April 1st, 2014:
Did bitter winter weather delay economic growth? Or simply mask a slowdown? The stock market wrestled with this question during the first quarter, apparently deciding to wait for a clearer picture from the spring data reports. Job growth, retail sales, wages and corporate earnings all looked anemic but the weather could certainly have been a contributor. So after a year of +30% gains for the S&P, the market paused for more clarity.
Before digging deeper into the economy let us first recap the market’s performance for the first three months of the year. With dividends, the S&P managed to advance 1.81%. Without dividends the index posted a 1.30% gain, and that was the best of the domestic indices. The Dow was actually down 0.72%, the tech-heavy NASDAQ advanced only 0.54% and the Small Cap Russell 2000 posted a 0.81% gain.
Although the end result was little changed from year-end, the ride was exhilarating. Many have expected a meaningful pullback in the averages and the beginning of the year seemed likely to deliver. After drifting lower for the first two weeks of January, the S&P was able to eke out a closing record high on January 15th. From there, the S&P 500 fell 5.76% through February 3rd. However, rather than fulfilling the promise of an official correction (down at least 10%) the market regained its footing and closed the quarter at another all-time monthly high. For the correction seekers, the meager selloff was no doubt a disappointment and served to keep uncertainty in place.
The roller coaster ride was at least in part fueled by confusing economic data. One year ago, corporate profit growth was expected to be about 16% in 2014. Now the expected rate of growth is down to less than 12% and likely shrinking. For the 1st quarter of 2014, profits are likely to be lower than in the 4th quarter of 2013. As for GDP, expectations have contracted similarly. Although there are some that still predict robust growth fueled by expansion in the second half of the year, the population of optimists is approaching the endangered level. A consensus is mounting for slow economic growth matched by slow corporate earnings growth. This likely means slow stock market growth as well.
While the stock market historically has been a solid economic indicator in the long run, the bond market is an outstanding indicator in the short run. There are 3 tables below that illustrate the bond market’s forecasting through the yield curve. For those unfamiliar with a yield curve, it simply shows interest rates for varying maturities at a fixed moment in time. Generally speaking, short term rates are lower than long term rates as one might expect. We will lend money for 30 days at a lower interest rate than we will lend for 30 years. There is more risk in lending for 30 years so we demand greater compensation. In these charts we use Treasury securities for the time periods indicated on the
First is Yield Curve Comparison #1 for December 31, 2012 and December 31, 2013. Interest rates were much lower in 2012 and increased throughout 2013. Typically interest rates rise (in spite of the Federal Reserve’s best efforts) when economic growth is expected. The rise in rates in 2013 corresponded with the rise in the stock market. Expectation of economic growth fueled these increases.
However, as we have entered 2014, expectations have been tempered. Whether the cause is a harsh winter or something else, the bond market is predicting slower growth today than it was three months ago. Yield Curve Comparison #2 is not nearly as dramatic as #1, yet rates are lower today than at the beginning of the year. While the yield curve has shifted lower, this does not indicate anything other than a recognition of lowered growth expectations. The expectation is
still clearly for growth, not recession.
The 3rd chart at the bottom of the page is a hypothetical yield curve predicting recession. The yield curve inverts when investors shun other investment options in favor of the safe haven bonds provide. They crowd into the long end of the bond market, driving longer-term rates lower. The short end of the curve is influenced by the Federal Reserve and when an inverted curve occurs, the market
has gotten ahead of the Fed. Lower rates are higher than longer rates because the Fed has not acted to lower rates as fast as the market. Yield Curve #2 indicates that we remain a long way from an inverted yield curve as the Fed continues to hold short term rates near zero to boost growth.
We have long believed that the direction of the unemployment rate is an excellent predictor of the stock market’s direction. Indeed, as unemployment has fallen since the recovery began, the stock market has risen dramatically. Today’s unemployment picture is a bit more muddled than usual and this no doubt causes uncertainty for the stock market. While the reported rate of unemployment continues to decline, the reliability of the reported rate has come into question. The percentage of the population that is employed is significantly lower than it once was. Has the decline in participation resulted from baby boomers retiring and leaving the job market? Or is it because so many have given up seeking employment but would gladly reenter the work force if the opportunity arose? We suspect it is both and that it will take time to sort out a clearer picture. So unemployment is not now the indicator that it once was.
Similarly, GDP is not as predictive as it once was. Government spending contributes to GDP and it has declined from very inflated levels as we have emerged from the Great Recession. While there have been certain increases in expenditure, they are in areas that do not contribute to economic growth. Personal consumption is the biggest component of GDP. Unfortunately, we seem to know less about the average consumer today than we once did. The wealthy have been holding up their end of the bargain but the lower end struggles. And the wealthy consumer may be inclined to scale back consumption as a result of new taxes that took effect in 2013 and were largely realized on April 15th.
The murkiness of data leaves us with corporate profits as our most reliable predictor. The problem we are experiencing with earnings expectations is that they have become more volatile than normal. In 2009 and 2010 as we emerged from recession, expectations were lower and companies easily exceeded projections. As the recovery has matured and slowed, expectations have become more challenging beat and earnings projections have been steadily lowered. The chart to the right
illustrates the decline in earnings expectations just for calendar year 2014 in the past 13 months. They have declined nearly 4% and it is reasonable to expect them to be lowered again if economic activity doesn’t pick up now that the snow has melted.
However, earnings growth and stock prices remain strongly correlated. The chart below shows the S&P’s price history since the end of 2009. Placed alongside is S&P earnings for the 12 months to follow. In short, the price for 12/31/2009 corresponds to 12 months of earnings ended 12/31/2010 and the price for 3/31/2014 corresponds to 12 months of earnings ended 3/31/2015. Although price is more volatile, it historically returns to a similar rate of growth as earnings. In the early days of recovery, price lagged as investors were skeptical of the economy’s strength. As time passed, prices began to trade more in line with earnings. At least until 2013.
In 2013, price gains reflected future earnings growth that is now being questioned. As earnings lag behind, stock prices seem to have paused to allow earnings to catch up. Some believe prices must fall to reflect the new reality. And they may. Or they may just continue to meander until a clearer picture emerges. We expect the market to be more volatile than in 2013 but think we are more likely in a range below last year’s high than due for any sharp pullback.
It is important to note that you, our client, do not own the stock market. You own individual companies that will behave in ways unique to them. If our companies grow earnings (as they have) through this environment, their share prices will ultimately reflect earnings growth. Although we constantly refer to the stock market, it is really just a market of stocks. Lots of stocks. And we think we own some good ones.