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The Sandy Spring Way

December Observations

December 2nd, 2014 | By Beau Mercer



We know that cancer occurs to two kinds of people…people who smoke and people who are otherwise healthy. We know that trees don’t grow thru the sky. We also know the following:

  1. The US economy is improving;
  2. Household wealth in the US is at an all-time high;
  3. US stock prices are at an all time high and are supported by all-time high earnings and free cash flow;
  4. Unemployment is declining;
  5. Inflation is low.

Because we read the paper this morning we know that the S&P 500 Index is up 12.2 % so far in 2014. We know that the stock market is only part of the economy and the economy is not the stock market. The economy is measured after the fact while the stock market looks forward and is a bet on the future. We also know that the 10 year Treasury bond is currently yielding 2.25%. Because we go to the gas pump frequently we know gas prices have fallen precipitously in the past three months.  We know that the stock market has performed twice as well during DOLLAR bull markets than during DOLLAR bear markets. We also know that government and high grade corporate bonds generate miniscule returns and that if interest rates rise currently owned bonds will lose value. We also know that the inflation index has not risen for some time and is a ‘far cry’ from recent past. We know with some confidence that the economy and market will be higher in 10 years (probably 5 years), that well run businesses will run better because of technology, and that investment values will rise but that mean reversion is inevitable. A universal truth is that investing should focus on the long haul and not on the short term. Investors should buy stocks that are undervalued and hold them until the value is recognized.

We also know that about EBOLA and Vladimir Putin and Islamic State terrorism. We are concerned that Western Europe can’t get out of its economic rut; that the Japanese economy is sputtering with any direction; and, China may be heading for its slowest growth since 1990. We also know that Apple is selling many iPhones, Boeing is selling many new airplanes, and North Dakota is shipping a lot of oil. We ABSOLUTELY know that corporations have too much cash on their balance sheets and that the cash needs to be deployed in CAPEX investments. Unlike the decision to bench RG3 or Harry Reed, the debate about the direction of the economy was silenced by the third quarter GDP report which indicated that the nation’s economic output rose at a healthy 3.5% annual rate (with no snow in the forecast). The recent GDP growth was driven by gains across the board (consumption, investment in fixed assets, government purchases and net exports). Employers have added 200,000 jobs for nine straight months-the longest streak since 1993 and wage growth continues to be almost nonexistent. [Consumer spending is 70% of GDP.] Companies are squeezing more profits from each dollar of revenue. The squeeze equals nearly 10 cents which is up from an average of 6.5 cents over the past 20 years. The wage freeze and increased sales create a leverage that boosts earnings. Seemingly in 2014, the economy quickened its transition to a business model based primarily on information technology (rather than industrialization, manufacturing and service). Finally the net debt on the balance sheets of companies in the S&P 500 index is much lower relative to their cash flows than has been the historical case.

We don’t know if any other country could take over the economic leadership of the United States…or if we want any other country to provide leadership. We don’t know the timing of the next recession or major correction, of the rise in interest rates or inflation, or the likelihood of deflation. We can’t assume that because the markets have been moving higher for the past five years that they will continue to move higher. (Stocks peaked on March 24, 2000, marking the end of the internet bubble.) Consistency and complacency do not mix! We don’t know how Congress is going to address the President or vice versa. We do know that the Republican Congress will not increase taxes on equities for at least the next two years. We don’t know how national or international political events will affect the investment markets. We don’t know how the currency wars will play out nor do we know the mid-year prices of commodities.

What was it that Forrest Gump’s mama liked to say?  Life is like a box of chocolates: you never know what you’re going to get inside. The US economy is the only major developed economy that successfully restructured after the 2007-2008 crises.  As a consequence, this is the sixth year of our recovery, the economy continues to grow, the unemployment rate has come down from 10% to 5.9%, and inflation is low. Possible wage and price inflation in 2015 may cause interest rates to rise but only modestly. We sort of think that the economy is progressing toward a paradigm based primarily on information technology (rather than industrialization, manufacturing or services) and that transformation is affecting wage growth and capex investment. Is the transition a chapter in the book entitled “American Exceptionalism”?  [The theory that the US is different from all other nations; not just because of the sheer size of its economy, but because of its fundamental strength owed to uniquely American traits like freedom, respect for human rights, and a history of ingenuity and entrepreneurship.]

