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 May 2007 Against the Odds
Perhaps most noteworthy was the breath of the ascent. Not only did the Industrials average move into rarefied air, so did the Utilities and Transports. That’s a Dow Theorist’s dream of confirmation. Small stocks weren’t left out, either. Both the Russell 2000 and the S&P Small Cap 600 also logged all-time highs. So much for the transition to large caps – at least for now. So what’s up with the disconnect between the market and the economy? Is it really different this time or is the market – typically viewed as a leading indicator—actually signaling the slowdown will be short lived?
Tangible Signs To be sure, earnings are still growing, just at a slower pace than before. It’s also worth noting that earnings growth has actually been declining for some time now, it’s just more noticeable this quarter. As this is being written, about two-thirds of the S&P 500 companies have reported first quarter results, and it’s almost a certainty that this will be the first quarter in 15 in which the growth rate will fall below double digits. On the positive side – and part of the reason for the recent market surge – first quarter earnings have actually been better than analysts expected. Coming into March, the consensus pointed to an 8% increase, but by early April, it had fallen to just over 3%. In other words, the bar was set pretty low just before the actual reports starting coming out. We suspect a great deal of the late April equity push was based on the relief that earnings didn’t roll off the table in just one quarter. Investors expected so little from the profit reports that a 6% increase (as it looks now) is much better than a 3% increase – despite being less than a double-digit or even 8%. When the buying mood hit, everybody bought. The Federal Reserve also has to be in the back of everybody’s mind. For whatever reason, investors still seem to be clinging to the belief that the Fed will cut interest rates to support both the economy and the stock market. This is an odd belief, especially in light of the market’s recent run. How much supporting can it need? As long as this belief persists, investors will feel emboldened to look beyond declining earnings growth and rising inflation. As long as the Fed is seen as a magic safety net, it’s OK to take a little more risk.
In a Box Even so, inflationary pressures persist. Although so-called “core inflation” which excludes food and energy costs remains relatively contained, broader measures are increasing. More importantly, it’s food and energy costs that are having the greatest impact on consumers. The late season cold weather and instability in the Middle East have driven crude oil prices back over $60 a barrel. Gasoline prices are hovering around $3 a gallon even before the summer driving season begins. Food prices are poised to rise as well as more resources are diverted to the production of ethanol. Corn is used in an astounding number of products and processes from corn oil, to high fructose corn syrup in soft drinks, and feed for cattle. As more is dedicated to the production of fuel, lower supplies will drive up food prices. As these increased costs hit the consumer each week, look for discretionary spending – one of the major drivers of the economy – to come under pressure. Under normal circumstances, the Fed would probably be ready to push rates a little higher to damp rising prices, but with the economy already showing definite signs of slowing, their hands are tied. Instead, they’ve been stuck in neutral for ten months now. Their official statements portray them as keeping a “watchful eye” on inflation, but it’s the move away from the prior tightening bias that’s given investors hope for future rate cuts. That, however, won’t happen soon because it would only fan inflationary fires.
Backward Bonds But if the Fed were to reverse course and begin trimming rates, investors would again demand an inflation premium for the increased risk of owning longer-term bonds. As a result, a rate cut would send yields at the short end of the yield curve down but those at the longer end would rise, returning the overall curve to its traditional upward-sloping pattern. This is already starting to occur as the 10-year Treasury yield has recently been trading in a range bounded by 4.65% to 4.8%, well above 4.5% where it started the year. Back in January, its yield was actually below that of the 2-year Treasury, but now it’s back above. Fixed income investors typically cheer rate cuts as the value of their existing holdings – which move inversely with rates – increase. Yet if this scenario plays out now, the benefits will be muted and only recognized in the short-term. Corporate borrowers would also suffer as companies would have to pay more to bring new bonds to market. Normally, as interest rates rise at longer maturities, corporate borrowing slows and with it, the overall economy as well. For at least the next six months, fixed income investors would be well advised to stick to bonds with shorter maturities allowing them to capture much of the yield of the longer-term but without the principal risk. When long-term rates do begin to rise, they can then consider extending maturities.
After the Runup
Corporate earnings are a better place to focus. After such a long string of double-digit earnings growth, it’s not unusual to see a slowdown. It’s important to bear in mind that a decrease in earnings growth doesn’t mean earnings aren’t still improving; they’re just doing so at a slower pace. In the past, investors were well advised to pay closer attention to the statements companies issued with their earnings announcements rather than the profit numbers themselves. Forecasts were more valuable than past history. This time, however, the numbers should command attention. Part of the reason investors were so relieved with first quarter earnings is because companies did such a good job of sandbagging. Knowing that growth would be harder to come by in a slowing economy, most firms issued extremely conservative guidance. By containing expectations, they were able to (easily) surpass them, resulting in “positive” surprises and lighting the fuse under share prices. The actual reported numbers tell a different story. Although in many instances they exceeded expectations, they still declined from comparable quarters. The downward trend in earnings growth is now fairly well established. More telling is the fact that there weren’t more negative surprises. This suggests that although the pace is slipping, companies anticipated it and handled it well. This is about the best investors could hope for at this stage in the economic cycle. The next thing to look for is a catalyst that could reinvigorate the economy and earnings. It’s hard to guess what that might be other than a tax cut, an overwhelming victory in Iraq, or a major drop in crude oil prices. With the democrats ruling Congress, irrational factions willing to commit suicide to promote terror in Iraq, and China’s burgeoning demand for oil, none of these seem likely, at least in the short-term. Failing one of these miracles or another unexpected one emerging, investors should probably focus overseas. Although riskier emerging market and Asian stocks continue to do well, investors can avoid some of the geopolitical risk by considering larger, more developed markets, particularly Western Europe. Economies there continue to strengthen while currency exchange rates magnify U.S. investors’ foreign investment returns. At this point, the Netherlands, Sweden, and the U.K. are particularly attractive. Their economies are still in the expansion phase and interest rates are rising, making them more attractive to foreign investment. Perhaps most importantly, earnings growth is accelerating in these countries. That’s a considerably better sign for an investor than hope for change in domestic monetary policy or an extended rally in the U.S. Search this site! Just enter you key word or words:
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UST WHEN IT BECAME generally accepted that the U.S. economy was losing steam, the stock market took off. The final weeks of April were remarkable for a number of reasons, not just the Dow Industrials’ all-time highs.
