The folks at the Financial Times are trying to make sense of the U.S. stock market rally, which, it is fair to say, has surprised them. Here is their take and my brief response:
- The state of the world economy is “underwhelming at best” with Europe in recession, China slowing, and U.S. growth only “bland.” Dr. Tom’s response: I agree.
- U.S. earnings growth is “respectable” but generated by cost-cutting, not revenue growth, and may be unsustainable. Companies cannot “cut their way to growth” forever. Dr. Tom: Profit growth is closer to “weak” than “respectable” but is not bad for this point in the business cycle. For the past 20 years I have been hearing that the “cost-cutting story is over” but it never is. Meanwhile U.S. GDP growth may pick up over the next few quarters. See below. (Note that Q1 revenue growth is not as bad as the aggregate figure sounds, because it is dragged down by a big drop in energy; most other sectors are up low-single-digit.)
- Companies are relevering, as Apple illustrates. Dr. Tom: Apple is a special case. Most large firms companies are not aggressively relevering. Some observers (e.g., Bill Gross) overestimate how much low rates are boosting earnings of large firms, many of whom have more cash than debt and so are actually hurt by low rates.
- Defensive stocks are outperforming, which reflects the weak macro environment. Dr. Tom: Partly true, but it also reflects their relatively high dividend yields.
- The main reason for the rally is “central bank speak:” “Central banks want companies to borrow, and investors to buy risky assets.” There is a “disconnect between stocks and the world economy.” Dr. Tom: The disconnect is common and normal; see below.
- A corollary of the above: when central banks finally raise rates, stock prices could crater. Dr. Tom: Not so; see below.
What the FT Fails to Mention
The alleged “disconnect” between profits and stock prices is not anomalous but normal. Historically when profits are “better than expected” because companies have pricing power (aka “inflation”) the Fed tightens and stock prices fall despite strong earnings. The best example is the 1987 stock market crash. Conversely, stocks frequently perform well in periods of weak profits but ample central bank liquidity such as 1985-1986 (when profits fell but stock prices soared) or the end of recessions (1982-83, 1991, 2003). Currently we are in the “sweet spot” – plenty of liquidity and underwhelming but not terrible profits. (As an aside, the tendency of stocks to rise in a weak economy is one of the many reasons why it is futile to time the stock market.)
After “going nowhere” since 2000, stocks are still reasonably valued (though no longer dirt cheap) with a trailing PE of 15.2x versus a Q1 2005-Q2 2007 average of 16.2X. With negative “tail risks” becoming less likely, investors are willing to pay up for equities offering better returns than bonds. With the dividend payout ratio at only 32%, dividends may rise faster than profits, causing yield hungry investors to pay up for stocks. (I am hearing that bond funds are starting to buy stocks for their yields, which is a bit scary. High yield stocks such as utilities, staples, telcos, etc. are expensive.)
Profits may reaccelerate modestly before the next recession. The Federal budget deficit is smaller than expected, so yet more fiscal austerity in the U.S. is not likely. Pro-growth reforms — tax reform, immigration reform, and possibly ObamaCare repeal — may boost confidence and growth. With his administration swimming in scandal, Obama won’t be launching new attacks on capitalism. And Europe may start to grow again. Meanwhile, corporate America is “rolling its own growth” via share buy-backs, judicious M&A, and restrained capital spending that avoids margin-killing over-expansion. (Here is another why it is so hard to time the stock market: full-blown “prosperity” a la the late 1990s leads to overinvestment and margin collapse, as well as Fed tightening.)
When QE Ends . . .
. . . stocks may well decline or flatten out for a while. But a true bear market is unlikely because A) the Fed will not tighten until the economy is stronger, B) stocks are seldom clobbered by widely anticipated developments. The way to think about it is that this year stocks may run up ahead of fundamentals, and then digest their gains and “rest” for a few quarters once liquidity is withdrawn. Today on CNBC David Tepper makes the smart argument that, with Treasury bond issuance declining as the deficit shrinks, the Fed actually “needs” to taper bond purchases to avoid putting the financial markets in overdrive.
Copyright 2013 Thomas Doerflinger. All Rights Reserved.