THE STOCKMARKET: In 2013, the S&P 500 rose 32% on roughly 8% earnings growth. In 2014, the S&P 500 is on track to rise 12-14% on 8% S&P 500 earnings growth. IS THIS A BROKEN RECORD? TIRED OF BEING SCARED YET? WHERE IS THAT IRRATIONAL EXUBERANCE? HAVE YOU THOUGHT OF THE STOCK MARKET YET? In the short term, many factors influence stock prices. In the long term, earnings drive stock prices. In 2015, the S&P 500, earnings growth should also come in around 8% earnings growth. (Understand the consistency versus complacency issue and the potential for a disconnect. Since 1900, only three of 23 bull markets have lasted 6 years or longer. The likelihood of a bear market correction of 20%-increases as the bull market grows older and yet the fundamentals are not sending foreboding signals.) When I originally drafted this paper I projected S&P earnings growth at 4% in 2015 but the drop in oil prices changed my thinking. If 2015 earnings growth expand by 8% and there is no expansion or contraction of the price earnings multiple, the S&P 500 will rise to 2150 in 2015 (6%). The price earnings multiple is psychological and yet permits comparisons. (My thinking) is that earnings will continue to increase in 2015 and but that volatility will drive the roller coaster with a consequence of no expansion or contraction of the price/earnings multiple in 2015. My earnings calculation is based on the following: net interest margins will rise but the EBITDA effect will be flat; the tailwinds from lower taxes and interest expense will dissipate; the benefits of financial leverage will not have a significant effect on S&P 500 companies and the world will be awash in crisis’ and cash. I am not concerned as others are about the stronger dollar. The US is going to have stronger growth compared to other developed countries  and will continue to provide higher yields on its bonds (in effect the US will benefit from the stronger dollar as global funding flows into the US and away from slower-growing and lower-yield economies.)

SECTOR PREFERENCES: In 2014, the technology sector and healthcare sector outperformed the S&P 500 and I believe that will be the case in 2015. I think arguments can be made for the industrial sector and profit margin improvements in consumer discretionary.

BOND YIELDS: In 2011, Bill Gross of PIMCO/JANUS predicted yields would go “higher, maybe even much higher” upon the end of the Fed’s monetary easing policy. BILL GROSS WAS WRONG! Yields have gone lower for two obvious reasons: 1.) the net new supply of US Treasury bonds has contracted dramatically with falling federal deficits as global demand for bonds has steadily risen, and, 2.) inflation slumped below predictions of the Fed and remained dormant. SHORT and LONG TERM interest rates are likely to remain low for some time. On December 1, 2014, the US benchmark 10 year note yield fell to 2.18% as tumbling oil prices pushed down inflation expectations. The US Treasuries still yield more than most G-7 countries. The 30 year bond yields 2.91 %. My guess or prognostication is that the 10 year Treasury bond will approximate 3% in 2015. I think the long bond will move to 3.5%.

CHINA and the Emerging Markets: The Chinese stock market has outperformed the Japanese stock market by a wide margin in 2014- the Shanghai composite has advanced 26.8% this year and the Shenzhen composite is up 34.3% while the Nikkei is up 7.2%. My sense is that the Chinese market will continue to outperform other Emerging Market markets despite the slowing economy and the issues in Hong Kong. In November (two weeks ago) the Hong Kong-Shanghai Equity link was finally consummated. The Hong Kong- Shanghai Equity link combines the stock markets in Hong Kong and Mainland China. The combination will increase the Chinese capitalization to the second highest in the world, behind the US, and may encourage global equity managers to boost Chinese equity exposure (consider Alibaba). China’s ‘A’ shares, especially, blue chip stocks are trading at a steep discount to the ‘H’ shares. Also the Shanghai composite is trading at a forward price earnings multiple of 9 times which is significantly lower than the S&P 500 forward price earnings multiple of 16-18 times and the Nikkei at 17 times. The Hong Kong-Shanghai single market will allow Chinese households to diversify their inefficient asset allocation which currently places 72% in property and 6% in equities.

LOWER OIL PRICES — Recently OPEC decided to maintain its current oil production target despite the steepest price decline since the 2008-2009 recessions. The price of Brent crude, the global benchmark plunged to about $65 per barrel, continuing its decline from a peak of $116 in June. OPEC is concerned that demand for its crude will keep falling as US supplies continue to grow and more of its oil makes its way to the global market.  Lower oil prices are a boon to American consumers. The average price per gallon has fallen to $2.79. In 2013, Americans spent an amount equal to 2.4% of GDP on motor fuels and home heating oil. The 2.4% share of GDP is now going to be reallocated and the reallocation is going to be seen in the economy. Also the money will STAY in the United States. A growing suspicion may arise that Congress will consider additional gas taxes as they reconsider the Highway Trust Fund legislation. CAR SALES: Car sales collapsed during the last recession. Currently car sales are running at a rate of 17 million sales a year, but the average car in the US fleet is 11 years old and that is old by historical standards. As a result car sales are likely to be robust in 2015. HOUSING STARTS: New home construction will provide a stiff economic tailwind that will be recognized in employment, materials and financing in 2015. As the US population expands by 3 million annually it will require 1.5 million housing units a year to accommodate growing household formation. Homebuilders are projected to build 1 million new housing units in 2015. The tailwind persist as new construction plans address the population growth and the number of housing units necessary to respond to increasing demand.

Upon reflection, the 2015 narrative is more chaotic than 2014 but then that can be said every year. Investment opportunities do exist but not without considerable nuance and divergence.

Enjoy the Holiday,