The U.S. stock market's gain in April was its best monthly
gain in nearly twenty years. Combined with a sharp three-week
rally that finished the month of March, as of April 30, the broad
market, as defined by the S&P 500 Index, is now up nearly
35% off its intra-day lows set only seven weeks ago on March 6th.
Given these sharp gains, everybody is wondering if the market
recovery can continue. In other words, has the train already
left the station? The intense gains of recent weeks aren't the
only concerns that investors currently have. Other top of mind
concerns include weak economic growth, continued troubles in the
auto industry, a potential pandemic, and even the old market chestnut
of "Sell in May, Go Away."
Despite these concerns, we retain our optimistic market outlook.
While we recognize that anything can happen in the near
term, and given continued elevated market volatility and investor
emotion that could even mean a move back to, if not through
the March
lows, there are still some powerful reasons why equity investors
should stay the course. If investors are not in the market,
we recommend that they set up a plan to do so.
In this month's commentary, we will address the reasons
we remain fairly upbeat. We will also comment on some of
those concerns we listed above which are still keeping many
investors
on the sidelines.
Why the Market Can Keep Running
Investor Sentiment Remains Fairly Negative
It has been said that bull markets, especially new-born bull markets,
climb a "wall of worry." Despite strong gains in recent
weeks, most investor sentiment surveys continue to be bearish.
Most investors simply don't believe that the market can
sustain the current rally. That's fairly remarkable. Generally
speaking, investor sentiment tends to track price action fairly
closely (albeit lagging), though this time it appears various
concerns have prevented investors from actually recommitting to
the market. Whether one measures what investors are saying or
doing, investors remain worried that gains will not stick. Historically
speaking, an imbalance of bearish opinion is typically a bullish
signal for market direction.
One more point about sentiment. As of this writing, there are
some loud voices that are currently saying "everybody is
bullish." We simply don't agree. Sentiment and asset
allocation surveys still reveal a mostly bearish mindset. Besides,
for those who are actually bullish at present, most seem to say "bear-market
rally" and don't necessarily believe that we are at
the beginning of an epic, multi-year bull run. To restate, this
means that many investors who are actually positive on the market
don't necessarily have a lot of conviction. We believe this
confirms our view that most market participants still doubt the
rally. The wall of worry continues to stand tall.
Corporate Earnings Are Coming In Better Than Expected
During the last few earnings seasons, earnings misses and negative
guidance torpedoed the stock market. This earnings season, however,
has been different as corporate earnings are actually coming
in better than expected -- or at least "less bad" than
expected. Two out of three companies are beating expectations,
and guidance for future quarters has generally been a lot less
negative than it has been in recent quarters.
If the economy is indeed bottoming, then it should not be surprising
that earnings are better than what many investors expected.
That's
because earnings expectations tend to become too pessimistic
near economic troughs. Add all these factors up, and earnings growth
for 2009 could even end up looking kind of gaudy -- even
if GDP growth is below long-term averages (more on that later).
Currently, 2009 reported earnings (what gets reported to the
taxman) for the S&P 500 are expected to grow over 90%
from 2008 levels. And there is a good chance the numbers could
be even better than
that. However, this number should be taken with a grain of
salt, since reported earnings numbers can sometimes be a bit
whacky,
especially during economic inflection points.
For an arguably better look at earnings growth, one could
look at operating earnings. Operating earnings exclude one-time
or
other extraordinary items from the income statement. Though
there are critics of operating earnings (the charge is that
companies
seem to have one-time write-offs every year), at least they
tend to offer a less volatile read on corporate health and
can ultimately
provide a reliable read on underlying growth trends over
time. Operating earnings for 2009 are expected to be more along
the lines of 20% higher than 2008.
While Higher, Valuations Are Still Attractive
Another bullish factor is valuations. While admittedly valuations
are not nearly as attractive as they were at the beginning of
March, the market is still cheap on a long-term basis. Using
a five year average price/earnings ratio (to smooth out earnings
peaks and troughs) we find that, even after the sharp rebound
in prices, valuations remain well below the 50-year average,
and suggest that the market is still approximately 30% undervalued.
The Wall of Worry
Nonetheless, there are real concerns out there that are keeping
many investors on the sidelines.
Weak Economic Growth
The initial estimate for first-quarter GDP (Gross Domestic Product),
released in the last week of April, was far worse than most had
expected. The number came in at an annualized rate of decline
of 6.1%, essentially matching the 6.2% decline in the fourth quarter
of 2008, and well below the consensus expectation of a 4.7% drop.
The largest hits to GDP were in business investment, inventories,
home building, and government spending. Over-all, it was an ugly
number.
That said, there were clearly some positive aspects to the report.
First, consumer spending was positive and grew at its fastest
levels in two years. The consumer may be weakened, but apparently
isn't dead quite yet.
Second, much of the weakness came from a drop in business investment
and a reduction in inventories. (Sales from inventory are
not included in GDP, because products in inventory were produced,
and counted in GDP, earlier.) However, a reduction in inventory
is a positive for future GDP growth, especially with consumers
spending more than expected earlier. When inventories are
low, a pick up in demand is more likely to translate into increased
production and business investment.
Third, it was somewhat surprising to see that government spending
actually had a significant negative impact on GDP. This
was mostly due to a sharp drop in defense spending. We think
it is unlikely
that government spending will continue to be a drag on GPD
given the aggressive fiscal policies already put into place.
It is also useful to remember that the "headline" losses
for GDP are more sensational than actual economic losses.
That is because changes in quarterly GDP figures are reported as annualized
figures. Real GDP did not actually drop 6% in the first
quarter,
but instead fell by about 1.5%. If that rate of decline
persisted for the whole year, then GDP for 2009 would end up a little
over
6% less than in 2008.
To re-state, the economy did not contract 6% during the
first three months of the year. In fact, real GDP is now
down only
about 3% from its all-time high reached in the second
quarter of 2008.
And "nominal" (i.e., not adjusted for inflation) GDP
is down only about 2% from its all-time high recorded in the third
quarter of 2008 -- a drop in our economy from $14.3
trillion to $14.1 trillion.
While GDP is still likely to contract further, the declines
are nowhere near the massive losses witnessed in the depression
in
the 1930s, a period many investors are using as a comparison
to the current environment. In the 1930s, nominal GDP
dropped by
nearly 50% while real GDP dropped nearly 30%.
Instead, today's GDP declines are more similar to 1982 in
terms of real GDP and 1958 when one looks at nominal GDP contraction.
Tough times for sure, but nothing like the Great Depression. Coincidentally
(actually it is not a coincidence at all), the years 1958 and
1982 were both excellent times to buy stocks.
Sell In May, And Go Away?
Another concern is the perceived negative seasonal pattern in
the stock market from May until the fall. The old saying is "Sell
in May, and Go Away." While historical data does indeed
show that the winter months (November to April) tend to provide
higher returns than the summer months (May to October), it is
important to note that the summer months still tend to produce
positive returns!
In addition, when just focusing on the month of May itself, the
market's performance in that month tends to reflect the
trend of the market heading into May. In other words, if the
market is trending higher heading into May (as it was this year),
then it tends to end the month higher. If the market is trending
lower, then the market tends to be lower in May. "Sell
in May, And Go Away" may sound snappy and provide an excuse
to get the summer started early, but it is generally not a profitable
strategy.
Inflation Will Rear Its Ugly Head
Given the extreme amount of fiscal and monetary stimulus the
government has injected into the financial system, many believe
that we are
about to enter a period of extreme inflation. It's a reasonable
concern and clearly worthy of being a prominent part of public
debate. That said, we're not worried -- at least
not yet.
The reality is that the economy is still in a process of deleveraging.
There is a massive amount of debt in the system that needs
to be worked down. While -- all else being equal -- the
historic amount of monetary and fiscal stimulus is indeed
inflationary, we believe that the powerful forces of deleveraging will
likely
contain inflationary pressures until the economy can fully
find its footing.
One very important market relationship that currently points
to this view on inflation is the breakeven spread between
the yields
of nominal Treasuries and Treasury Inflation-Protected Securities
(TIPS). Some consider this relationship to be a more effective
forecast of inflation than the consensus view of flesh and
blood economists, since the break-even spread is the result
of real
money invested on the outcome.
TIPS are Treasury bonds that have an inflation adjustment
feature for protection against future inflation. The "cost" of
this inflation protection is generally a lower yield than
nominal Treasuries. The breakeven spread in yields is
the rate of inflation
that would equate the returns of conventional Treasuries
and TIPS. In other words, if the rate of future inflation
is greater than
the breakeven yield spread, TIPS will turn out to offer
a higher return and vice versa.
Currently, the breakeven rate between 10-year Treasuries
and TIPS shows the expectation for inflation over the
next ten
years is
only in the neighborhood of 1.5%. While this number
seems admittedly very low to us, it is still a powerful signal
that hyper-inflation
in the near-term is not necessarily a shoo-in, or even
a few years away. Nonetheless, we remain on alert for
any
significant
changes
in inflation expectations.
Summary
It is fairly remarkable that as of this writing, despite a massive
amount of bad economic news, the broad U.S. stock market is
nearly even with where it was last October after the Lehman
Brothers bankruptcy ignited a panic sell-off. Since that time,
we have seen economic growth come to a standstill, along with
a bevy of other incredibly significant negative news items,
yet the market seems to have taken the punch and is still standing.
Though current conditions in liquidity, credit and confidence
are not back to normal, they are all improving. Couple this
with improving earnings growth, and it's likely that we'll
see some investors start to redeploy their cash back into risky
assets (i.e. stocks). If that is indeed the case, the stock market
could yet end up enjoying some pretty impressive gains in 2009.
Sincerely,
