How Now, Dow Jones?
Why has the stock market risen over 8% in September – potentially the best September market performance since 1939? Will this run up be sustained or will it fall back again as it has several times this year? These are two of the many questions on investors’ minds these days.
A number of reasons can be given for the stronger market in September. Chairman Bernanke’s assurance that the Federal Reserve would initiate quantitative easing II (QEII), if needed, to stave off any overt deflation is, in our opinion, the fundamental basis for the rally. As David Tepper of Appaloosa Partners commented on CNBC this week: Either the economy will strengthen in the months ahead and the stock market will rise or the Fed will pursue QEII and the market will rise on the back of increased liquidity.
Another force helping the market has been an improving technical positioning. The broader market broke out through resistance to the upside weeks ago. Typically, a broadening market is stronger than a market dominated by a few stocks. Confirming the breakout of the broad market has been the subsequent breakout of the major market indices. Absent has been a significant pick up of volume. Lack of volume during rallies this year has been a harbinger of follow on setbacks in prices. Lighter than expected volume ultimately reflects a lack of confidence and conviction by investors. Despite relatively low volume, we believe that there has been pressure to put cash to work before the end of the third quarter.
A rising tide of mergers and acquisitions as well as share buy backs has provided encouragement to the bulls who cite that these actions underscore the undervalued nature of many stocks. While some acquisitions may be based on value, we suspect that the buyers, who are motivated by growing balance sheet liquidity, are more concerned about adding assets that may pep up growth for their companies. After raising liquidity, in part, because of a cautious outlook for growth, corporate managements are beginning to deploy this cash on a potential growth basis. As to buybacks, we believe a program of raising dividends over time is a wiser use of capital, especially where a company is relatively mature in its growth cycle.
Another reason given for the recent strength in the stock market is a growing expectation that the Republican Party may win control of the House of Representatives and further reduce the Democrats’ hold on the Senate. Such an outcome might short circuit future growth in new programs and be a boost to individual and corporate confidence. Two considerations – one is the possibility that Republicans do not have as much success as now expected and second, gridlock may not be desirable when the economy is struggling to grow. Nonetheless, the top 20% taxpayers are responsible for 40% of the spending in the economy. A case can be made to carry all the Bush tax cuts forward for a two year period. Having said this, one wonders if QEII is really a strategy to offset some loss of spending from any rise in taxes in the months ahead. So far low rates have not had as much impact on stimulating growth as they have had in the past. The monetary base has not grown recently, probably because velocity of money has not picked up due to constrained consumption.
Before leaving the matter of the midterm election, we hasten to note that the market in an election year tends to sell off in the first half of the year and then rise in the second half. Perhaps this recurrent pattern is another catalyst for the recent rally. Looking out to 2011 and 2012, we find that the third and fourth year of the presidential election cycle are usually the best years for the market.
With all these reasons given for the market’s rise, we believe the fundamental underpinnings of the U.S. economy’s growth will produce 2 – 2.5% growth in the quarters ahead as unemployment remains high, housing continues depressed, lending remains constrained, and profits growth slows down. While the current positioning of these factors may not create a new bear market, they are not strong enough to carry the market significantly higher. Let’s review the profits’ situation. Corporate profits growth is likely to be about 36% this year as earnings rebound from depressed levels in 2008, margins expand due to cost cutting, and revenue growth picks up. In 2011, earnings are expected to grow less than 10% as aggregate top line growth continues to slow and opportunities for further significant cost cutting recede. As a sign of what’s to come, there have been many more negative earnings preannouncements than positive ones for third quarter earnings reports. Again the bulls may argue that these negative preannouncements are reflected in stock prices. We doubt that because prices of most stocks are up in recent weeks.
Perhaps the best indicator of what lies ahead is the stronger performance of growth stocks over that of value stocks. Growth stocks usually perform well when overall growth in corporate profits is slowing down. The period of 1995 – 2000 is one example when the cyclical leadership of the market in the early 1990s evolved in 1995 and 1996 to large cap growth stocks that represented great value at a time when the rate of change in corporate profits was peaking and ultimately slowed down. If the outlook were for the economy to strengthen, then the large cap growth stocks would not be performing as well as they are. Without their better performance, the stock market would not be as high as it is today. Moreover, investors have become more aggressive buyers of emerging markets – a strategy linked to growth.
While attention is being paid to the factors supporting the market, political, economic and technical, we find other entertaining events and trends worthy of attention. Has anyone really noticed that a mini trade war is brewing? One aspect of this is the U.S. raising tariffs on Chinese tire imports. In retaliation the Chinese have raised the tariffs on chickens exported from the U.S. – one of the few products where the U.S. has a trade surplus with China. Meanwhile, the Democratic Congress would like to take various actions to bring jobs back to the U.S., including encouragement of a higher Yuan and threats of more tariffs. Has anyone really noticed the rising inflation in Asia in food and wages? Chinese inflation is running at a 5% annual rate. If inflation continues to climb in China, we expect the government will move to slow growth. History is clear that governments best not permit inflation to rise to a degree that unsettles their constituents. Any slowdown in Chinese growth would not be good for emerging markets and for commodities. Nonetheless, this setting would be bullish for large cap U.S. growth companies.
Overall, as we have stated in the past, there is no quick fix for many of the economic challenges affecting the U.S. The same might be said for other countries also. Along the way there may be new issues with trade and China. None of this suggests that a strong period of growth is at hand. Markets will remain volatile.
A. Marshall Acuff, Jr., CFA
Director of Research
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC