The stock market’s performance in April was
impressive. The S&P 500 and Dow Jones Industrials were up
4.5% and 5.9% respectively, posting their best months since December
2003. And, the consistency of the market has been exceptional
as well. Over the last 18 months, the S&P 500 has finished
higher a remarkable 16 times or roughly 90% of the time! To help
understand just how exceptional that is, we examined the last
20 years of monthly returns. During this period – a time
when the stock market posted some strong total returns - the
S&P 500 posted positive monthly returns less than two-thirds
of the time.
Despite this strong market action, we are holding tight with our
current equity allocations in client portfolios. To explain why,
we will address three factors: liquidity, earnings, and sentiment.
Each of these factors had a hand in why prices moved higher in
April, but each factor also provides reasons to not raise equity
exposure now.
Before we get to those factors though, and while the topic of
last month’s returns is still fresh, we would like to briefly
comment on some interesting market behavior last month. While the
predominantly large cap Dow Jones and S&P posted strong returns,
the Russell 2000, a benchmark for smaller companies, was up “only” 1.8%
(still a nice return).
This relative underperformance by smaller companies was a bit
of a surprise given that small cap securities tend to be more leveraged
to the market (i.e., have higher betas) than larger companies.
Again, examining the last 20 years of returns, when the S&P
500 was higher for the month, the Russell 2000 was on average even
higher. And, when the S&P 500 was lower, the Russell 2000 was
even lower. There are exceptions, of course. One notable exception
was March 2000. That month, the S&P 500 was up 10% while the
Russell 2000 was down 7%!
Liquidity
So, why was April so strong for the markets? It isn’t
the economy (more on that later). Instead, one driving factor is
the
easy access to cheap money available to private investment funds
that's allowing them to buy publicly traded companies and take
them private. This is creating near-term demand for stocks and
reducing the supply available for purchase. As a result, this drives
up share prices.
Lombard Street Research reports that net retirement of stock in
non-financial US companies reached over 5% of GDP in the last quarter
of 2006. Approximately 85% of that was financed by debt of some
kind, either through buy-backs, takeovers, or private equity. As
reported by The Wall Street Journal, the current level of buyout
activity is now larger than the buyout period in the 1980s. Thanks
to this leveraged buy-out (LBO) activity, along with increased
merger and acquisition (M&A) activity and corporate stock buy-backs,
more stock has been withdrawn from the market than has been issued
in each of the last three years. According to the Federal Reserve,
in 2005, $295 billion in U.S. corporate stock was taken off the
market. Last year, that number skyrocketed to $548 billion. With
nearly $1 trillion of stock disappearing from the U.S. market in
just the last two years, its no wonder stock prices have moved
higher. It’s just basic supply and demand.
The rub is that eventually, these LBO firms will want to sell
their equity back to the public so they can reap their profits.
In other words, all this current LBO activity and contraction in
shares will likely provide the fuel for an initial public offering
(IPO) boom where there will be plenty of opportunities to buy stock
in debt-laden companies. Given that M&A activity started to
really pick up a few years ago, it should not be a surprise to
see a surge in new equity issuance coming back to the market in
the near future. If this scenario was indeed to play out, the supply/demand
backdrop for the market could turn from a positive into a negative
for private equity, the stock market, and especially smaller companies.
Corporate Earnings
In the last week of April, the initial estimate
for growth in real (inflation-adjusted) Gross Domestic Product
(GDP) for the
first quarter of 2007 came in at a 1.3% annual rate. The consensus
expectation was 1.8%. This represented the weakest growth rate
since early 2003, and the fourth consecutive quarter of below-trend
real GDP growth (the long-term average is 3.5%).
Nonetheless, the headlines on quarterly earnings coming out of
the corporate America remain mostly positive. Another oft-cited
reason for the strong stock market performance in April was “better-than-expected
corporate earnings.” As of April 30th (approximately half
of the S&P 500 had reported as of this time), operating earnings
per share for S&P 500 companies were running around 7% higher
than the prior year. At the beginning of earnings season, earnings
growth was expected to be closer to 3%. This was a pleasant surprise
indeed as beating expectations is good for stock prices, at least
in the short term.
However, as with most market factors, it’s not only the
level, but the trend of the data that is critical to future market
prices. After posting an incredible 18 consecutive quarters of
double-digit year-over-year operating earnings growth, S&P
500 companies “only” posted a 9% gain (the long-term
average is 6%) in the fourth quarter of 2006. With the first quarter
of 2007 now running at 7%, the trend is clear: earnings growth
is decelerating. Moreover, that growth is expected to decelerate
further dropping to less than 6% for the second quarter of 2007,
then down to approximately 2% in the third quarter. Despite the
lift in April, it appears that the trend in corporate earnings
will not be the stock market’s friend in the coming quarters.
Sentiment
We often talk about investor sentiment in this commentary.
The idea behind using sentiment is that when investors reach an
emotional
extreme, either overly positive or overly negative on a particular
market area, that area often tends to move in the opposite direction
in the near future. There are several explanations for why this
is the case. One explanation is that people’s attitudes toward
the markets and their actions are linked. In other words, if people
indicate they are very bullish, they have either already put their
money to work in the market, or are about to, and will soon have
little buying power left.
Another possible reason is that markets move not so much on expectations,
but on changes in expectations. Therefore, if everybody expects
the market to move higher, any change in expectations would be
to the downside, causing investors to sell their securities.
At the end of March, investor sentiment surveys were overly bearish.
One example is the The Ned Davis Research Crowd Sentiment Poll,
which registered a bearish extreme about that time. Going back
to the mid-1990s, bearish extreme readings on this particularly
indicator have been fertile grounds for rallies, producing on average
21% gain/annum for the S&P 500. In other words, at the end
of March, sentiment conditions were ripe for a rally. And in April
the markets complied nicely.
Where is sentiment today? By the later part of April, this very
same sentiment indicator moved sharply higher to a bullish extreme.
Extreme bullish readings in this indicator have historically produced
forward 12-month returns of -1.6% for the S&P 500.
Hold Steady
In the current market environment, with low interest rates, strong
liquidity, and positive price momentum, reducing equity exposure
doesn’t seem to make sense. However, for the reasons cited
above, it is not likely that we will be adding to our equity allocations
any time soon either.
Our assessment of the risk/reward tradeoff in the market, causes
us to believe the better part of valor is definitely discretion
at this time. We are staying with our current asset allocations
while continuing to focus on our discipline of building diversified
portfolios consisting of money managers who we think can add value
(within the parts of the markets that they invest in) regardless
of market conditions. While glory may go to the bold, too often
their medals are awarded posthumously.
Sincerely,
Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio
ManagerCo-Portfolio Manager
