"Don't Fight the Fed"
- Marty Zweig, Investor (1942 - 2013)
Many Wall Street observers have pointed out that the equity and fixed income markets are sending mixed signals about what to expect in the near future. On the one hand the stock market is at an all-time high, indicating an improving economy and a positive outlook. On the other hand, the bond market is also at an all-time high, resulting in record low yields, which generally precede a weakening economic environment. On the surface, the two economic indicators appear incongruous. While the pace of the current economic expansion has been anemic, the picture is improving, and we expect the current low growth positive trajectory to continue moving up. The confusion in the contrary signals from the stock and bond markets is a direct result of the Federal Reserve monetary policy. With interest rates near zero and the continued purchase of assets through quantitative easing, the Fed is aggressively adding stimulus to the economy. This stimulus inflates asset values such as the stock market and real-estate. The unprecedented liquidity requires us to discount what the bond market is telling us. Interest rates are at extreme artificially low levels because of the Federal Reserve's massive monetary stimulus and not because of a weakening economy. As the year progresses, we expect to see continued improvements in economic growth resulting in further gains in equities and housing and a sideways year for bonds.
Ultimately stock prices are driven by earnings. However, earnings are the result of profits derived from sales; sales which are the result of spending and consumption as measured by GDP. We are continually evaluating earnings expectations against the realities of economic growth in an effort to determine the direction for the equity markets. In our March 7th note we argued that the doubling in earnings rationalizes the doubling in the stock market since 2009 and that we thought the current rally had room to run. Looking forward, we believe that economic growth will continue and possibly accelerate in the coming 18 months, driving equities even higher. We remain alert to a slowdown in the slow growth data but the recent numbers are encouraging and we see signs of improvement.
The revised earnings forecast on the S&P 500 after most of the first quarter results is for $110.53 in 2013, down from the $112.17 estimate back on January 1st. This forecast is a 14.6x price-to-earnings multiple on the S&P 500 after Friday's close. The EPS forecast for 2014 is $123.01 or 13.1x. The current forecasts represent 14% year-over-year EPS growth from 2012 to 2013 and 11% earnings growth from 2013 to 2014. Although earnings in the first quarter met expectations, revenue growth was lackluster, which could be somewhat troubling. Of 404 companies to have reported first quarter results to date, 72% exceeded EPS expectations in 1Q13, while only 47% have exceeded revenue estimates according to FactSet. Year-over-year revenue growth in the 1Q13 over 1Q12 is only 2.2%. These marginal results are commensurate with lackluster GDP growth of 2.5% in the March quarter which was well below the consensus forecast of 3.0% and well off the 2013 full year growth rate forecast of 3.3%. Revised forecasts for U.S. GDP growth in 2013 is a meager 1.9%.
We have some difficulty reconciling the high earnings growth estimates and low GDP forecasts. We suspect the GDP forecast is too low and the earnings forecast for the second half of 2013 is high. With slow revenue growth, earnings growth must come from increasing profit margins. Early in a recovery, earnings can grow considerably faster than revenue as companies increase their profitability. Companies are currently at record levels of profitability with 9.6% operating margins for the S&P 500 in 1Q13. Businesses have been reluctant to hire and have been utilizing overtime rather than adding new workers in an effort to hedge against a downturn. Profit margins have reached their peak, in our opinion, meaning earnings growth will be dependent on revenue growth in the months ahead.
Our current thinking is that the slower growth recorded in the first quarter is not indicative of a broader slowing trend in the overall economy and there are several factors that may contribute to drive an acceleration in growth over the coming quarters.
A. The Fed will continue to pour fuel into the economy for the balance of the year and we believe that the stimulus justifies a multiple expansion for stocks. Price-to-earnings ratios on the S&P 500 have hovered at nearly 13x expected earnings since 2009. If the $110 estimate forecast for 2013 is accurate, the argument could be made that either the market is a few months ahead of itself or estimates are too conservative. There is a third interpretation: there is an external cause for P/E expansion, which is further Federal Reserve manipulation through monetary policy. Many on Wall Street think we are due for a pause and slight correction, frequently forecast for this summer. Unless we see accelerating growth we think the estimates for 2013 are slightly on the high side rather than too conservative and would agree that the market is due for a pullback. We believe that there is justification for an expansion in the acceptable price-to-earnings ratio and we attribute it to the Fed and therefore continue to believe stocks are fairly valued rather than expensive at current levels. There is a lack of investment options in the current environment. With yields for fixed income and savings rates at all-time lows, equities have quickly become the only game in town and with increasing returns over the last several years, investors are returning to stocks.
B. The jobs outlook continues to improve and may be accelerating. Ultimately the key to moving the stock market forward is through growth. Growth will drive corporate sales which will drive earnings which will drive stocks. Growth has been slow, but it has been positive. If two-thirds of GDP spending comes from the consumer then we should look to the consumer first for potential changes in growth rates. One of the key drivers for consumer spending is employment. It's hard to spend when you don't have any income. Other important indications of potential consumer demand include household income rates and consumer sentiment. Unemployment has continued to decline and the economy has been adding about 200,000 new jobs a month since January. Initial data showed a slowdown in the month of March, however the April data showed a surprising uptick that included a strong upward revision to the low March estimate.
C. Housing will be a key driver for accelerating growth. Data on housing trends are somewhat unreliable and at times volatile month to month, however it is clear that prices are increasing and new housing starts are certainly on the rise. Through February 2013, the Case-Schiller Housing Index gained 9.3% over the last 12 months with all 20 cities in the index posting year-over-year gains. New housing starts have doubled since the low, reaching a 1.04 million annual rate in March 2013. In decades past, housing construction has represented 4-5% of total GDP, but has shrunk to about 2.5% of GDP currently. If housing re-accelerates it would be a significant driver for growth. A continued recovering in housing would add jobs, spur spending and as the largest single asset for most consumers, values directly affect consumer sentiment.
D. With unemployment on the decline and housing improving, consumers are feeling more confident. Consumers have increased spending as evidenced by a decline in savings rate. This data point could become problematic in the long-term but in the near-term more spending gives a boost to the economy and points to strengthening consumer confidence. Sequestration has had small impact on the economy by slowing government spending, but the consumer has made up for more than the government reduction. Consumer spending increased 3.2% while government spending declined 4.1% in the March quarter.
E. Supply of equities is shrinking and there is a lot of cash yet to be put to work. Companies are aggressively buying back stock and in some cases taking advantage of record low costs of capital to borrow in order to buy their own stock. Apple, for example, recently raised $17 billion in debt to buy back stock rather than pay taxes to repatriate funds parked overseas. Apple sold 10-year bonds with of yield of only 2.43% which were snapped up by bond funds. We find the equity with its 2.7% dividend yield and opportunity for appreciation far more attractive. Corporate stock buybacks totaled nearly $400 billion in 2012 and are on track to beat this total in 2013 according to FastSet. Mergers and LBOs also have reduced the quantity of shares available while the IPO market remains largely shuttered. Supply is shrinking just as investors are returning to equities. This scarcity of supply is helping to push equity prices higher. Lastly, there is a tremendous amount of cash sitting on the sidelines. Investors have been slow to return to equities but momentum appears to be building. Foreign investors are looking to the U.S. equity markets due in part to a lack of alternatives for positive returns. Commercial banks have been reluctant to lend due to uncertainty and residual fear from the recent recession. Cash at commercial banks totals nearly $2 trillion. If confidence continues to improve more of these funds will be put to work as loans to small businesses, increasing jobs and accelerating growth.
The Fed has more than $1.0 trillion in mortgage backed securities currently on its balance sheet. In addition to cutting rates nearly to zero these asset purchases are part of a coordinated effort by the Federal Reserve to maintain very low interest rates, reflate assets and spur growth. There are reasons for optimism and certainly still cause for caution, however equities have performed well, and assuming growth can continue, are poised to move higher, in our view. While there is always a possibility for a correction in the near-term we expect the long-term trend to be rewarding. In 2013 the defensive sectors have outperformed as bondholders look for higher returns. These include utilities, health care, consumer staples, and telecom. We have been focusing on these sectors so far this year, however if growth does accelerate we expect growth oriented sectors such as technology, to outperform.
Earnings estimates for 2013 may be too high for the second half of 2013 and we will pay close attention to the low GDP and revenue growth rates for signs of further slowdown. The consumer is key and to that end, data on jobs and housing are very important. The bond market has been stable but gains from price appreciation are over. Even the high yield bond market returns have slowed to a trickle this year after increasing more than 14% in 2013. The spread for BBB rated corporate bonds is less than 2.0% over Treasuries. The reward for taking the risk of default is a paltry 2% premium, which is not commensurate with the risk, in our opinion. For now we will continue to seek better returns in the stock market where the dividend yield is more than 2% for the S&P 500. We have no interest to fight the Fed.