Renewed Optimism

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Monday, 13 September 2010 15:10 Written by James Van de Voorde

Renewed Optimism 

Having held between 15% and 20% cash in portfolios throughout the summer, we have been looking for evidence, answers to the “known-unknowns”, that might buoy our confidence in the stock market and influence a more constructive view.  The stock market decline in August, accompanied by better-than-expected economic data, presents the rare combination of lower valuations with improving fundamentals and offers us an opportunity to put some of our cash cushion to work.   

The S&P 500 Composite, Dow Jones Industrial Average and NASDAQ Composite trended steadily lower for the month, with respective August declines of 4.74%, 4.31% and 6.24%.  These major market indices are now down 5.90%, 3.96% and 6.84% year-to-date.  Despite these declines, we have become more confident that the recent dip was a mere correction, a pause in the bull market that began last March, and not the beginning of a new bear market.  Our renewed optimism is based on surprisingly strong economic data in the United States and overseas, growing investor and analyst pessimism, political developments in the United States, increasingly attractive valuations, especially relative to “safe” alternatives, and the renewed commitment by the Federal Reserve to support the economic recovery.     

U.S. Economy: We offered evidence in last month’s newsletter that the economic data “points to a slow recovery, but does not substantiate the fears for an imminent double dip”.  This thesis is now strengthened by continued better-than-expected data.  Consider the following: 

• While second quarter GDP was revised down from 2.4%, the actual 1.6% rate of growth was “less bad” than the gloomy consensus.
• After increasing 0.4% in July, retail sales continued to beat expectations in August.  The International Council of Shopping Centers reported that August same-store retail sales rose 3.2% and expects sales to increase 3% in September. 
• Industrial production rose 1% in July after falling 0.1% in June. 
• The Conference Board’s Consumer Confidence Index rose unexpectedly to    53.5 in August from 51 in July.  Meanwhile, the University of Michigan sentiment survey increased to 62.9 from 62.3 for the month. 
• The ISM Manufacturing Index may have been the greatest positive surprise for the month, rising to 56.3 in August from July’s 55.5.  The consensus called for a decline in August to 52.9.
• The ISM Services Index may have been the greatest negative surprise for the month, dropping to 51.5 in August from 54.3 in July.  Despite the deceleration, the Index remains above 50 and continues to point to expansion. 
• The August employment report revealed the creation of 67,000 private sector jobs for the month, much better than consensus.  For the year, the economy has created an average of 95,375 private sector jobs per month. 
• Personal income rose 0.2% and personal spending increased by 0.4% in August.   

Global Economy: With particular strength in emerging markets, economic data overseas continues to support the thesis of a synchronized global recovery.

·         Europe: Second quarter GDP for the 16-nation European Union grew 1% quarter-over-quarter, the fastest pace of quarterly growth in four years.  The rate of quarterly growth for the first quarter was revised higher to 0.3%.  Year-over-year, EU GDP grew by 1.9% in the second quarter and 0.8% in the first quarter, better than the previously reported 1.7% and 0.6% respective growth rates.   

Growth was strongest in Germany, while Greece was the only EU nation suffering economic contraction during the second quarter.  Interestingly, exports accounted for a scant 0.1% of the overall 1% quarterly expansion.  A surge in consumer spending and business investment led the expansion and indicates that the EU may be less vulnerable to potentially weaker demand in the U.S. and other parts of the world.  Further, the fact that this level of GDP growth was sustained in the midst of the European sovereign debt crisis is encouraging.   

·         China: The official Purchasing Managers Index (PMI) rose to 51.7 from 51.2 in August, the first such increase in four months.  A separate PMI report from HSBC Bank rebounded to 51.9 from 49.4, a three-month high.  Separately, automobile sales in China rose an astounding 56% in August from the year ago period and 15% month-over-month.  The data suggests clearly that China may have engineered a soft landing and should help support other economies in the region (South Korea, Taiwan, Australia) that have shown recent signs of decelerating growth.  Indeed, machinery orders in Japan jumped unexpectedly by 8.8% in July. 

·         India: Led by strength in manufacturing, India’s second quarter GDP rose by 8.8%, its fastest level of growth in two years.  The Reserve Bank of India has increased its key interest rates four times since March to quell inflation and support a soft landing.   

According to the Investment Company Institute, there is a combined $2.827 trillion invested in retail and institutional money market funds as of September 1^st.  Meanwhile, investors continue to take money out of stocks ($9.54 billion for the last week) and pour money into bond funds ($6.65 billion for the last week).  The combination of excessive pessimism and an abundant surplus of cash should provide ample kindling to fuel a market rally, especially if data continues to surprise to the upside.   

Politics:  With the important November mid-term elections looming, recent polling data suggest a potential Congressional sea change that may rival the 1994 mid-term elections during the Clinton administration.  With the Labor Day weekend traditionally marking the beginning of the campaign season, MSNBC reports that “Republicans have a nine-point edge among those considered likely voters, plus a near 20-point lead among those expressing the highest amount of interest in the midterms”.   

MSNBC continues that “six in ten believe the country is on the wrong track; nearly two-thirds think the nation is in a state of decline; and a similar number aren’t confident that their children’s generation will enjoy a better life.  Perhaps more ominous for Democrats, the number of Americans who approve of Obama’s handling of the economy – the top issue in the country – has declined below 40% for the first time”.   

This lopsided polling data is leading many key Democrats to rethink their position on taxes and the imminent expiration of the Bush tax cuts.  Even President Obama has recently announced plans for business tax cuts as a means to spur the economy.  The President has consistently promised to maintain present income tax brackets for families earning less than $250,000 and has further promised to cap taxes on dividends and capital gains at 20%.  With the odds increasing for a change in leadership at least in the House, so too grow the odds for a great compromise on tax policy.  At the very least, even if the Bush tax cuts do indeed expire at year-end, the expected influx of Republicans in the House and Senate will restore balance in Washington, a period of gridlock that the stock market tends to favor.   

Valuations: With second quarter earnings now in the bag, Standard & Poor’s estimates that S&P 500 companies will earn $82.86 for 2010 and $94.16 for 2011.  With the S&P 500 now hovering near 1,100, the market PE ratio is a very reasonable 13.2x this year’s earnings and an even more attractive 11.7x next year’s estimated earnings.  As the economic data in the U.S. and overseas continues to demonstrate resilience, it is becoming increasingly likely that third quarter earnings will deliver as expected and perhaps even surpass the consensus.  With rampant pessimism and excessive cash providing abundant kindling, third-quarter earnings just may provide the spark that fuels the market higher.   

In addition to attractive valuations, the collective balance sheet for corporate America has never been stronger.  J.P. Morgan recently reported that U.S. corporations are sitting on $1.05 trillion of cash ($3.2 trillion if banks are included) and on pace to generate an astounding $800 billion of free cash flow in the coming year.  This extraordinary balance of cash and growing free cash flow should continue to support dividend increases, buybacks and merger and acquisition activity.   

The dividend yield on the S&P 500 at 2% is higher than the approximate 1.5% yield on 5-year Treasury notes and comparable to the approximate 2,2% yield on 7-year Treasury notes.  And the average 2.8% dividend yield for the Osher Van de Voorde core equity composite surpasses the 2.7% yield on 10-year Treasury notes.   Since the Osher Van de Voorde core equity composite is chock full of leading blue-chips that have demonstrated the ability to grow earnings and consistently raise dividends through various economic and political cycles, it is clear that one does not have to assume a great deal of risk to obtain income greater than that of the 10-year Treasury.  Relative to fixed income, high-quality stocks appear especially attractive in the current environment.   

Federal Reserve: With its announcement last month to engage in a second round of quantitative easing (QE2), the Fed is going “all-in” to ensure that that the economy does not slip back into recession and doing whatever it takes to prevent deflation from taking hold.  Further, the Fed has clearly telegraphed that it will keep interest rates low for an extended period of time.   

With an expected imminent change in congressional leadership, we are hopeful that fiscal policy and overall government initiatives will be more business friendly and conducive to economic expansion.  With fiscal and monetary policy working in tandem, the economy may be able to reach a new and higher plateau of growth than is currently predicted.   

Incidentally, the Consumer Price Index (CPI) rose by 0.3% in July after falling the three previous months.  This was higher than the consensus for an increase of 0.2%.  While it is premature, this may be an early sign that the Fed is succeeding in its campaign to prevent outright deflation.  We believe that further signs of a pick-up in inflation or the absence of deflation would be very welcome news for the markets.    

With all of these factors in mind, we are increasingly confident that the S&P 500 can reach our expected year-end price target range (that we published in January) of between 1,200 and 1,280, implying a return of between 8% and 14% between now and year-end.