It’s About Time
Time is of the essence. Time flies. It’s about time! We fret about time all the time. We mark various anniversaries on a regular basis, the beginning of spring, your birthday, holidays and other special occasions. We have a calendar full of such days. The markets have just marked a couple of anniversaries as well. This past March 10th, it was the 10th anniversary of the peak of the tech bubble. On March 9th, it was the first anniversary of the bull market that started a year ago at the bottom of the last bear market. It is an interesting coincidence that the two days should fall so close together on the calendar.
Let’s look at the first of these, the tech bubble top and what it means. First, all the talk of the lost decade for investors says more about the beginning of this past 10 years than it does about the end of it. Back in 2000, we were at truly unprecedented stock market levels. Even at prior bull market peaks, we had never experienced such a disconnect between the market and reality. All of us were in the throes of a mania, we were crazy. The decade prior to March 2000 was one of the best that investors had ever seen (part of an 18 year span that saw the Dow gain 15 fold). That was a decade with no real bear market, only a couple of modest corrections (yeah, we had the 1994 nearly a bear and the 1997 LDC debt crack that amounted to about 20%, but neither was deep enough or long enough to be a real bear market). It was a prolonged era of almost unbroken gains for investors in stocks. It had started after the fall of the Berlin Wall and collapse of the Soviet Union. With only one true super power, the world would enjoy a Pax Americana. The peace dividend that Jimmy Carter had proclaimed 13 years earlier was about to actually arrive.
Stocks already sold at prices almost unheard of before that time. Sure, the Dow had traded at 2722 in August, 1987, but Black Monday had brought us back to ‘reality’. On the first day of the 1900s we traded at 2810. On March 10th, the Dow was at 2683 (this matters only because it was the start of an amazing decade in prices). Many pundits argued that prices were too high, and in the years to come we would see prices lower than this only occasionally. In the hubbub leading up to the First Gulf War, prices got as low as 2365 as war and recession brought the market down. The apparent ease with which we drove the Iraqi army out of Kuwait and the massive casualties they suffered compared to a relative handful of allied casualties surprised our friends and foes alike. By the summer of 1991, we were already above 3000.
“It’s the economy, stupid.” That was the tag line of the Clinton run for the presidency and it was silly because the economy had already turned up long before the November 1992 election. Oh well, no one said that politics and economics ever really meant anything to one another. But, the 1990s were largely about the economy. An expansion that went from the second quarter of 1991 straight through to 2001 is the longest in US economic history. Stocks also had an unbroken string of gains in the decade with losses only in 1990 and 2000, gains in all the other years.
The principal story line for the economy was the huge gain in productivity enjoyed by corporations as they applied technology to one process after another to reduce labor input and improve quality and consistency. No matter what the question might be, technology was the answer. Need to reach your customers any time, night or day? Technology can handle that. Need to service new markets without a physical presence? Technology to the rescue again.
We saw a ‘new economy’ rise from the old one and new products and services grow up out of thin air. We were smitten with technology and what it could do. We were also infatuated with technology stocks and the fortunes that could be made from them. At the distance of ten years, it is easy to joke about all the wacky ideas that were floated back at the height of the tech bubble. But, real people bet real money on those ideas and lost. In many ways, the bear market that was born out of the mania was more destructive than the one we just endured. The biggest difference was that the bear market in 2000-2002 was focused, laser-like, on technology shares and other growth segments of the market. While the Standard and Poor’s 500 lost roundly 50% in each, the NASDAQ lost nearly 80% in the earlier bear versus 55% this last time.
That brings us to the discussion of the lost decade in stocks. Very true if you keep your discussion focused on large cap stocks or growth stocks in particular. But, that’s not the only asset to mention. Small cap stocks and mid cap stocks have done much better since the top in 2000, gaining 2% and 6% respectively. Even the old-fashioned Dow Industrials gained 2% over the decade after the top in 2000. Most other assets available to investors did well in the 00s. Bonds gained anywhere from 5% top 7% depending on which sub-sector you’re looking at. Real estate and commodities were gainers as well. Foreign stocks did better than their US cousins with modest gains for most European and Japanese shares. For owners of diversified portfolios, the calamity of the lost decade doesn’t quite ring true. It may not have been a walk in the park, but it wasn’t a dead-end street either.
So, the ten year period happens to correspond to the top of one huge bull market and the bounce off the bottom of a severe bear market. That gives us essentially one long market cycle in the decade but two bear markets. Most decades hold two entire market cycles or at least the lion’s share of two. We got short-changed by a full bull market. Surprise, we had a tough decade for returns. What usually happens after a period of relatively poor performance by the market is a fairly good period of returns. Statisticians call this regression to the mean, or averaging-out good times and bad to give a better picture of the whole. Over long time periods, US stocks have tended to return about 10% to holders. That argues for a period of time when returns are a lot better than we’ve had in the last little bit.
This doesn’t seem to square with the prospect that so many expound that we are in a time of poor economic growth. Well, maybe they’re wrong about that outlook? Maybe we’ll do a lot better than a lot of people think? Actually, it depends a lot on the time period measured, where it starts and where it ends. This last year was one of the best the market has ever seen. But, no one expects that to continue. This is the mirror image of the scene ten years ago when most investors expected the good times to roll on and on and on. We are probably over-reacting to the recent bear market just like we over-reacted to the extended bull market ten years ago. The reality in both cases will likely be a lot different than the current outlook.
Crisis of the Week
The broad market has finally caught on to the inevitability of higher interest rates. How long have we been worrying about this? At least six months would be our guess. But, now it is front and center on everybody’s mind. So, the crisis this week is how can stocks survive higher rates? Please! Stocks can do just fine with higher rates so long as the other parts of our bear market math equation compensate. Most bull markets have to deal with higher rates sooner or later. Sure, at the end, when the growth in earnings slows to a crawl and the prices get kind of high rates become a problem. But it is high rates, not necessarily rising rates that are the problem. If 10-year Treasury rates were 6% today instead of 3.8%, we’d have a problem with our stock valuation. But, rates aren’t 6%, yet. When they are, we’ll have to reassess, but how they get to 6% and when they get to 6% is the more important question today. If they get there quickly due to some new, unexpected crisis, we could be in trouble. If they get there over several years of relentless growth and rising inflation, we should do alright.
Ah yes, inflation, that’s the culprit. But, there is hardly any inflation today, although the precursors to inflation are all in place. So, rates at 4% with 1% inflation make some sense. We think that rising rates today have more to do with rising inflation expectations and much higher supply in the bond market than anything else. The huge Treasury borrowings lately along with a return of corporate offerings have at least temporarily sated investor demand for paper. The strength of the dollar, or better explained the weakness in the Euro, Sterling and Yen, have created an assumption of a weakening dollar in the future, so higher rates are needed to compensate lenders for that risk, too. There are a lot of elements that aren’t only inflation at work. The trouble with so many of these other elements is the difficulty in measuring these impacts, while the inflation impact is comparatively straight-forward.
Yes, we will have inflation. .It is in the cards and at this point, it is unlikely that the Fed will put up such a defense that they would stop it. We have ranted before on the willingness of the Fed to tolerate a lot of inflation as they will not tolerate any deflation. They will err on the side of inflation and err mightily. They already have.
So, what are stocks going to do when interest rates go up? The answer is – probably go up too. Over the balance of this year and also next year, we are going to witness a huge improvement in earnings, which will rise much faster than interest rates are likely to react. After the next couple of years of a powerful earnings push, we will continue to get some earnings advance, just not at a truly historic pace. Once the pace of earnings growth subsides to more normal, there will be a change in the analysis, but since we don’t know the details of that phase three, we will leave that for another missive much later.
Now, what matters is when the serious rise in rates starts and how far it goes. The Fed has said that they are in no hurry to raise rates and that when they do they will telegraph their intentions ahead of time. They believe in this transparency crap. So, it is April, they haven’t raised rates yet and their ‘extended period’ language is still in use. Let’s assume a rapid timeline for a Fed increase. That would mean at the earliest possible date, they would dump their ‘extended period’ language. Then count two meetings before they would actually raise rates. By our count, that puts the earliest possible date at mid-September, but more likely late October. That allows for only two rate increased from the Fed this year. We could possibly get three, but that’s pushing it. At the outside, that means 1% Fed Funds at year-end. Assuming again that the whole increase in Fed Funds will not make it all the way out a very steep yield curve, we could get 60-75 basis points of increase at the 10-year, probably less. That doesn’t seriously move the needle on the pressure gauge on stock prices. Another 200 basis points of rise next year still won’t do it unless a lot of that works its way out the yield curve to the 10-year area.
Translating this timeline back into what it means for stocks says that we probably have 18 months to maybe 30 months before we are in any serious danger from interest rates in the stock market. There are other risks that could either accelerate or decelerate that timeframe, but those will have to await their own missive.
This same bearish cohort will continue to beat on the market with every conceivable risk factor so long as we listen to them. When we stop listening to them, then we ought to start to worry. But worrying from 18,000 on the Dow and 2,000 on the S&P will be a lot tougher than it sounds. Oh, the lonely life of the contrarian.
Consumer spending and personal income were reported on Monday. The numbers were decent but not really great. Benign might be the way to put it. Personal income rose less than 0.1%, hardly any at all. Part of that was the weather on the Eastern Seaboard in February, most of it was probably just a slow economy. Consumer spending was up by 0.3% in February from January. The difference was absorbed by a decline in the savings rate from 3.3% to 3.1%.
The Case-Shiller index says that the prices of homes fell in January by 0.4%. That is the second month in a row that prices have fallen after a series of small gains last fall. For the past year, prices have fallen just 0.7%. That is an average wherein several cities have seen prices rise and many have seen price drops of more than 10%. Averages generally conceal more than they reveal, as our old statistics professor used to say.
Consumer Confidence rose in March from February, to 52.5 from 46.4. This index has been surprisingly volatile lately with gains and losses of several percentage points each month. Consumers remain at a somewhat depressed level of sentiment. An index value of 100 is the base for this survey, which was established in 1985. Currently, the complaints are about jobs, incomes and a nagging expectations that things won’t get better quickly. Boy, are they in for a surprise!
The ISM Manufacturing index moved higher again in March. The new number of 59.6% was higher than expected but any number above 50% is a good number in this diffusion index. The employment index within the ISM index stayed healthy at 55% though it was lower than in February. But, any number above 50% here also means that factories are hiring more people than they are firing. The prices paid index is also on a tear. That gauge rose to 75%, meaning that three times as many respondents were seeing higher prices than lower prices for what they buy. Lastly, the inventories index rose above 50%, meaning that more companies were building inventories than were liquidating inventories. That argues for a period of inventory building in the broad economy to help sustain the recovery.
Motor vehicle sales were broadly higher in March. Ford sales jumped nearly 40%. GM sales were 20% higher. Chrysler sales fell 8%.
The monthly employment report was much anticipated and it didn’t disappoint. Well, maybe it did a little bit, so before we start talking about details; let’s rant about the silliness on Wall Street one more time. A month ago, the guess for this month’s employment number was plus 150,000. That was due to the weak report last month due to weather and the government’s hiring of census workers temporarily boosting the number. Then we started sliding and by two weeks ago the guess was more like 125,000 new jobs. Then last week, we got the ADP report, which is a number generated from ADP payroll data for the thousands of firms for whom they do payroll. The number slid suddenly to 110,000. Then there were ‘whisper numbers’ from who-knows-where that the number would be big. Either Bureau of Labor Statistics workers can’t keep their mouths shut or this was just a rumor started by someone for some reason, but by last Thursday, the day before the number came out, the guess was suddenly 200,000. So, this month’s number could have been anywhere from 110,000 to 200,000 and made somebody happy.
The actual number was 162,000, right about where we started a month ago and it was viewed as being good, but not great. The unemployment rate was unchanged at 9.7% because enough people reentered the work force to largely offset the gain in workers. Goods-producing industries saw a gain in workers for the first time in three years. The recent gains in the ISM data had telegraphed this shift. Construction employment gained due to the weather-induced drop the month before. Service workers gained and government was boosted by the hiring of 48,000 temporary census workers.
The trend has been in place since last summer of smaller and smaller monthly losses in jobs which, if you draw out the trend line on a graph, looked like it would break above zero last month. We were one month off schedule from that. The gain in jobs could easily have the effect of convincing a lot of people that this recovery is self-sustaining and that consumer concerns are over-done. We needed this report and we also need a couple more with plus-signs in front of them. We’d prefer further gains, but we’ll take anything.
We had an odd week last week with many markets closed for Good Friday but many still open. US banks were generally open on Friday as was the bond market here. Most European markets were closed, most Asian markets were open. But, we managed a gain in most markets none the less.
US stocks were able to put in new recovery highs. We are verging on 11,000 on the Dow, 1200 on the S&P 500, over 2400 on the NASDAQ and closing in on 700 on the Russell 2000. Not a bad week’s work in only four days.
Foreign markets also generally stayed on the recovery trail. The EAFE is back to within a whisker of its early February highs while the Emerging Markets are back to new recovery highs, again. The world seems to realize that the dark days are over and that the world is in recovery mode. If only investors would get on board!
Bond markets didn’t fare so well. The recovery trail is going to be a bumpy ride for bond markets all over the world. Foreign bond markets were quiet with either very modest gains or losses. The exceptions were in emerging markets where Greek bonds did poorly.
Real estate securities prices were modestly lower from what we can see. Commodities were generally up with energy gaining, precious metals gaining and basically everything else gaining.
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.