The Triumphant Return of Volatility

The falsely mnemonic tone of market behavior of the last few years has deluded multitudes of market participants to plod along blissfully unaware the volatility bugaboo had simply taken an extended sabbatical. With a not insignificant amount of ferocity, volatility has returned to test our resolve.

In the absence of our aforementioned confrere, markets in general and debt markets in particular had priced themselves for perfection. The elimination of risk premium in certain mortgage related debt led ultimately to the sub-prime related re-pricing of risk that has occurred over the past six weeks. Fortunately for investors, this crisis has been contained because of strong global economic growth, pristine corporate balance sheets, and an accommodative Federal Reserve Board. At this writing, volatility has returned to more historical norms and risk has been more efficiently priced into the market.

US corporations continue to produce financial reports consistent with more conservative accounting techniques. This may be because they have nothing to hide at the moment. Balance sheets are chock full of cash that can be used to fund earnings growth through capital expenditures, acquisitions and share buybacks.

Strong gains can be found from nonresidential construction, capital equipment expenditures, and growth in exports. Global economic expansion and a declining US dollar have complotted to create a surge in export growth, the absence of which would likely see the US headed towards recession in the coming quarters.

During the first two quarters of 2007 earnings growth of the S&P500 (SPY) trounced analysts’ estimates and grew at 7.9% and 7.8% respectively. Estimates for the third quarter which begin reporting October 9th are for 3.9% earnings growth, despite Financials (XLF) and Homebuilders (XHB and ITB) contributing negative numbers. 2008 S&P500 Operating Earnings are expected to be $100 per shares roughly double their level in 1999. Recently, I have added homebuilders (XHB and ITB) to our client portfolios.

Despite a plethora of reasons to be constructive on the economy, I remain vigilantly watchful of the very real risks that present themselves. I expect spending on Residential Fixed Investment to decline 16% this year and another 15% in 2008, this on top of a nearly 5% drop in 2006. In addition, the twenty plus year decline in inflation rates has come to its terminus. With this arrives the real possibility of wage inflation (the largest component of business costs). If wage inflation continues to be offset by technology driven productivity gains we may just have our cake and eat it too.

Healthcare costs could be a detractor to economic growth. Premiums for employer-based health insurance rose by 7.7% in 2006 while small employers saw premiums rise 8.8%. Larger companies have had moderate success at cost containment but challenges still remain.

While fundamentals remain quite positive and stock prices have risen, I find equities cheap by historical standards. The earnings yield of the S&P500 (SPY) and the Dow Jones Industrial Average (DIA) both exceed the “risk free” rate of the ten-year US Treasury by significant margin. We remain overweight equities.

Comments

[MNRTrading]

Herb, thanks for the thoughtful and well written post. I believe that most of us will agree that you have touched upon some of the key issues facing us.

Note that the traditional methods of looking at wage inflation may no longer work. For example, despite the demographic reality of the working population, which strongly suggests an inflationary tendency, outsourcing and the presence of a large foreign population have kept inflationary force at a minimum. Basically, modeling wage pressures is more complex than it was in the 1950s and 1960s.

However, healthcare costs of our population is a huge economic and social burden, and effects all segments of the population. That is where some new and large efficiencies are needed, and we are all scanning, back and forth, on the IPO frontier for some signs of a solution, hopefully before politicians are tempted to fabricate one.

The "cheapness" of equities in comparison to risk free returns is however a very uneven condition, and thus while your statement is certainly true for groups of equities, it is not a general rule.

[Contrarian]

Herb is in denial as well as many others market participants. The market is assuming business as usual while we have started to witness an unprecedented de-leveraging of the consumer balance sheet as a consequence of a natural unwinding of the unprecedented credit bubble. Exports are no hope. They are only $1.2 trillion versus $9 trillion of consumption. The price deflation (5-10% in the next year) in a $23 trillion asset called residential real estate will take a huge toll on the consumer, on top of the increase in oil prices, on top of the increase in prices due to the USD decline, on top of the increase in interest rates in ARMs, on top of the food inflation, on top the sluggish economic growth,...

Time to run for the hills...