Tuesday the Dow finished above the 12,000 mark for the first time since June of 2008, before Lehman's apocalyptic demise. Investors cheered, particularly given the unrest in Egypt and its foreboding geopolitical implications.
At a minimum the Dow's climb back to 12,000 marked a triumph for the buy and hold crowd: Those who sold during the downturn are left with less than if they'd turned the other cheek (more probably ducked to avoid a body blow). Nevertheless, the sellers did take less risk, and perhaps slept better.
The bears acknowledge 12,000 but derisively point to all the stimulus that's been thrown at the economy, from the Federal Reserve's 0% interest rate policy as it buys up US Treasuries (QE2), to Washington's trillion dollar deficits, to the nation's 9%+ unemployment rate. They warn the stimulus can't last forever, and when it's withdrawn look out below.
Our Outlook in a Nutshell
Although the fundamentals favor stocks, be cautious; the markets have almost doubled since the crisis low of March 2009, including a near 25% gain over the last four plus months. What kind of a correction could we expect? Stocks retreated nearly 17% beginning last April following a similar run. Catalysts for a pullback include a weak job recovery, contagion from Egypt's turmoil, even contemplation of an end to Federal Reserve largess. Nevertheless, over the longer haul equities hold more promise than fixed income and commodities.
12,000: Psychological Implications
The party line is that round numbers have no fundamental significance. After all, ultimately stocks trade based on revenues and profits; what Walmart shopper is going to spend more because the Dow's at 12,000?
Nevertheless, in the short term stock prices are determined by supply and demand; positive sentiment boosts demand, and most investors' enthusiasm sharpens as prices rise.
However, this 12,000+ close was no all-time high milestone. Since the Dow first settled above 12,000 October 19, 2006, subsequent market volatility caused five more ascents of 12,000. Some investors can be forgiven if, looking at history, Dow 12,000 represents a sell signal, not a buy point.
Bottom line: Long term investors should not pay much attention to round numbers, including this one.
Valuations: It Can't Be a Straight Line Up Forever
Measure valuation by looking at what you could have paid then versus what you have to pay now. S&P 500 investors now must pay 83% more than was the case on March 9, 2009, and nearly 25% more than August of last year. Stocks were either very cheap then or rather expensive now; assume it's some of both.
On the other hand, stocks still stand 17% below their all-time high of October 2007, as measured by the large cap S&P. That suggests there's more room to run, eventually. Currently, the health of the housing and jobs markets doesn't support a new all-time high. Not well known, however, is that mid cap stocks have broken through to new all-time highs.
Offsetting valuation concerns is the low interest rate environment. The traditional comparison is the inverse of stocks' price to earnings ratio, called the earnings yield, with the payout on the ten year Treasury bond, now at 3.6%. Stocks' earnings yield is now over 7%, netting investors a generous double the return on Treasury bonds.
A yellow flag is that the dividend yield is at a low 1.83%, down from 2.16% just a year ago. Historically, anything under 2% does not bode well. The bullish response is that corporations are sitting on record amounts of cash; cash will eventually find its way back into the hands of the investing public, whether in the form of enhanced dividends, stock buybacks, or merger and acquisition activity.
Corporate Earnings: Stellar but Slowing
Earnings, the mother's milk of stock prices, continue growing at a stellar pace. With two out of every five S&P 500 companies having reported their Q4 2010 results, 72% have beat expectations, with the biggest surprises in the energy, financial, and information technology areas. The overall year over year growth when all Q4 numbers are in is expected to be 36%.
Unfortunately, stock prices look forward, not backwards. Q1's earnings year over year are expected to be up a less heady 13.6%. As we get further into 2011, earnings comparisons will become more difficult, as comparisons will be against a relatively decent 2010. Costs, led by raw materials, will rise. Analysts will be looking carefully for revenue improvement to keep the bottom lines growing.
Inflation Ahead?
Amid sharp commodity price increases, many strategists worry about inflation. Inflation will push bond yields up, making fixed income more competitive. It will also squeeze margins, potentially depressing earnings.
An index of commodities is at its highest level since November 2008. Prices at the pump have risen 15% since August. Global food prices are more than 30% higher than a year ago.
