The strong rally in equities and commodities continued unabated into the beginning of the first quarter of 2011. The tragedy in Japan and the uprisings in the Middle East and North Africa region (MENA) all caused selloffs in equities but they have so far proven short-lived. As of March 31st, the S&P 500 has regained almost all the ground it lost in the selloffs and increased 5.92% for the quarter to bring its one year trailing return to 15.65%. Although the market’s rally continued in the first quarter of 2011, it was not as broad based as in past quarters. Energy, health care and industrials were the only sectors that outperformed the index (usually around five outperform, and around five underperform), which could foreshadow future weakness in equities. Emerging markets and developed European markets continued to underperform the US due to persistent inflation and sovereign debt worries in the respective regions. Additionally, we are pleased to announce that our aggregate client portfolio composite has reach an all time high and now stands 1.63% above where the market previously peaked at the end of 2007. Despite one of the most unprecedented rallies in history, the S&P 500 remains 6.15% below its previous peak, which emphasizes the important of maintaining a long term view of the markets.
Fixed income markets in the US improved in Q1 but you wouldn’t know it by looking at the Barclays Aggregate Bond Index, which only managed to return 0.42% in the first three months of the year. The aggregate index’s returns were lower than what our portfolios achieved because we are overweight inflation protected securities, which performed well, and because we had very little exposure to US Treasuries (which declined in value) during the quarter. Our holdings of foreign sovereign debt also performed very well during Q1 with a gain of over two percent.
The first quarter was also quite eventful for the currency markets with fears about inflation and quantitative easing causing the US Dollar to decline towards multi-year lows against most major currencies. Fiscally sound currencies such as the Swiss Franc and resource based currencies such as the Australian and Canadian Dollars have broken out to decade long highs against the US Dollar. Monetary metals such as gold and silver continued to appreciate in this weak dollar backdrop.
Gross Domestic Product (GDP) grew at an annualized rate of 3.1% during the first quarter of 2011, marking the sixth consecutive quarter of positive growth. Austerity measures taken in Europe to combat the sovereign debt issues in the PIIGS countries (Portugal, Ireland, Greece and Spain) began to show up in the data, resulting in a tepid 0.3% GDP growth rate for the Euro zone. China and India continue to grow their GDP at a 9.7% and 8.2% annual rate respectively but their official inflation rates have grown as well to 5.4% in China (a 32 month high and also very likely to be under reported based on on-the-ground surveys) and 8.82% in India. Although these developing markets are growing fast, the equally aggressive pace of inflation is putting pressure on many consumers and businesses.
U.S. Industrial production has been booming except for the construction market, which continues to lag significantly because of the excess capacity of commercial and residential property. While this is not good news for construction workers, it is a positive sign for the rest of the economy. We also set a new record in March for exports when adjusted for inflation (tip of the hat to Chairman Bernanke and his printing press which has made our exports more competitive with other countries).
The economy generated about 331,000 jobs in the first quarter of 2011, making for the sixth month of consecutive gains. We are hopeful that this trend will continue to accelerate because the job market is not yet growing at a rate that can absorb the growth of our population, not to mention the more than 7 million jobs lost during the Great Recession (more on this later).
Headwinds for 2011 & 2012
Popular media has swung from pessimistically bearish at the bottom of the market to enthusiastically bullish now that the S&P 500 has almost doubled off the March 2009 lows. Despite the ongoing trickling of positive economic data and the media exuberance over the rising stock market, it is more important than ever for us to maintain a watchful eye on the several key issues that still have the potential to derail the fragile recovery just as the fundamentals are beginning to improve.
Jobs & Housing
In the early stages of The Great Recession, it was often referred to as the subprime mortgage crisis or the housing crisis, but both of those terms belied the root causes behind the collapse: a multi-decade long decline of the real purchasing power of most Americans in the face of rising prices and credit expansion. Since the 1970’s, the average American has seen their income stagnate when adjust for inflation. Meanwhile, goods and services like homes, health care, education and energy have all outpaced inflation.
To fill the vacuum in real disposable income, American households had been saving less and turning to credit and debt in greater and greater numbers. Then, in the early 2000’s, the value of homes started to increase more rapidly, further fueling the debt driven consumer spending based economy. Banks began loosening credit standards to satiate the demand of both homebuyers and investors creating the real estate fueled bubble. Homeowners then used equity from their homes to fund discretionary spending based on the popular assumption that housing prices would rise indefinitely. In essence, Americans did not feel like they were becoming poorer even though their income was declining once inflation was taken into account.
In 2008, the debt-driven household wealth machine broke (see chart above) and a vicious cycle kicked in: 1.) home prices stopped going up, 2.) which led banks to pull back on lending, 3.) which lowered demand for real estate, 4.) which caused prices to fall, 5.) which took away the piggy bank of millions of Americans and caused the balance sheets of major financial institutions to deteriorate because of their heavy exposure to mortgage derivatives, 6.) which caused overall consumer spending in the economy to fall, 7.) which led to massive layoffs and further pullbacks in credit.
Throughout the recessions over the last half-century our economy always pulled through because American households kept spending (even when we did so by saving less and using more debt). However, as you can see from the graph below, all good things must come to an end.
The steady decline in savings that began with the credit bubble in the 1970’s has sharply reversed course. From here on out, further demand growth in our economy will need to come from more jobs, higher disposable income or lower inflation because the banks can no longer provide credit the way they did when home prices were perpetually rising. Currently, inflation is ticking up and real weekly earnings have been declining since June, which leaves the onus for further growth on increased jobs.
The unemployment rate declined to 8.8% in March from 9.4% at the end of 2010 but a closer look at the raw data reveals that had workers not given up looking and dropped out of the labor force, the unemployment would have actually risen to a bit more than 10%. This also does not take into account that we have population growth of about 1% per year and that we still need to make up for the more than 7 million jobs lost in the recession. Additionally, non-Government polls including the Gallup Poll and IBD/TIPP Survey as well as several prominent economists, all have estimates of the current unemployment situation that are north of 19% and rising (they also include part time workers who would like a full time job).
The continued slack in the job market has resulted in corresponding slack in the demand for existing homes. After rebounding slightly from the earlier plunge in prices, the 10 and 20-City Composite indexes have spent the last six consecutive months declining and are now only 2.8% and 1.1% above their respective bottoms from 2009. Over the last two years, we have at best seen the housing market bounce along at lows, and at worst, the much-feared double dip in housing may be happening (as we have been predicting for quite some time now). Some measures of the housing market such as new home sales and residential construction have already reached new multi-decade lows and are yet to show any signs of improvement. On the positive side, the commercial real estate prices have continued to rise and have regained approximately 85% of their value since the 2007 peak according to data compiled by Green Street Advisors. Reasons for the turnaround include the lack of new construction and improving occupancy rates across most commercial real estate sectors (especially hotels and apartments).
European Sovereign Debt Crisis
The sovereign debt crisis facing Europe has intensified since our last report. Elections in Ireland resulted in the populist Fine Gael party coming to power with the goal of re-negotiating Ireland’s bailout from the year earlier in order to pay lower interest and reduce principal. Portugal also finally requested a bailout from the European Union and the International Monetary Fund (IMF) after seeing their cost of borrowing more than double since the beginning of 2010. This move has once again called into question the solvency of the other PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries as shown by the recent spikes in their respective 10-Year treasury yields. Austerity measures implemented in Greece have weighed heavily on their GDP, which has fallen in each of the past six quarters. The big elephant in the room however is Spain. Spain currently has a higher budget deficit ratio that Portugal but is a much bigger economy. If Spain were to fail, there is simply not enough money in the Euro zone to fund an adequate bailout and the entire European banking system would once again come under scrutiny. GDP growth in much of Europe has barely managed to stay positive and if the bailout of Portugal is not successful, the peripheral country sovereign debt crisis could quickly escalate into one of continental proportions.
Domestic Budget Deficit
Over the past decade, a combination of the Bush tax cuts, lower income tax receipts because of lost jobs, multiple ongoing wars and recession-induced stimulus programs have left our country with an absolutely astounding debt burden when you account for off balance sheet liabilities such as the wars, Medicare, Medicaid and Social Security.
The normal way that countries reduce their deficits is a combination of lower spending and higher taxes applied to where they will have the greatest net economic impact (taxing the poor destroys aggregate demand because almost 100% of the poor’s disposable income is deployed right back into the economy. Wealthy individuals have a much higher propensity to save their income, which does not directly benefit the economy but may increase investment). Unfortunately, Democrats will not allow sufficient budget cuts and Republicans are unwilling to raise taxes (even though they are currently the lowest they have been since WWII) so the deficit reduction efforts we have seen so far have been mostly token political gestures.
In the absence of political will and an almost insurmountable level of debt, the Federal Reserve has embarked on its own plan to reduce the deficit through monetary policy that destroys the value of the US Dollar by maintaining artificially low interest rates which, when combined with rising inflation, are producing negative real rates of return on Treasuries. While these actions may not technically count as defaulting on our debt, they have the same result for our creditors who end up being paid less than they were supposed to in real inflation adjusted terms.
However, after more than two years, popular anger (both domestically and from abroad) over our debt and the opaque actions of the Federal Reserve have put pressure on them to scale back their monetary operations, and they have now stated that a third round of quantitative easing is unlikely to be initiated after the current QE2 ends in June. This is a concern for equities because since the Fed began QE two years ago, there has been an approximate 86% correlation between the Fed’s balance sheet and the price of the S&P 500 according to data compiled by Haver Analytics and Gluskin Sheff. The heavy selloff in the middle of 2010 was largely due to uncertainty surrounding what would happen when the Fed was no longer supporting the market.
In the beginning of 2011, we now face the same looming end of QE as well as the new reality that Federal Government spending (which has been helping to fill a huge gap in private demand) will begin to be rolled back in 2011 and 2012 due to vocal opposition to government spending by Republicans, incoming Tea Party members in the House of Representatives and even Democrats who are beginning to realize that opposing spending cuts is turning into more and more of a dangerous political game to play.
While we welcome this new attitude toward fiscal responsibility, we believe the timing is a bit questionable. By pulling back fiscal support for the economy before we have reached a level of self-sustaining growth, we risk making the same mistake that we did in the early 1980’s when we pulled back support too soon and sent ourselves into a double dip recession. In a more recent example, the United Kingdom posted negative GDP growth for the fourth quarter of 2010 after taking measures to reduce their deficit.
Valuation of Market
All of these issues bring us back to the issue of market valuation, in other words, are investors paying too much for the underlying earnings of the businesses they own? This is where things get interesting. Commentators who are bullish on the stock market cite the fact that the current P/E ratio of around 16 on the S&P 500 is well below its average of 30.6 over the past ten years and they therefore conclude that the market is a bargain and has plenty of room to run.
However, the decade that they are citing included two of the biggest stock market bubbles to take place over the last 100 years. When instead we look at the widely respected Shiller 10-year inflation adjusted P/E ratio (which incorporates multiple business cycles to smooth out distortions), we arrive at a P/E ratio in excess of 23 times earnings, which puts today’s current market valuation in the same territory as the bubble years from 2005-2008 and the post World War II boom that peaked in the mid-1960’s and preceded the economic malaise and stagflation from the 1970’s. The technology bubble’s peak in 1999 and the two years proceeding Black Tuesday in 1929 are the only periods in the 20th century that were equivalently as overvalued as the market is today when using the Shiller 10-year P/E.
While it’s true that earnings for the S&P 500 are expected to grow a great deal over the next year or two, which would justify a premium for the P/E, we believe that earnings expectations may have gotten slightly ahead of themselves. According to data compiled by Bloomberg, the expected earnings for 2011 are currently 59% higher than the average actual yearly earnings over the last ten years (which includes multiple business cycles).
So when else have earnings been expected to grow by such a large amount? August 2000 and December 2006 which, in retrospect, ended up being within months of when profits were peaking and economic expansions were ending. In other words, analysts get the most exuberantly bullish towards the end of bull markets because they see a trend and then extrapolate to the sky. Given the current “optimism” in the analyst community, we feel it would be wise to give more heed to the trends of the past century than those of the past decade.
The dividend yield on the S&P 500 currently sits at 1.77%, which is slightly lower than the average over the past twenty years (implying that the market is very slightly overvalued). However, when you look at the last 100 years, we see a similar trend as with the P/E. From 1900 to 1990, the yield on the S&P 500 ranged from about 3%-7% and averaged 3.38 in the post war period after 1950. From where we stand today, dividends would need to grow by 100% next year (dividends have grown by approximately 1.01% per year over the past twenty years), or the S&P 500 would need to fall by 46.4% to bring the dividend yield back to average.
The market looks cheap when compared to the yield of the 10-Year treasury but this is more a matter of quantitative easing which has maintained rates at artificially low levels than anything else. If Treasury yields rise as they did during the inflationary scare in the late 1970’s and early 1980’s, (or even to a historically normal level of 3-5%) the percent of GSP that goes toward paying the interest on our debt would soar (we are currently paying very little interest because rates are so low) and a drop in the S&P 500 would be expected.
Global Macroeconomic Risks
Although the previously discussed issues are very important to the global economy, it was the devastating events in Japan and the continued unrest in the Middle East North Africa (MENA) region and that grabbed most of the headlines in Q1.
