Equity Investment Outlook
Osterweis Capital Management
July 19, 2012
In the politically correct atmosphere that permeates many of our college campuses, the euro-centric view of world history is regarded as hopelessly anachronistic, small-minded and possibly even racist. Perhaps so, but try telling that to the financial markets. In the last year, they have become hopelessly euro-centric, rising or falling in concert with the news coming from the eurozone. If the euro was having problems, the markets fell. If a solution or compromise was at hand, the markets rose. A few years ago the markets focused on growth in emerging markets. Today, they focus on problems in the developed world. Times have changed.
In this Investment Outlook, we trace the evolution of the economy since the 2008 crisis and present the most likely outcomes going forward. Obviously, enormous uncertainty colors any forecast made today. There are some significant and obvious risks to the global economy. But there are also some powerful longer-term trends that should prove quite beneficial over the next decade.
For some time, we have warned that the post-2008 recovery would be anemic by historic standards. Unlike the typical post World War II business cycle, which was basically an inventory cycle, the current cycle began with a banking crisis – which itself was occasioned by a massive debt-financed housing bubble. Recovery from a banking crisis takes longer than from an inventory cycle because the economy’s credit engine takes a long time to repair. Additionally, housing which would normally be the locomotive pulling the rest of the economy out of recession was unable to fulfill that role this time because of the massive over-building that occurred leading up to the 2008 crisis. When housing crashed and house prices plummeted, many homeowners were pushed “underwater” with the value of their homes slipping below the value of their mortgages. Homeowners defaulted in droves, leaving the banks with a huge bad debt problem and saddling the housing markets with a flood of foreclosed properties for sale.
Homeowners who were underwater and did not default obviously felt pinched and financially cautious, contributing to subdued consumer spending. Banks were hurt by bad debts and had to restrain their lending. As a result, in the early part of their recovery, small businesses could not expand and therefore added fewer jobs than big businesses, which could tap the bond markets for credit. That big businesses added more jobs than small businesses was highly unusual and unemployment levels thus receded far more slowly than normal.
Given the sluggish pace of recovery, the big surprise in 2009 and 2010 was how robustly corporate profits grew (Figure1). This largely reflected productivity gains as corporations grew sales far faster than they added workers. It also reflected restrained wage growth in the face of high unemployment and possibly growing profitability in emerging markets.
Source: Renaissance Macro Research (Bureau of Economic Analysis)
So where do we go from here? As we write this Investment Outlook, the global economy appears to be slowing. Emerging market economies are experiencing a slowdown in their growth rates. Europe is likely in recession with some countries, such as Greece and Spain, appearing to be in depression. It is clear that the structural problems of the peripheral economies in Europe are severe and that the austerity measures aimed at fixing them have been causing a near collapse in economic activity. Finding a comprehensive solution is not easy.
None of this is good for the U.S. economy or corporate profits. According to the New York Times, about a third of all technology company revenue comes from Europe1. We have seen estimates that as much as 45% of U.S. corporate profits depend on exports and foreign operations. Thus, the slowdown in foreign economies poses a significant risk to U.S. corporate profits. Additionally, we worry about declining productivity gains and, one has to conclude, that the probability of earnings disappointments has increased, which in turn poses increased risk to equity prices.
Add to this the uncertainties tied to the 2012 presidential election and the potential disruption tied to the fiscal cliff, which would occur in 2013 if the Bush tax cuts are allowed to expire and sequestration of federal spending kicks in. With our political system bordering on dysfunctional, it is difficult to be optimistic about the ability of Congress and the President to work out a timely compromise to avoid the impending fiscal shock.
Looming uncertainty over tax and spending policies has multiple negative implications for growth. High earning tax payers fearing tax increases may postpone large expenditures. The same goes for businesses considering new investments in their workforce or plant and equipment.
So what’s the good news? Actually there is quite a lot. First, housing appears to have bottomed. Given the drop in house prices and today’s low interest rates, housing affordability is quite high. Unsold inventories of homes have declined (Figure 2). Foreclosure rates have been dropping (Figure 3). Housing starts have been inching up. House prices in many markets have stabilized and have moved up. Over time, housing starts should roughly track the rate of household formations. This would suggest that housing construction should double from the 2011 levels just to come back in line with trendline demand (Figure 4).