However, core inflation for 2010, stripping out food and energy, was a muted 0.7%. Bond investors do not seem particularly concerned about inflation, given the low rates prevailing. With the labor and housing markets so weak, inflation from those key sectors of the economy does not seem imminent. A bit of inflation is to be expected as the economy recovers.
We don't expect inflation to spoil stock investors' party any time soon.
Is It All About Jobs?
It does seem anomalous that stocks are rising with nearly 1 out of every 10 Americans out of work, particularly considering that consumers account for 70% of this country's spending. January's employment report disappointed, as just 36,000 jobs were created, although the unemployment rate dropped as more workers gave up the search.
Yet, weak jobs numbers are not necessarily the investment head wind the media would have you believe. Jobs are an expense; enhanced productivity has allowed corporations to produce more with less people, not a great story for the politicians or those out of work but profitable for shareholders.
Employment continues to shift outside this country. The financial crisis sped up a secular outsourcing trend. With up to 50% of large companies' sales overseas, conditions in Dearborn may be no more important than those in Calcutta.
Improved Economic Climate
You can disparage the cause, for example, excessive government spending or a profligate Federal Reserve, but the fact is the economy is improving. Auto sales have rebounded strongly, to a level implying annual sales of 12 million per year. Manufacturing is showing strength, being helped by a weaker US dollar. The index of leading economic indicators has recently accelerated upward, with the latest showing a surprise reading of up 1.1%.
Beyond jobs, housing remains a weak area, and that's important since it typically represents consumers' largest asset. The latest index of home prices showed a fifth straight month of year over year declines. No question, the housing market may take years to recover, and that's not helpful to companies focused there.
Sentiment: Too Much of a Good Thing?
From a contrarian perspective, too much enthusiasm is linked with future subpar returns, the theory being that excessive optimism produces excessive prices; ultimately, the prices and optimism are unsustainable and a cyclical downturn in both sets in.
Where we are on sentiment is actually unclear, so it may be a neutral factor now. Professionals are upbeat, and the major brokerage houses all predict gains, some as much as 25%, for the year ahead. Surveys of individual investors show unbridled enthusiasm, although the recent weeks have seen that lessen a bit.
On the other side of the ledger, mutual fund investors have just begun adding to domestic equities after several years of withdrawing. Further, insiders and corporations seem to be middling in their views. Finally, as all experts are expecting a correction imminently, this also bolsters the case for no correction any time soon.
State and Local Finances: On the Brink
States and local governments have been hard hit by the downturn, as tax revenues have fallen off sharply. Expenses keep rising particularly for healthcare and pensions. As a result, there's been much debate as to their fiscal soundness.
If there ever was a catalyst for a double dip back into recession, default by a major municipal bond issuer would be it. The ripple effects could be unimaginable. But, it's hard to envision a scenario where politicians would turn their back on such a situation.
For the last several months individual investors have been massive sellers of tax exempt bond funds. Fear may become self-fulfilling, as the fewer bond buyers there are the higher interest rates must rise and the worse the issuers' finances become.
At a minimum, the fiscal belt tightening required for state and local entities to balance their books will slow the recovery, especially in the labor market. Troubles in the municipal bond market have the potential to create volatility among equities.
Emerging Markets: Is it Time to Rethink the Risks?
Emerging markets have been market darlings for at least a decade, as the lure of rapid growth has been compelling.
Historically, valuations on emerging market stocks have been lower than the developed world, reflecting political risk, a potentially laxer legal and regulatory framework, and the cyclical nature of much of the commodity focused industries in those regions.
The massive inflows into the emerging markets have induced inflationary pressures; monetary authorities in both China and India are making concerted efforts to cool their economies. Stock markets there have now started to underperform; China's lagged ours last year and is down since early November, while India's has started 2011 with a double digit decline.
The recent turmoil in Egypt has underscored the perils in these regions. Coupled with still historically high valuations, investors may tend to steer clear going forward.
Can Stocks Rise if Interest Rates Rise?
Federal Reserve Chairman Ben Bernanke has stated that one of his goals, by reducing interest rates and buying up Treasury debt, was to boost the stock market. At some point, however, the Fed will cause or allow interest rates to revert (up) to normal, and unload positions on its balance sheet. The great question is how the market will react.
Indeed, interest rates have risen since their nadir of about 2.4% on the ten year Treasury in early October to the current 3.6%. It's not just stocks that can be adversely affected. For example, despite the weak housing market, home mortgage rates are off their lows and beginning to rise.
As the economy improves loan demand rises. Rising interest rates are a necessary and expected accompaniment to economic revival. A gradual rise in the ten year Treasury to over 4% should not derail equities. It may help certain sectors like banks, as they'll be able to obtain a better return on their lending.
Sector Roulette: Healthcare, Utilities, and Financial Services May Offer Opportunity
Large cap pharma has been much maligned. Research and development has been less than fruitful, so many of these companies face revenue waterfalls when their patents expire, amid fierce competition by generic drug makers. Health care reform and cost sensitivity has created pricing pressure. Investors have had trouble making the case for relatively non-cyclical drug companies amid the hope for global recovery.
Yet, many of these issues are now baked into prices.Pfizer (PFE, Financial) is the cheapest stock on the Dow, while it and peerMerck (MRK, Financial) boast dividend yields north of 4%, European drug makerRoche (RHHBY, Financial) has a yield topping 3%. What could be the catalyst for better returns going forward? Pfizer spiked sharply this week when it announced it was going to spend less on hapless research and more on stock buybacks.
Utilities have been passed over amid the recovery. They have little cyclicality, enjoy little global exposure, and are hamstrung by rate regulators from raising rates. But, a renewed focus on yields by investors rotating out of bonds, plus any possible hiccupping in the pace of economic recovery may bring interest in such names asExelon (EXC, Financial) andConstellation Energy (CEG, Financial). While you wait, enjoy robust dividends equaling nearly 4.3%.
Financials were laggards in 2010's second half; housing, a key part of the business, stayed moribund, loan demand was weak, and concerns about their existing loan portfolios festered.
However, stock prices relative to tangible book values remain at historically low levels. Loan portfolio quality seems to be improving and default rates declining. Many of these companies are expected to boost or reinstate their dividends before year end.Wells Fargo (WFC, Financial),JP Morgan (JPM, Financial), andBank of America (BAC, Financial) should participate in these improving trends.
At a minimum the Dow's climb back to 12,000 marked a triumph for the buy and hold crowd: Those who sold during the downturn are left with less than if they'd turned the other cheek (more probably ducked to avoid a body blow). Nevertheless, the sellers did take less risk, and perhaps slept better.
The bears acknowledge 12,000 but derisively point to all the stimulus that's been thrown at the economy, from the Federal Reserve's 0% interest rate policy as it buys up US Treasuries (QE2), to Washington's trillion dollar deficits, to the nation's 9%+ unemployment rate. They warn the stimulus can't last forever, and when it's withdrawn look out below.
Our Outlook in a Nutshell
Although the fundamentals favor stocks, be cautious; the markets have almost doubled since the crisis low of March 2009, including a near 25% gain over the last four plus months. What kind of a correction could we expect? Stocks retreated nearly 17% beginning last April following a similar run. Catalysts for a pullback include a weak job recovery, contagion from Egypt's turmoil, even contemplation of an end to Federal Reserve largess. Nevertheless, over the longer haul equities hold more promise than fixed income and commodities.
12,000: Psychological Implications
The party line is that round numbers have no fundamental significance. After all, ultimately stocks trade based on revenues and profits; what Walmart shopper is going to spend more because the Dow's at 12,000?
Nevertheless, in the short term stock prices are determined by supply and demand; positive sentiment boosts demand, and most investors' enthusiasm sharpens as prices rise.
However, this 12,000+ close was no all-time high milestone. Since the Dow first settled above 12,000 October 19, 2006, subsequent market volatility caused five more ascents of 12,000. Some investors can be forgiven if, looking at history, Dow 12,000 represents a sell signal, not a buy point.
Bottom line: Long term investors should not pay much attention to round numbers, including this one.
Valuations: It Can't Be a Straight Line Up Forever
Measure valuation by looking at what you could have paid then versus what you have to pay now. S&P 500 investors now must pay 83% more than was the case on March 9, 2009, and nearly 25% more than August of last year. Stocks were either very cheap then or rather expensive now; assume it's some of both.