The loss of life that took place in Japan as a result of the 8.9 magnitude earthquake and subsequent tsunami was truly shocking and saddening. The potential for a serious nuclear situation is still present as radiation continues to seep from the damaged Fukushima Daiichi nuclear power plant. Beyond these immediate humanitarian disasters, companies all around the world are being affected due to the important role that Japan plays in the global supply chain (especially for high-tech and automotive companies). It also remains to be seen how fast production will be able to return to normal because of rolling brownouts and restrictions on power usage as a result of the lost capacity from nuclear sources.
Over in the Middle East and Africa, attention has shifted from Egypt, which appears for the moment at least to be moving towards a new democratic government and towards the conflicts in Libya and the Ivory Coast, as well as the protests in Syria and Yemen. The conflict in the Ivory Coast has strained global supplies of cocoa and the loss of supplies from Libya has put pressure on the price of crude oil. Additionally, concerns have arisen that the protests in Syria (where a Sunni minority also rules a Shia majority) may spread to Saudi Arabia, the world’s biggest exporter of petroleum, but so far the monarchy has managed to avoid major demonstrations by announcing reforms and paying out large sums of cash to its citizens.
Since the protests began in Egypt on January 25th, Brent Crude oil rose 20.9% to $116.94 and Light Sweet Crude rose 13.5% to $106.79 as of March 31st. This rise has been closely watched by investors because rising oil prices will ultimately squeeze corporate margins, lower household disposable income and slow economic growth. The rise in oil prices has already canceled out all of the simulative effects of the payroll tax decrease that was enacted last quarter and is threatening to overheat many emerging market countries that are currently serving as the main driver of the global economy.
Aside from the rise in oil, prices of many food commodities have continued to rise, putting an estimated 44 million people into poverty since June on 2010 according to the World Bank, with poverty being defined as living on $2.00 or less per day. This is arguably a larger threat to emerging markets than the rise in oil because food accounts for such a great proportion of their incomes. In the U.S., rising commodity prices are showing up in higher input costs for companies, which will have to either suffer lower margins (substantially in some cases) or pass the prices on to the consumers for many daily staples, further pressuring GDP growth.
Poor crop yields in many countries have been attributed to “extraordinary” events such as fires in Russia and floods in Pakistan, but the likely reality is that these events will become much more ordinary moving forward into the future as global climate change continues to make the weather patterns more and more volatile. In addition, growing middle classes in developing markets like China, India and Latin America are creating increased demand for proteins, and it takes about 16 pounds of grain on average to produce one pound of meat because you need to feed the livestock.
While the economy certainly is expanding, it is doing so at an unacceptably slow pace despite the presence of more direct and indirect fiscal and monetary support than at any other time in history. These actions have resulted in substantial distortions to economic indicators such as GDP and more importantly, the interest rate on Treasuries (the “risk free” rate of return). The “risk free” rate is used in discounted cash flow calculations, which are used to make investment decisions regarding asset pricing, corporate spending and M&A activity. So long as the rate is being held artificially low, it increases the incentives for companies and individuals to borrow and spend while penalizing savers with a negative real rate of return after inflation. Therefore, we will need to wait until these distortions have been removed before we can assess whether or not the recovery we are currently undergoing is self-sustaining and whether the current pricing and valuations of equities will hold up under normal conditions.
Although we do not feel that the market is overvalued, it is by no means a bargain. This has been the case for the last three or four quarters where earnings have grown to meet the higher expectations. Margins, which were previously increasing to cycle highs, will now be coming under pressure due to rising input costs and lower consumer demand arising from higher energy costs. Potential supply chain-related aftershocks from the catastrophe in Japan, the end of QE2, and the pending withdrawal of fiscal stimulus as the Federal Government moves to cut the deficit are all issues of concern in the short to intermediate term. However, we would welcome the re-pricing of markets as an opportunity to add selectively to positions at lower prices. In the meantime we will continue to be patient and focus our buying on relatively lower-risk equities and on holdings with low correlations to equity markets such as currencies.
As always, please do not hesitate to give us a call should you have any questions.
– The Pacific Mountain Advisors Team
Words of Wisdom for Q2
“If you are of the view that a new secular bull market began in March 2009, then please follow your beliefs. Secular bull markets tend to last between 16-18 years. It will be the first time a secular bull was born from printing money and the onset of state capitalism.
But if you are of the opinion that what we just witnessed since March 2009 was a typical cyclical rebound within the confines of a secular downtrend, well, these tend to last two years (Ned Davis found 34 of these since 1900) and see average gains of 86%. This time around, it was just a month under in duration and 13 percentage points over in magnitude.”
– David Rosenberg, Chief Economist & Strategist at Gluskin Sheff (from February 24th)