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Despite Uncertainty, the Market Still Looks Strong - Royce Funds Commentary

October 17, 2013 | About:
Holly LaFon

Holly LaFon

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Charlie Dreifus—manager of Royce Special Equity and Special Equity Multi-Cap Funds—offers his observations on:



The Government Shutdown and the State of the EconomyAlthough it was an ugly battle, on Thursday morning October 17 President Obama signed a bill that reopened the government into January 2014 and raised the debt ceiling until early February of next year.

As I said prior to the 2012 elections, politicians will be politicians no matter what harm they potentially inflict on the country. From the onset, it was assumed that the shutdown would be short lived as a growing group of more moderate, non-Tea Party Republicans began defecting and trying to get our government up and running again while minimizing the harm to the Republican Party. Some of those leaders may also be motivated by their own desire to run in 2016 for the presidency on the image of being a “healer.”

There are some offsetting items to the damage wrought by the shutdown, such as the Federal Reserve’s decision not to taper along with declining gasoline prices and lower mortgage rates. Furthermore, while the shutdown has been a negative in the short run, it may ultimately lead to a deal that lessens the impact of sequestration in the year ahead.

When a party gets too loud and silly, does the host have an obligation to reduce or eliminate the alcohol that is causing the party to get out of control? In the world of monetary policy this has been referred to as “removing the punch bowl.” What are any central bank’s mandates? To avoid bubbles? Perhaps under the guise of some catch-all phrase about promoting economic stability, it could be.

Yet most, if not all, central banks operate under either an inflation mandate or an inflation and full employment mandate. Are the majority of the world’s central bankers willing to allow bubbles because unemployment is too high and inflation low? If so, despite a market that can at best be viewed as fairly priced, could stocks go higher, not so much because of earnings improvements, but rather by continued P/E (price/earnings ratio) expansion? Will the melt-up continue?

When the Fed makes cash trash with near-zero yields, everything else looks attractive by comparison. This can lead to multiple bubbles that ultimately result in everything becoming overvalued until the cycle reverses. Federal Reserve chairman Ben Bernanke wants to protect the wealth effect coming from housing and the stock market. A social issue that could begin to receive more attention is that QE (quantitative easing) has fostered, and will continue to foster, widening income and wealth disparities in the U.S.

Despite concerns about “irrational exuberance,” did Alan Greenspan not allow a bubble to inflate? It’s almost a philosophical question—should any country risk lower national output and higher national unemployment to avoid a bubble? Do we attempt to limit excesses that could threaten financial stability that could in turn impact employment and inflation? As we already have unemployment that is too high and arguably inflation that is too low, is U.S. monetary policy currently too tight?

The Fed’s Indecision on Tapering and the Market

Many expected, ourselves included, that because of the May-June pre-commitment, the Fed had to begin a modest tapering effort rather than have the luxury of waiting to see whether the economy and labor market improved. Perhaps as a result of their premature announcement and the ill effects on the economy that it wrought, the Fed had second thoughts. Higher mortgage rates and falling emerging market currencies were among the consequences of their May tapering announcement.

For my entire career, I have favored full disclosure and transparency, but I disagree with the Fed’s premature tapering announcement because it was TMI (too much information). One might even argue that some slowing in growth in the economy has occurred in anticipation of tapering. If the Fed hadn’t laid out a tapering plan in May, mortgage rates probably wouldn’t have surged, and the economy may have accelerated going into the third quarter.

There has been some thought that the Fed’s recent non-taper stance was a result of something the central bank knew that rest of us did not. Among the possibilities mentioned were greater problems in Puerto Rico than those already known, the consequences of a federal shutdown, and that the Mid-East is not as calm as has been recently suggested.

In the end, a data-dependent Fed ultimately needs to make a judgment call, which is all about the leadership at the Fed about which we will learn more once Janet Yellen is confirmed. Essentially, it could be interpreted that tapering will not occur until inflation moves off its lows and approaches the upper end of their base range of 2%. Of course, the longer we remain dependent on easy money, the more difficult it will be to return to something approaching a more neutral (that is, normal) environment.

In this era of financial repression, determining the proper market multiple is difficult. In essence, we are flying blind. Furthermore, in the case of the U.S., are we in the midst of an upward P/E revaluation vis-à-vis other developed countries because of our uniquely favorable conditions and outlook? Currently favorable conditions for the U.S. include population growth, a potential energy boom, a competitive dollar, a favorable labor situation, strong corporate balance sheets, re-shoring of manufacturing, and a housing recovery.

The Fed went into the September FOMC (Federal Open-Market Committee) meeting probably determined to push back the sharp increase in rates and tightening since they began talking about tapering. They got what they wanted—a sharp decline in rates. They no doubt realized the cost of their premature taper talk in May. However, just like with a difficult child, the Fed may have created an ongoing problem.

Every time the Fed tries to tighten, the market overreacts, causing the Fed to back away. The Fed must deal with the conflict of wanting to be more transparent and the harm of too much information. Indeed, it seems clear now that the Fed was both a victim and a perpetrator for establishing the market’s expectations based upon its tapering statements back in May.

In his most recent press conference, Bernanke provided additional guidance. The first rate increase “might not occur until the unemployment rate is considerably below 6.5%” and “the committee would be unlikely to increase rates if inflation were projected to be below our 2% objective for some time.” Thresholds have been lowered, with tapering and ultimately rate increases delayed.

Employment remains critical. The situation has improved, yet we are still 5.8 million full-time jobs (35 hours a week or more) short of the level at the November 2007 peak. Unemployment rates for part-timers are noticeably lower than that for full-timers. The reasons low unemployment claims don’t have the same punch as earlier are that while firings are way down, hiring is still restrained, and wage gains are unusually restrained.

The U.S. Manufacturing Renaissance

As part of the U.S. economic renaissance thesis, we are starting to see manufacturing’s market share as a percentage of total GDP increase, with a wide range of industries expanding production in the U.S., including many foreign manufacturers.

U.S. manufacturing continues to benefit from a host of long-term competitive advantages such as restrained labor costs, abundant low-cost energy, a stable yet flexible labor market, rule of law, relative economic and accounting transparency, favorable demographics, deep and liquid capital markets, a relatively well developed infrastructure, and a historically low dollar. Unit manufacturing labor costs in the U.S. have been steady for 30 years, a record no other country can match.

No Signs of Inflation Ahead

With the U.S. budget deficit beginning to shrink, it could, in a perverse manner, lessen the urgency of a divided Washington to compromise. Inflation remains subdued. There are huge over capacity situations. Overly stimulated emerging markets can no longer absorb these excesses.

Healthcare inflation in the U.S. has slowed to a record low, which has dramatically lowered government projections for Medicare. We could always see an inflation scare, if for no other reason due to a comparison to an unusually low figure a year ago. However, the basic trend remains low and subdued.

The relief from inflation caused by a slower Chinese economy seems set in place because China’s hands are tied. Any additional easing there to spur the economy, and thus commodity consumption, would exacerbate both their real estate inflation and “ghost cities” situations. Meanwhile, the resulting lower inflation in the U.S. remains a tailwind to our P/Es.

Consumers are benefiting from declining mortgage rates, declining gasoline prices, and increasing consumer net worth. Forward inflation expectations are well contained and should not pose a problem for equities even after the mixed message on tapering.

Total U.S. consumer debt continues to decline—deleveraging is still at work. Credit card debt declines have been greater than auto loan increases. In fact, over the past few years U.S. households have deleveraged by 30%.

Lower Energy Costs Boost Consumer Confidence

Further, we are set to become the largest producer of crude oil in the world. Our potential energy self-sufficiency brings other economic benefits. Huge infrastructure build-outs will be required, particularly regarding pipeline construction. These types of projects have huge multiplier impacts on the economy while also reducing unemployment among non-college educated males who make up a disproportionate percentage of the unemployed.

The energy renaissance will further support the U.S. manufacturing renaissance by lowering manufacturing energy costs, making the U.S. even more competitive globally, boosting spending on equipment and structures, increasing expenditures on infrastructure, and adding to inbound foreign direct investment.

The decline in gasoline prices bodes particularly well for consumer spending as it increases both real income and consumer confidence—every $0.10 decline in gas prices is a $13 billion “tax cut.” Reduced healthcare inflation is also pushing out the “crisis” date regarding funding Medicare. The decline in rates, especially mortgage rates, should reinvigorate re-financing activity that will in turn provide disposable dollars to consumers.

Home equity and mortgage debt are now in parity for the first time since the third quarter of 2007. As a result of increased receipts and declining outlays, the U.S. federal budget deficit is now “only” about 4.4% of our GDP, which by definition is out of the crisis zone. Rising rates in anticipation of improved economic data, along with well-anchored inflationary expectations, are not a cause for alarm.

What’s Happening in the Market

Low quality has been dominating the market—non-earners, non-dividend payers, and low ROE (return on equity) stocks continued to outperform year-to-date through the end of September.

The market has benefited from higher P/Es, which in turn are a result of lower inflation, a stronger dollar, and a smaller budget deficit, among other things. Recall that P/Es, compared to EPS (earnings per share), take into account both long- and short-term issues. It could be that the market via higher P/Es is predicting a better long-term outlook.

One potentially positive surprise that has not been fully discounted by the market relates to the $2.4 trillion in cash held overseas by U.S. corporations. There is talk of a bipartisan compromise to get these funds back to the U.S. at an 8% tax rate (rather than the existing U.S. corporate tax rate of 35%). The proceeds would be earmarked for a national infrastructure fund whose expenditures would carry a high multiplier effect on the economy.

If, say, $1.5 trillion is repatriated that would equate to more than 10% of GDP as well as about 10% of the S&P 500 market value. The repatriated monies could find their way to actions by corporations, such as M&A, dividends, and capital expenditures, that also would have a multiplier effect on the economy. This makes so much sense that only a totally incompetent Congress could mess it up—should we be skeptical?

Investing in relatively high-yielding equities such as Utilities, REITs (real estate investment trusts), and telecommunication companies has not proven to be the loss-avoiding, conservative approach many had expected. Remember that we never stressed yield, but advocated dividend growth instead.