On the other hand, stocks still stand 17% below their all-time high of October 2007, as measured by the large cap S&P. That suggests there's more room to run, eventually. Currently, the health of the housing and jobs markets doesn't support a new all-time high. Not well known, however, is that mid cap stocks have broken through to new all-time highs.
Offsetting valuation concerns is the low interest rate environment. The traditional comparison is the inverse of stocks' price to earnings ratio, called the earnings yield, with the payout on the ten year Treasury bond, now at 3.6%. Stocks' earnings yield is now over 7%, netting investors a generous double the return on Treasury bonds.
A yellow flag is that the dividend yield is at a low 1.83%, down from 2.16% just a year ago. Historically, anything under 2% does not bode well. The bullish response is that corporations are sitting on record amounts of cash; cash will eventually find its way back into the hands of the investing public, whether in the form of enhanced dividends, stock buybacks, or merger and acquisition activity.
Corporate Earnings: Stellar but Slowing
Earnings, the mother's milk of stock prices, continue growing at a stellar pace. With two out of every five S&P 500 companies having reported their Q4 2010 results, 72% have beat expectations, with the biggest surprises in the energy, financial, and information technology areas. The overall year over year growth when all Q4 numbers are in is expected to be 36%.
Unfortunately, stock prices look forward, not backwards. Q1's earnings year over year are expected to be up a less heady 13.6%. As we get further into 2011, earnings comparisons will become more difficult, as comparisons will be against a relatively decent 2010. Costs, led by raw materials, will rise. Analysts will be looking carefully for revenue improvement to keep the bottom lines growing.
Inflation Ahead?
Amid sharp commodity price increases, many strategists worry about inflation. Inflation will push bond yields up, making fixed income more competitive. It will also squeeze margins, potentially depressing earnings.
An index of commodities is at its highest level since November 2008. Prices at the pump have risen 15% since August. Global food prices are more than 30% higher than a year ago.
However, core inflation for 2010, stripping out food and energy, was a muted 0.7%. Bond investors do not seem particularly concerned about inflation, given the low rates prevailing. With the labor and housing markets so weak, inflation from those key sectors of the economy does not seem imminent. A bit of inflation is to be expected as the economy recovers.
We don't expect inflation to spoil stock investors' party any time soon.
Is It All About Jobs?
It does seem anomalous that stocks are rising with nearly 1 out of every 10 Americans out of work, particularly considering that consumers account for 70% of this country's spending. January's employment report disappointed, as just 36,000 jobs were created, although the unemployment rate dropped as more workers gave up the search.
Yet, weak jobs numbers are not necessarily the investment head wind the media would have you believe. Jobs are an expense; enhanced productivity has allowed corporations to produce more with less people, not a great story for the politicians or those out of work but profitable for shareholders.
Employment continues to shift outside this country. The financial crisis sped up a secular outsourcing trend. With up to 50% of large companies' sales overseas, conditions in Dearborn may be no more important than those in Calcutta.
Improved Economic Climate
You can disparage the cause, for example, excessive government spending or a profligate Federal Reserve, but the fact is the economy is improving. Auto sales have rebounded strongly, to a level implying annual sales of 12 million per year. Manufacturing is showing strength, being helped by a weaker US dollar. The index of leading economic indicators has recently accelerated upward, with the latest showing a surprise reading of up 1.1%.
Beyond jobs, housing remains a weak area, and that's important since it typically represents consumers' largest asset. The latest index of home prices showed a fifth straight month of year over year declines. No question, the housing market may take years to recover, and that's not helpful to companies focused there.
Sentiment: Too Much of a Good Thing?
From a contrarian perspective, too much enthusiasm is linked with future subpar returns, the theory being that excessive optimism produces excessive prices; ultimately, the prices and optimism are unsustainable and a cyclical downturn in both sets in.
Where we are on sentiment is actually unclear, so it may be a neutral factor now. Professionals are upbeat, and the major brokerage houses all predict gains, some as much as 25%, for the year ahead. Surveys of individual investors show unbridled enthusiasm, although the recent weeks have seen that lessen a bit.
On the other side of the ledger, mutual fund investors have just begun adding to domestic equities after several years of withdrawing. Further, insiders and corporations seem to be middling in their views. Finally, as all experts are expecting a correction imminently, this also bolsters the case for no correction any time soon.
State and Local Finances: On the Brink
States and local governments have been hard hit by the downturn, as tax revenues have fallen off sharply. Expenses keep rising particularly for healthcare and pensions. As a result, there's been much debate as to their fiscal soundness.
If there ever was a catalyst for a double dip back into recession, default by a major municipal bond issuer would be it. The ripple effects could be unimaginable. But, it's hard to envision a scenario where politicians would turn their back on such a situation.
For the last several months individual investors have been massive sellers of tax exempt bond funds. Fear may become self-fulfilling, as the fewer bond buyers there are the higher interest rates must rise and the worse the issuers' finances become.
At a minimum, the fiscal belt tightening required for state and local entities to balance their books will slow the recovery, especially in the labor market. Troubles in the municipal bond market have the potential to create volatility among equities.
Emerging Markets: Is it Time to Rethink the Risks?
Emerging markets have been market darlings for at least a decade, as the lure of rapid growth has been compelling.
Historically, valuations on emerging market stocks have been lower than the developed world, reflecting political risk, a potentially laxer legal and regulatory framework, and the cyclical nature of much of the commodity focused industries in those regions.
The massive inflows into the emerging markets have induced inflationary pressures; monetary authorities in both China and India are making concerted efforts to cool their economies. Stock markets there have now started to underperform; China's lagged ours last year and is down since early November, while India's has started 2011 with a double digit decline.
The recent turmoil in Egypt has underscored the perils in these regions. Coupled with still historically high valuations, investors may tend to steer clear going forward.
Can Stocks Rise if Interest Rates Rise?
Federal Reserve Chairman Ben Bernanke has stated that one of his goals, by reducing interest rates and buying up Treasury debt, was to boost the stock market. At some point, however, the Fed will cause or allow interest rates to revert (up) to normal, and unload positions on its balance sheet. The great question is how the market will react.
Indeed, interest rates have risen since their nadir of about 2.4% on the ten year Treasury in early October to the current 3.6%. It's not just stocks that can be adversely affected. For example, despite the weak housing market, home mortgage rates are off their lows and beginning to rise.
As the economy improves loan demand rises. Rising interest rates are a necessary and expected accompaniment to economic revival. A gradual rise in the ten year Treasury to over 4% should not derail equities. It may help certain sectors like banks, as they'll be able to obtain a better return on their lending.
Sector Roulette: Healthcare, Utilities, and Financial Services May Offer Opportunity
Large cap pharma has been much maligned. Research and development has been less than fruitful, so many of these companies face revenue waterfalls when their patents expire, amid fierce competition by generic drug makers. Health care reform and cost sensitivity has created pricing pressure. Investors have had trouble making the case for relatively non-cyclical drug companies amid the hope for global recovery.
Yet, many of these issues are now baked into prices.Pfizer (PFE, Financial) is the cheapest stock on the Dow, while it and peerMerck (MRK, Financial) boast dividend yields north of 4%, European drug makerRoche (RHHBY, Financial) has a yield topping 3%. What could be the catalyst for better returns going forward? Pfizer spiked sharply this week when it announced it was going to spend less on hapless research and more on stock buybacks.
Utilities have been passed over amid the recovery. They have little cyclicality, enjoy little global exposure, and are hamstrung by rate regulators from raising rates. But, a renewed focus on yields by investors rotating out of bonds, plus any possible hiccupping in the pace of economic recovery may bring interest in such names asExelon (EXC, Financial) andConstellation Energy (CEG, Financial). While you wait, enjoy robust dividends equaling nearly 4.3%.
Financials were laggards in 2010's second half; housing, a key part of the business, stayed moribund, loan demand was weak, and concerns about their existing loan portfolios festered.
However, stock prices relative to tangible book values remain at historically low levels. Loan portfolio quality seems to be improving and default rates declining. Many of these companies are expected to boost or reinstate their dividends before year end.Wells Fargo (WFC, Financial),JP Morgan (JPM, Financial), andBank of America (BAC, Financial) should participate in these improving trends.