Source: U.S. Census
(1) Number of U.S. properties that received foreclosure filings.
(1) 2012 represents annualization of YTD May 2012 Housing Starts data.
Source: U.S. Census
Second, corporate balance sheets are generally in great shape and, when the time is ripe, should enable businesses to fund growth plans, expand through mergers and acquisitions and return cash to shareholders.
Third, we are beginning to see evidence of jobs being repatriated back to the U.S. This reflects an increase in Chinese and other emerging market wage rates as well as a surge in natural gas supplies and the attendant price decline that is making the U.S. extremely cost competitive in energy intensive industries. The U.S. has developed extensive reserves of unconventional oil and gas that appear to have driven down the price of natural gas to multi-decade lows and created a global cost arbitrage in oil and gas. The most obvious impact is a significant expansion of our domestic petro-chemical industry in Louisiana and Texas. A more incipient but potentially larger driver of repatriated growth could come from continued technology advances that further mitigate the advantage of low cost labor in emerging markets.
David Rosenberg, of Gluskin Sheff & Associates, points to a fourth trend as potentially very important – namely the trend at the State and local level to rein in public sector unions and their attendant pension and benefit costs. Just as the private sector was able to rationalize work rules, wage rates and benefits over the last two decades, tax payer pressure is forcing the public sector to do the same now. Rosenberg argues that the political will to accomplish needed, but difficult, tasks often starts at the local level and moves up to the national arena. From a broad perspective, business has its fiscal house in order, consumers are making progress at improving their financial position, but governments at all levels are in bad shape and often getting worse. A genuine improvement in government or public sector finances could underpin the next strong up-leg in the U.S. economy.
Fifth, the U.S. is still an extraordinarily innovative economy. Improvements in technology can spur growth in a variety of sectors. For instance, between cheap natural gas (the result of new drilling technologies), advances in “green” energy sources and efficiency gains, it is possible that the U.S. energy cost structure could be extremely favorable for the next couple of decades and our dependency on Middle East supplies significantly lessened.
Finally, given the extremely low levels of interest rates, stocks now appear more attractive than bonds. Stocks are not dirt cheap, but they are relatively more attractive. At some point, money should flow back into U.S. equities. Perhaps we will need to have a final washout in stocks before that happens but, for the first time in several years, we are beginning to see the makings of a new secular bull market. While not necessarily imminent, such a shift does seem probable to us. For the last decade, bonds have outperformed stocks. Recently, investors have been net sellers of equities and buyers of bonds. We think that stocks will eventually outperform bonds when investors become net buyers of equities.
As of the end of June, the S&P 500 dividend yield exceeded the yield on the 10-Year Treasury (Figure 5). When one considers that, historically, dividends of well-run companies have tended to grow over time, stocks look quite attractive relative to investment grade bonds both from a total return perspective and, surprisingly, from a long-term income perspective.
This is underscored by Figure 6 which compares the S&P 500 Index’s earnings yield to the 10-year Treasury yield. The index’s earnings yield is near a record high compared to the Treasury yield. Some of these earnings are paid out in the form of dividends and the rest are reinvested to produce growth, which in turn is expected to generate higher dividends.
Source: Bloomberg, 2012 data is as of June 30, 2012.
Source: Bloomberg, 2012 data is as of June 30, 2012.
Given all the near-term issues – problems in the eurozone, slowing emerging market growth, political uncertainty and issues surrounding the fiscal cliff – it seems safe to forecast a slowdown in the U.S. recovery and an increased likelihood of earnings disappointments in coming quarters. As the stock market appears reasonably priced but not dirt cheap, we believe it could be vulnerable to near-term setbacks. We are, therefore, keeping some cash on the side lines both to help cushion the effect of a potential market drop and to have a buying reserve should bargains appear. We are focusing on companies we believe can grow earnings despite potential slowing of economic activity. We also favor companies with strong free cash flow that are able to support growing dividends and share repurchases. In a slow growth environment, dividends take on increased importance in generating total returns from equity investments.
1 New York Times, Europe’s Fade Becomes Drag on Sales for U.S. Companies, June 5, 2012
Past performance is no guarantee of future results. This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The S&P 500 Index is an unmanaged index which is widely regarded as the standard for measuring large-cap U.S. stock market performance. This index includes the reinvestment of dividends. The index does not incur expenses and is not available for investment.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
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