Higher stock prices are boosting consumer wealth and building the consumer confidence that can spur spending. Thus QE has transformed the stock market into a catalyst rather than a discounter or forecaster. Delaying the onset of tapering is in effect a new form of QE.

While bullish, market sentiment is not extreme. The change in NYSE margin debt has not all been euphoric, with one observer calling it, “managed optimism.” While still well below its 2000 peak, the Nasdaq 100 (QQQ) is at a 13-year high. Some have made the comparison to 1987, when the market ultimately crashed. Yet that crash was a result of yields surging from 7.2% to more than 10% in seven months while the CPI (Consumer Price Index) went from 1.2% year over year to 4.5%. We are neither at these levels nor advancing at comparable speed.

The market’s advance has been broad based. In fact, the S&P 500 equally weighted index is outperforming the cap-weighted one. Pessimists fear that sentiment has run ahead of economic fundamentals while optimists argue that stocks are a predictor of economic prospects. Straddling these views are those who are committed because of no viable alternatives. Still, it is sobering when one reflects on the mere $1.3 trillion of economic growth off the 2009 lows compared with the $12 trillion improvement in equity values.

If we are correct that multiples are fair and can even advance further until inflation poses a problem, then the fix that China finds itself in is comforting. To wit, they cannot or do not want to add any stimulus because of an overheated real estate market. So absent any stimulus in China and no inflation threat here in the U.S., P/Es can continue to rise.

The Benefits of Dividend Growers

Is it still possible that fiduciaries will see the light in terms of reducing their exposure to alternative investments while adding to public equities? Many now realize that alternatives are expensive and generally only obtain good performance if the public equity market is strong. Further, many now question the interim “take-my-word-for-it” valuations of their investments.

Over long time periods, the value of any business will grow in line with the change in the cash distributed from it, all other things being equal. If one does not overpay initially, and the distributions grow, the value should increase. This explains why we search so diligently for dividend growth candidates.

We remain steadfast in our belief that dividend growers remain an attractive asset class among all market capitalization ranges. While one needs to select among these companies based upon traditional metrics, valuation remains the primary criterion.

The other metrics we look for, such as high ROIC (returns on invested capital), high free cash flow generation, and high-quality financials generally exist in these names. Increases in dividends are the most tangible statements a company’s leadership can make about its confidence in their company and their future. Dividends are less prone to manipulation or accounting gimmicks, particularly if internally funded through free cash flow generation.

In its August-September 2013 issue, Worth published a study done by the Haverford Trust Company that showed for the time period January 1, 1969 to December 31, 2012, dividend growers outperformed steady payers, cutters, and non-payers, all with a lower standard deviation—better performance with less risk.

In its September 2, 2013 edition, Barron’s cited a study done by Ned Davis Research. Using data going back to 1977, this study found that companies which have raised dividends tended to outperform those that boasted large yields. Current yield, we believe, is less important than consistent dividend growth and the likelihood is for that to continue.

Can the Rising Market Benefit Main Street?

It has now been five years since the Lehman crisis. There is a vocal group who feel that Wall Street has benefited far more than Main Street in the recovery. Comparing the day before Lehman fell to now, employment is about unchanged, the S&P 500 is 38% higher, and the Financial Sector percentage of the S&P 500 market cap has actually increased from 15.3% to 16.4%—all while the classic textbook economic recovery has not occurred.

Unlike any other developed nation in the world, the U.S. has the best chance of growing itself out of its fiscal problems. This in part is due to our population growth, our relative openness to immigration, labor rules (i.e. shutting down unproductive facilities), and our natural resources. On the latter point, currently more than 50% of our trade deficit is due to petroleum and petroleum products—shale oil has the potential to dramatically alter that.

On a secular basis one of the long-term attractions of the U.S. versus the rest of the world is our long-term inflation outlook. We are benefiting from declining consumer debt, low unit labor cost gains, increased usage of low-cost natural gas, a stronger dollar, potential for healthcare inflation to remain restrained, and our self-contained economy depending little on either exports nor imports.

As long as inflation remains low, consumers benefit, and we can expect further economic improvement. With profit margins becoming more difficult to sustain, we suspect earnings quality will become more important.

The ultimate market question remains: Can we have a sustained period of noninflationary, albeit modest, growth that would permit multiples to rise further?

This is the conundrum currently facing investors—a market that can at best be described as fairly valued, leaving it an open question as to the likelihood that it will rise further, perhaps meaningfully so.

Important Disclosure Information

Charlie Dreifus is a principal and portfolio manager of Royce & Associates, LLC. Mr. Dreifus's thoughts in this piece are solely his own and may differ from those of other Royce investment professionals, or the firm as a whole. No assurance can be given that the past performance trends as outlined above will continue in the future. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements. There can be no assurance that companies that currently pay a dividend will continue to do so.

The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The Nasdaq 100 Index includes 100 of the largest domestic and international non-financial securities listed on The Nasdaq Stock Market based on market capitalization. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.


Rating: 4.0/5 (6 votes)

Comments

vgm
Vgm - 1 year ago
Thought-provoking commentary. Thanks!

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