbooks will tell you that countries with weak currencies often benefit from the relative value of their exports. What they fail to tell you is that in order for this to occur, foreign trading partners must be willing to buy the exports. Unfortunately that doesn't seem to be the case. To be sure, the U.S. has increased exports recently, but the current account deficit is simply growing at a slower pace. Why? Because foreign consumers are net savers while their U.S. counterparts save almost nothing. China and South Korea are seeing their net exports to the U.S. rise while Japan has been attempting to export itself out of recession for the better part of a decade.
Not only is the current trade deficit a concern, there's mounting fear that foreign central banks will eventually "diversify" their holdings of U.S. dollars and investments. The worry here is that significant selling by trading partners would lead the dollar to plunge, taking the U.S. economy with it. While all this sounds bearish -- and quite frightening -- it's also important to realize a sharp decline in the dollar is not in anyone's best interest. Clearly it would be detrimental to the U.S. economy, but it would also harm our trading partners as well. As large holders of U.S. securities, they would suffer major losses right along with domestic investors. Nevertheless, February 22 offered a preview of what a dollar selloff might look like. The previous evening the Bank of Korea released its annual report to the National Assembly. One line -- that's right one line -- in the report expressed the central bank's desire to "expand investment into nongovernment bonds, which have relatively higher yields, and diversify the currencies in which it invests." That's all it took to send the Dow Jones Industrials to their biggest one-day loss since May 2003 and for the dollar to fall 1.4% against both the yen and the euro. Fortunately the Korean central bank subsequently issued two separate statements denying it was selling dollars, allowing the markets to recover. However, "diversification" can occur in other, less direct ways. In fact, there are tangible signs that this process is already underway. For example, the Treasury's February auction of new 2-year Notes suffered an overall decrease in demand. More importantly, only 32% were awarded to indirect purchasers, the category that includes foreign buyers. This was the third month in a row in which indirect buying was around 30%, well below the historical average. It's likely that those dollars, which previously would have bought Treasuries, are now being "diversified" into other nations' securities or currencies. Equity investors should monitor these situations closely. Coupled together, equities face some pretty strong headwinds, perhaps supporting the bears. A Market of StocksOf course one of the things astute investors quickly realize is that it's not a stock market but rather a market of stocks. Even when the environment is not favorable for the overall stock market, there are still opportunities to find stocks with good upside potential. It simply takes a little more work.Again, history can be a guide. For example, over the last six years, small cap stocks have beaten their large cap counterparts. In the past, small cap cycles have lasted about 5-6 years, so this one should be nearing an end. Contrary to the so-called "January Effect" selling in the first few weeks of the year hit small caps harder than large caps, so perhaps this transition is already underway.
Along the same lines, investors may be again returning to dividends. Small cap companies tend to reinvest profits back into the business, so any move into dividends would favor large cap stocks. Many -- including us -- had predicted that high yielding stocks would see increased demand in light of the favorable tax treatment given dividends under the Bush tax revisions. Surprisingly, that didn't happen last year. But now, more and more companies are paying dividends, while those that already did are increasing them. In the first two months of the year -- admittedly a short measurement period -- stocks of dividend paying companies bested those of non-dividend payers. Historically, dividends have accounted for over 40% of equity total returns. Since 1926, the S&P 500 has had an average total return of 10.5% with dividends constituting 4.4% of it. If earnings growth does slow as anticipated, a steady stream of dividends will become much more valuable. It's also important to consider market sectors as well. Many investors begin the New Year buying stocks in sectors that did the best in the prior year. Often this "if it ain't broke don't fix it" type of investing works well, especially in a trending market. It is, after all, a form of "momentum investing" that worked so well back in the 1990s. But this year may be a little different -- in fact last year was, too. Just consider:
Additional sector rotation is likely in 2005. Like the transition from 2003 to 2004, some sectors that were laggards last year are poised to become this year's leaders. Stocks in sectors that can produce consistent revenue growth are best bets in a slow but steady economic environment. Briefly looking at each in order of 2004 performance:
No single sector or market segment has a monopoly on 2005 investment opportunities. As always diversification across all sectors is the long-term investor's best approach. It's highly likely that the economy will continue chugging along in 2005. Its moderate pace may not be enough to excite either the bulls or the bears, but that doesn't mean it won't be enough for prudent investors. Search this site! Just enter you key word or words:
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HE U.S. ECONOMY CONTINUES TO confound both the bulls and the bears. For months now, both camps have been expecting trends to turn in their favor, but so far it just hasn't happened.
