Time for Alpha
Another year and another decade are history. For 2009, equities rose 24% and soared 60% from their March lows. For the decade, U.S. stock indices declined 25%. On the other hand, long term Treasury bonds sank 15% in 2009 while other credit investments had very positive results. However, Treasuries outperformed stocks over 28 years as of September 30, 2009.
In the late summer of 1982, both the bond market and stock markets made major bottoms. Who would have guessed that Treasury bonds would outperform the S&P 500 over the ensuing 28 years? A persistent trend of declining inflation together with very high yields in the 1980s helped bonds outperform stocks. In retrospect, a 70/30 mix should have favored bonds over stocks. Bonds were an investment, while stocks were a trade.
The dramatic rally in stocks since March represented a recovery in valuations from unsustainably low levels at a time of low interest rates. This rebound was primarily a beta rally, which is a typical phenomenon off a major market low, and which highlights the performance of the more volatile sector of the market. Moreover, the breadth of the recovery, i.e., the number of stocks advancing compared to those declining, has been very impressive and again typical of a market recovery from a major low. More recently, the market has narrowed with high quality blue chips taking the lead.
Where does the stock market go from here? We continue to believe that a cyclical bull market is in process. So far most signs of a bull market are typical of the early stages of past bull markets. One disquieting feature is that over more than 100 years of stock market history a correction of 10-30% typically occurs before equities rebound to a new high. So far, corrections since March have been about 7%. Consequently, history would support 2010 as being an up and down year, compared to a dramatically positive year in 2009. 2011 and 2012 are more likely to be up years of some degree.
For the stock market to move higher from current levels, more alpha is needed. The valuation or beta rally is behind us. Now is the time for the fundamentals to assert themselves in the form of rebounding profits. The stage has been set for a strong earnings recovery. For the past three quarters, managements have cut costs aggressively, in part, because of concern about the rate of future growth. Their cost cutting has already had a positive impact on margins and earnings as productivity gains have been impressive. Investors have already been speculating about the degree of profits increase that might occur with any increase in sales growth.
The consensus view is for the U.S. economy to grow between 2-3% in 2010. The principal constraint on growth continues to be the expected slow recovery of consumption compared to historical norms coming out of a recession. Nonetheless, some signs are pointing toward a stronger economy than currently expected in the quarters ahead. Inventory liquidation, which has been a drag on overall growth, is almost complete. Production has been rebounding for some months and is likely to continue to do so through the first six months of 2010. Exports growth is strong reflecting rising overseas demand. Capital spending in a number of areas, including technology, is poised to rise. Meanwhile, consumption at retail was better than expected over the holiday season. Housing is showing signs of bottoming in some regions. Affordability of housing is at its most attractive level since 1970 thanks to lower home prices and depressed interest rates. Federal budgetary policy remains stimulative. The fall elections may encourage more of the same from Washington. Meanwhile, state and local governments are having tough going.
Most encouraging is the decline in initial claims for unemployment insurance from a high over 700,000 per week earlier in 2009 to more than 400,000 currently. While monthly employment statistics can be volatile, we believe the fall in initial claims is leading a trend toward some improvement in employment in the months ahead. With the economy growing, we are confident that managements will be recalling some of their workforce. While believing that the rate of unemployment will remain on the high side during this recovery, nonetheless, rising confidence by business will bring with it some improvement in the jobs market.
Pulling together all the aforementioned factors that influence the economy, we conclude that the breadth of the recovery will be the driver of future growth, not one single area. If we are correct in this assessment, then the potential for surprisingly good profits (alpha) is growing. In our careers, we have always been impressed by how much analysts can be surprised on the upside during a business recovery. Our guess is that this will happen again in the first half of this year. Consequently, the stock market may be poised to move from a valuation (beta) rally to a profits driven (alpha) market. Unfortunately not all companies will share equally or simultaneously with the aforementioned trends. Still, sufficient participation should occur to move the major stock indices higher.
Concomitantly, the Treasury bond market, which has declined 15% over the past year, could head lower as concerns begin to mount about a more sustainable economic recovery than has been expected by some observers. Rising Treasury yields will eventually pull short term rates higher, perhaps sooner than the bond bulls expect. In this setting, rising profits are needed for higher stock prices to overcome any rise in the discount rate of future growth.
2010 should also see a continuation of an increasing number of mergers and acquisitions. Initial public offerings are slated for their best year since 2007 as private equity and venture firms equitize their investments of the past 10 years.
Rising interest rates over time may support the recent strength in the dollar. In this context, gold prices may mark time. Other commodities should move higher, although some are currently inventory heavy. Stronger earnings for U.S. companies could pose some competition for non-stock asset classes. At 13.5x consensus projected 2010 Dow Jones earnings, large cap stocks remain appealing compared to other asset classes.
Longer term, concerns will still remain about a reversal of the factors, such as inflation and interest rates, that produced the great bull markets of the 1980s and 1990s. Meanwhile, stronger profits have the potential to refocus investors on the shorter term. Retail bond buyers of recent years may eventually return to stocks, but not until equities pay more dividends.
A. Marshall Acuff, Jr., CFA
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC