No Quick Fix
Over the course of 2010, the U.S. stock market has been on a rollercoaster with some up months followed by down months resulting in no change in the S&P 500 index for the year to date. The principal driver of the ups and downs in the market has been changing perceptions about growth in the U.S. and abroad. The stock market rallied in March and April as investors felt more confident about growth after concerns about momentum in economies here and overseas. During April, the worries returned again about trends in the U.S. and abroad. Then in July, the market put on a summer rally followed by a sinking spell in August as investors confidence waned again about growth after waxing positively in July. So far the market is up 6% in September subsequent to Chairman Bernanke’s assurances that the Federal Reserve would initiate quantitative easing, if needed, to stave off any potentially overt deflation.
Nonetheless, the market is flat for the year and down about 10% from its April high. Year to date, gold and fixed income investments have been the winners. Since mid July, Cary Street Partners has been cautious toward equities. The primary reason for our cautious stance has been concern that earnings estimates were too high for 2011. Subsequently, profits expectations for 2011 have been lowered by the analysts responsible for their coverage. Earnings preannouncements this month and profits reports in October and November will provide an additional benchmark about future expectations for earnings. Nonetheless, the likelihood of slow economic growth in the quarters ahead will not produce as many upside surprises in profits as experienced in the first and second quarter of this year.
The reality is that there is no quick fix for growth. Over the next 12 months U.S. economic growth is expected to expand at a 2 – 2.5% annual rate, below the 3% rate needed to grow the labor force. Inventory growth has been a significant benefit to the recovery of the U.S. economy since last summer, but is no longer likely to help growth as much going forward. Capital spending has helped. More recently, trade has been a negative influence on growth, but the third quarter may experience reduced drag from imports growth. Much of the federal government stimulus effect has passed. New measures proposed by the President to enhance investment are promising, but will have their greatest positive effect when managements feel more certain about the longer term outlook. Meanwhile, bank lending remains more restrictive than it has been in the past. Overseas, European countries are following more austere fiscal policies which for a time will constrain growth. Emerging countries continue to expand, but an inflation rate nearing 5% in China raises questions about the degree of its future growth. Historically, heightened inflation in China has resulted in a slowdown of growth there. Returning to the U.S., the heavy debt incurred by the federal government in the past two years is going to be difficult to reduce without putting some additional constraint on growth. This situation is quite contrary to the 1980s and 1990s when debt rose at a more rapid pace than in the prior two decades, but was ultimately absorbed by foreign governments. Going forward the U.S. may have to absorb more of its debt. A rising savings rate over time might help, but at a sacrifice of current consumption.
The midterm elections in November have brought forth bullish optimism and may continue to provide support in the run-up to the election. The general presumption is the Republicans will retake the House of Representatives and may even gain a majority in the Senate. Such an outcome, it is thought, will bring gridlock in Washington. The President will be unable to gain passage for his proposals that Congressional Republicans might not wish to support. Citing a similar circumstance during the Clinton presidency, the bulls argue that the stock market will move up in the months ahead. 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, costly programs for the future might be eliminated or reduced in size and the President, as Clinton did, will be forced to go along with a Republican Congress. Cutting through it all, growth will still be slow. No quick fix for the fundamental underpinnings for growth is yet visible.
Consequently, markets are likely to rise and fall as they have been doing and asset classes may become even more correlated to the movement of the stock market than they already have become. Recently, investment sentiment has rebounded strongly, although stock market volume, which has remained low, provides no reinforcement to this sentiment change. One visible technical factor is encouraging. The breadth of the market has recently made new highs and in doing so has positively diverged from the market overages. This indication suggests a higher market ahead.
Another recent development bears watching. For the year, value stocks have outpaced growth stocks. Value stocks typically do well when optimism rises about cyclical growth. On the other hand, growth stocks do well when investors worry about the pace of the economy and of profits. Very recently, growth stocks have begun to outperform value. Many of these are defensive in nature and one index of defensive growth stocks we follow is breaking out on the upside.
In a range bound market, meaningful returns are hard to come by. Fixed income investors have benefited as interest rates dropped since 2000, a period when the stock averages remain under water. But fixed income yields are very low historically. Meanwhile, many large cap growth companies offer current yields north of 3%. Over the longer term, these securities should be more rewarding than fixed income because they represent companies with sufficient earnings growth that can be translated into meaningful dividend growth. The combination of a 3% dividend yield and 8 – 10% growth in dividends will be a tough act to beat over time. Meanwhile, investors continue to be interested in advancing their income opportunities in an environment of inconsequential yields for short term securities. Equity securities offering yields over 3% and growth in dividends would seem to present a nexus where investors needing income and growth in income would have a common interest with a growth investor seeking good value in stocks of high moat multi-nationals.
The bottom line is that we are now more neutral toward markets than negative.
A. Marshall Acuff, Jr., CFA
Director of Research
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC