Starting after this month, you are going to see more of your year-over-year performance reports show gains, rather than losses. The strength in the market since March has finally overcome some of the weakness last fall. Once we are past the collapse last October, we will be ahead for the past year. Funny how that works, just like the rant last week on why the ‘lost decade’ tells us more about where it started than where it ends, the past year tells us more about last fall than this year. The decline in September last year was -8.9%. October fell -16.8%. November was a further -7.2%. We’ll have just gotten rid of that first bit in the short-term history when this month is over. After December’s gain of 1%, January fell by -8.4% and February dropped -10.7%. Add in the first 9 days of March and that put us down over 25% year-to-date from December 31st. Most of the whole big stock rally since then has only just recently gotten that 25% drop back and a little bit more. (Remember that you need to gain one-third to overcome a drop of one-quarter, up a half to get back a third, up 100% to get back a half.)
If you want to talk about getting ahead of ourselves this year in the rally, didn’t we get a bit ahead of ourselves with a 34% drop from September 12th to November 20th? The fall from January 2nd to March 9th was pure overkill. The way the media portrays the bottom, it was as some sort of pre-ordained level which we had to achieve before we could stop the bleeding. That is false. March 9th was just the point at which the silliness had gotten so bad that we had to rebound no matter what. Instead of some standard of valuation that made sense, either then or now, it was a point of undervaluation that compelled many true investors to buy regardless of the apparent risks faced in the market. Our dividend discount model argues that we were 45% undervalued on the S&P 500 in mid-March.
Think about how the financial collapse impacted most businesses. Most businesses aren’t financial companies. Most businesses don’t need to go to the financial markets to get credit. Many businesses were impacted by the sudden withdrawal of many banks from providing credit. This was the point where the financial crisis became an economic crisis. And, this was the point at which the Federal Reserve should have intervened to save Main Street. But, the Federal Reserve wasted too much ammo trying to save Wall Street. (That’s a rant for another day.)
Most businesses are impacted somewhat by the economic backdrop, but not all to the same extent. Many manufacturing companies are hurt, but many service companies aren’t. A lot of companies have some other aspect driving their fundamentals. It can be new products or innovations that give them a competitive advantage (like Apple). It can be a single commodity that people need regardless of the economic climate (like oil or electricity). But, in times like late last year and early this year, we don’t care. We throw the baby out with the bath water and create values that can’t be denied.
Think about how this financial collapse really impacted most people’s lives. Basically, not at all! Most of us didn’t try to get a new mortgage or try to IPO our company. We didn’t need to float a few billion in debt. The biggest impact for most folks was a letter from their credit card company telling us our maximum credit limit was being reduced. Most of us just over-reacted to the environment around us regardless. For those folks who did lose their job, lose their home, there was real pain. For most of us, it was sympathy pains that didn’t help matters, but actually made things worse.
It is hard to do, but we really ought to ignore the peaks and troughs. The peaks and troughs don’t define ‘normal’, the in-between defines ‘normal’. Our valuation approach tries to tell us when we aren’t normal. The idea is to identify those areas that are way too high or way too low by contrasting those with normal periods. Right now, we have most of the available asset classes still below normal valuation levels. The only areas that are really expensive are Treasury bonds and small caps. Nearly everything else is one degree or another of cheap.
Inflation (or lack thereof) Update –
We keep getting questions about the inflation outlook. As you can read below, there isn’t a big push for inflation right now. Where we are is we’ve planted a lot of inflation seeds (very low interest rates, vast amounts of new money, runaway fiscal stimulus) but nothing has really sprouted yet. We are getting off again/on again commodity inflation, but that won’t really matter all that much to the inflation outlook. What really matters is who can raise prices, especially prices of labor. When wage rates start moving up, we will have lots of inflation and it will be tough to corral.
As of last month, capacity utilization of our nation’s factories, mines and mills was below 70%. Usually, you don’t get much inflation until that number gets to 85%. It will likely take us a while to get there. We may accelerate the pace by writing-off a bunch of old factories that aren’t going back into production ever again. But, that isn’t what is going on now. Our guess is that when production of a lot of stuff cranks-up again it will crank up in Mexico and not in Ohio. So, that factory will finally get torn-down. Then, capacity utilization will start to rise.
The other element in broad inflation is wages and with unemployment at 9.7% that isn’t a problem right now. We proved in the 70s that you can have high unemployment and rapid inflation and several European countries experienced just that a couple of years ago. So, we can have high unemployment and inflation but usually it is improving unemployment, and that may start in a couple of months. When people feel like their job is solid, they go ask for a raise, not when their co-workers are getting laid-off.
The recent rush into inflation hedge assets, especially TIPS, baffles us. TIPS yield less than 2% and then you add in your inflation adjustment. That adjustment is liable to be fairly modest for the next many moons. There is plenty of time to enjoy the fairly high coupons from other parts of the bond market and then get into TIPS before the inflation train is leaving the station. There are still plenty of seats available.
Economic News (we’ve discontinued the Good News section since most of the economic news seems to be good news these days.)
Kind of a dull week for economists, maybe this is when all of them are supposed to take vacation.
The pace of economic change has been startling. We’ve gone from wondering where the bottom would be to guessing how strong the recovery will be in a couple of months. We noticed that the guesses for where GDP would be reported in the first guess, available next week, have moved from 1.5% a month or so ago to 3.7% right now. What was once the lunatic fringe of economic forecasting at 4.0% this quarter is now mainstream. The only reason the guess isn’t higher is the bunch who cling to the idea that the start to the recovery was very late in the quarter and so won’t have that big an impact on the numbers. There is also a dichotomy between the folks who think there will be major inventory building and those who doubt it. The ‘cash for clunkers’ program alone should have made a dent in inventories of cars at least. That argues for a lower quarterly number (stuff coming out of inventory doesn’t count as production, it was produced earlier and has already been counted once.)
Producer prices fell in September from August by -0.6%, core PPI fell -0.1%. The decline was bigger than expected and was driven by falling energy prices (?). You’ve got to be nimble to keep track of energy prices. It has seemed that they were either stable or rising, but that is what is happening today, not way last month. And, you have to realize that there is more to it than gasoline. Prices for natural gas had been falling most of the summer due to oversupply and limited demand, home heating oil prices fell as did gasoline. For the past 12 months, producer prices are down by -4.8%, core PPI rose by 1.8%.
Housing starts were essentially unchanged in September at 590,000 units (versus 587,000 in August). Forecasts had been for a modest gain to over 600,000, but evidently it is too late this year to get any real pop in starts.
The Federal Housing Finance Agency says that homes in the US fell in price in August by 0.3%. This would be the first decline in this series in four months.
Leading indicators rose again, this time by 1.0% after a gain of 0.4% in August. Eight of the ten leading indicators rose while two fell. This is the sixth straight month where the leading indicators have risen.
Existing home sales rose by a surprisingly strong 9.4% in September to a seasonally adjusted annual rate of 5.57 million. This is a 24% rise from the nadir of home sales early this year, but we are still down from peak levels reached in early 2005. The surge was blamed on the soon-to-expire $8,000 tax credit for first-time home buyers. Like ‘cash for clunkers,’ this program simply borrowed sales from future periods and most followers of these numbers expect something of a hangover once this program ends in November.
A market of stocks or a stock market? We follow the major indices on a regular basis, but what are those indices but baskets of stocks? We occasionally dive into the make-up of those indices and why it matters, but today we’d like to take a somewhat different turn. There are a lot of people who buy ETFs with the idea that they are buying the market. There are other people who buy this stock or that stock because they like what is going on with the company, its management, its products, its outlook. For the last couple of years, it really hasn’t much mattered whether you were right or wrong on the details of good stocks versus bad stocks. The market has dominated the stocks and market moves have driven performance. Sure, if you bought the cheapest stocks in March you did better than buying the most expensive. If you bought the smallest market caps you did better than buying the biggest. But, you were buying attributes, not companies. You could largely ignore fundamentals and just buy attributes. We bought more beta in the stock model. We focused on quality in our choices. One of those factors helped, the other hurt our performance. But, it wasn’t so much the stories we were following, it was the attributes that mattered. You could get a pop here or there on an earnings announcement or a product introduction, but if your attribute was out of favor, it didn’t much matter.
We think that is about to change. We’ve started seeing it lately as the market has gone largely sideways while we’ve seen some distinct benefit from being in the right companies. To use an example that we don’t own, Apple had its earnings announcement and the stock soared because it beat expectations and didn’t disappoint on announcements of initiatives. Microsoft, another stock we don’t own, exceeded the guesses on earnings and launched a big, new operating system. Individual news seems to matter. When Intel announced their earnings and raised their guidance for the rest of the year, the whole market rallied, but the semiconductor companies actually cared about the details. When JP Morgan Chase reported earnings, all the banks responded, but when Wells Fargo reported, it was largely just Wells that went up (that’s one we do own). Fundamentals are starting to count more than attributes. Not all small cap companies are created equal and not all large caps are either.
With this hopeful change, we expect to see a sea change in the market’s behavior. The market may go more sideways than up or down and then have little bursts of up or down as important news breaks. The bias will still be up, but the day to day wiggles will likely be smaller and the exceptions more likely. We will probably have fewer days when 90% of the stocks go one way or the other and more days when it is generally 60%/40% one way or the other. This is just what has happened in most early bull markets. If you recall back in 2003, after the final low in March (not the lowest low, but the last serious correction before the upward explosion), stocks went up almost non-stop until March of 2004. Then we went sideways with an upward bias through 2005. We’ve come farther, faster this time so maybe we stop a little sooner and go sideways a little longer? Who knows? But, we are relieved that the stampedes are less likely and the market of stocks may be back.
Don’t presume that we think stocks are fairly valued, let alone overvalued, due to this shift in perception. Stocks are still cheap, by about 20% as we see it. There is still a good value story behind the market, but that story doesn’t necessarily apply to all the stocks in the market. We think that many of the low quality industrial and material companies that have led the rally since March are overvalued. Many of the small cap companies are overvalued. Many of the low quality companies and low priced companies are overvalued. But, the types of companies that we have favored all along, the high quality, growth companies are great values. At P/Es below the average now but with dependable earnings growth that will be better than the averages, growth should do better. But, only if we look at the market of stocks rather than the stock market.
Speaking of stocks, the major indices were down a smidge on the week and the small caps were down pretty noticeably. The quality idea is already starting to bear fruit. Foreign stocks actually gained with help from a slipping dollar. Emerging markets did best as those economies continue to show the most improvement and strength.
Bond markets were mixed with the Treasury market wallowing under heavy supply and many other areas benefitting from a flow from Treasuries outward following the relative performance of the other segments. High grade corporates gained while high yields gained a lot more. Mortgages and munis followed Treasuries south. Foreign bonds, aided by the weaker dollar, gained.
Real estate securities rose a smidgen on the week. Foreign real estate markets did better.
Commodities tended to rise but precious metals tended to miss this rally. Energy prices were generally up as were industrial metals, and most agricultural commodities.
Have a really great week.
Karl Schroeder, RFC
Investment Advisor Representative
Schroeder Financial Services, Inc.