This morning's "Daily State" report was penned by Robert Barone (Ph.D., Economics, Georgetown University), a Principal of Universal Value Advisors (UVA) based in Reno, Nevada and a fellow Investment Committee member with Dave Moenning at CONCERT Wealth Management. We are pleased to be able to offer Robert's views this morning. Dr. Barone's firm focuses on core value investing using Benjamin Graham's "Margin of Safety" approach. We hope you enjoy Robert's take.
It really must be confusing for the ordinary investor as the media continues to emphasize negative economic news (an economy where GDP growth was 0.2% in Q1 and likely to be revised negative while even that of Europe, long stuck with socialism, appears to have been 1.6%) and the country seems to be slipping back into the 1960's mode of civil unrest, but more deadly this time. Generally, this is not a good environment for equity markets to advance. In fact, even at the Strategic Investment Conference (SIC2015 - Mauldin and Altegris) held in San Diego on April 30 and May 1, there was no consensus as to the direction of equity prices in the U.S. for the near-term. The best advice there was to move money to the growth areas in the world including Europe (especially Germany where ECB QE policy is sure to raise asset prices), China (before the RMB is included in the IMF's Special Drawing Rights calculations - possibly this November - and the Chinese markets get included in benchmarks), and India (where this year's growth may exceed 7%).
Nevertheless, it is difficult to forecast a significant and lasting dip in U.S. equity prices because 1) no recession is in sight and 2) the Fed begins raising interest rates when the economy has exhibited permanent signs of strength. According to economist David Rosenberg, the first rate hike occurs when the equity markets are only 35% of the way toward their peak. And we are still debating when that first rate hike will occur (September? Or perhaps later).
Indicators of the Health of the U.S. Economy Today
- The Conference Board's Consumer Confidence Index unexpectedly dipped in April to 95.2 from 101.1 in March; but the University of Michigan's Consumer Sentiment Index went the other way, from 93.0 in March to 95.9 in April. Hard to tell much from this; so we will have to await the May readings.
- It also looks like Q1 GDP will end up contracting slightly (preliminary data showed a 0.2% gain), similar to what it did in 2014's Q1. GDP was clearly impacted by an unprecedented rise in the value of the dollar which caused a surge of imports and a fall in exports. According to Rosenberg, this shaved 1.9 percentage points off of GDP's growth rate. And, the west coast port strike along with winter weather that, in some areas, was more than two standard deviations from normal, further muddied the waters. With the recent retracement in the value of the dollar and the return toward normalcy of the west coast ports, such a negative impact is not likely in Q2. [Note: Rising imports also means that underlying consumer spending is strong; in Q1 private domestic demand grew at a Seasonally Adjusted Annual Rate (SAAR) of 1.1% despite the impact of the weather. After 2014's severe winter the SAAR growth in consumption for the remainder of the year was 3.4%.] Finally, CNBC did a study of Q1 GDP growth rates using 35 years of data and found that there is a significant downward bias to Q1 growth rates - perhaps the seasonal adjustment process used by the Bureau of Economic Analysis leaves something to be desired!
- If we exclude the energy sector, the rest of America's businesses are doing well. Through Thursday, May 7th, 73% of reporting companies (ex-energy) beat their bottom line analyst consensus estimates (which is about normal) while 52% beat on the top line (also normal).
- Institute for Supply Management Indexes (ISM): the Manufacturing Index stopped its 5 month slide (from 57.9 last October to 51.5 in March), coming in unchanged at 51.5 despite a continued contraction in the energy sector. The Non-Manufacturing Index, which has a weight of nine times that of the Manufacturing Index in service oriented America, rose to 57.8 in April from 56.4 in March. This measure also had some very strong sub-indexes: Business Activity = 61.6%; New Orders = 59.2%; Employment = 56.7%. The composite index of both Manufacturing and Non-Manufacturing rose to a five month high of 57.0 in April, a number which implies GDP growth in the 3%-4% neighborhood.
- The price of oil is rising (near $60/bbl) and for the first time in many months, oil storage in Cushing, OK fell. Saudi Arabia is boosting production. While some of the rise in the price is, no doubt, due to speculation, there is no doubt that demand, worldwide, is rising. This is a good sign for equity prices moving forward.
- Home prices continue to rise. Luxury home sales (homes priced at more than $1 million) rose 13% year over year (YoY) in Q1. And, despite the backup in yields since mid-April causing some angst in the mortgage application market, purchase applications were up slightly in April's last week. Nevertheless, there are still supply issues in housing.
- Bond markets recognize the strength of the world's economies, including that of the U.S.; the 10 year T-Note closed on Friday, May 8th at a 2.14% yield (was as high as 2.23% earlier in the week). This is significantly higher than its recent low on April 17th of 1.87%. The backup in yields appears to be a worldwide phenomenon (10 year German Bunds have backed up from .08% to near 50 basis points). Apparently the world has suddenly recognized that deflation isn't the issue that everyone had feared.
- Payrolls staged a comeback in April (223,000) although there were modest downward revisions to the prior two months (March now showing 85,000 vs. original estimates of 126,000). This occurred despite the loss of 15,000 jobs in America's energy sector; more than offset by a rise of 45,000 in the construction trades (perhaps a prelude to growth in America's housing industry this summer). Excluding the energy sector, the rest of America seems to be doing okay.
- The U3 unemployment rate fell to 5.4% while the U6 rate is down to 10.8%, both 7-year lows. This occurred despite a slight uptick in the labor force participation rate, which is inversely related to the unemployment rate.
- Other indicators of labor market tightening include a decline of 125,000 of those working part-time for economic reasons (i.e., can't find full-time employment). In addition, the share of the long-term unemployed (greater than 6 months in duration) fell to 29% of total unemployed in April from nearly 32% last December.
- The 4 week moving average of new claims for unemployment (279,500) is a 15 year low. This has historically been a leading indictor for the employment markets.
- Average hourly earnings, one of Janet Yellen's favorite labor market indicators, rose at 2.2% YoY. This particular indicator is one of the most lagging indicators of labor market conditions that there is.
- More timely measures include the employment cost index. In Q1 that index rose 2.6% YoY, and the index of unit labor costs rose 5.0% (SAAR) in Q1 vs. 4.2% in Q4. (The employment cost index is among the most comprehensive labor cost indicators; it includes both wages and benefits.)
- Real compensation was up an astounding 6.2% SAAR in Q1 vs. 2.8% in Q4.
- The fall in labor productivity (-2.1% in Q4 and -1.9% in Q1) is worrisome. Back to back declines rarely occur outside of recessions. The productivity decline is mainly the result of underinvestment in organic growth in the U.S. We are in the midst of the worst 5 year record of growth in the capital stock in the post-WWII era. The corporate sector has chosen to use its cash to pay dividends, to buy back stock, or to affect mergers rather than investing in organic growth by modernizing and growing its plant and equipment. Much of this has to do with a wildly out of date, unintelligible, often contradictory and outright hostile tax code. This appears to be well recognized, but politically impossible to rectify.
Equities - A Replay of "Irrational Exuberance"
- On December 5, 1996, then Fed Chair Alan Greenspan uttered is now infamous "irrational exuberance" phrase. Specifically, referring to equity prices, he said to a Congressional Committee: "But how do we know when irrational exuberance has unduly escalated asset values…?" The stock market (S&P 500) barely reacted, closing down 4.78 points (.6%) the next day to 739.60. In fact, the market would continue higher for 39 more months and more than double in value at its 1,527.46 peak in March, 2000.
- Moving forward to this past May 6th, at an event sponsored by the IMF, Janet Yellen played out her own version of "irrational exuberance." When questioned by the IMF's Managing Director, Chirstine Lagarde regarding the Fed's near zero interest rate policy and its impact on financial stability, Yellen said: "I would highlight that equity market valuations at this point generally are quite high… There are potential dangers there … We've also seen the compression of spreads on high yield debt, which certainly looks like a reach for yield… When the Fed decides it's time to begin raising rates, these term premiums would move up and we could see a sharp jump in long-term rates." The equity market reacted in a similar manner as it did to Greenspan's remark more than 17 years earlier. The S&P 500 fell 9.31 points or 0.4% for the day.
- Greenspan's "irrational exuberance" remark and its succeeding history should be instructive as to what exact insight Fed Chairs might have as to equity valuations. If the Greenspan remark is any indication, it may be quite some time, and the markets may be quite a bit higher, before a significant market peak is reached. After all, today there is every indication that GDP will spurt higher in the coming quarters, that, except for energy, corporate profits and revenue growth are positive; there is no recession in sight, and that the first Fed rate hike occurs many months before the equity markets peak (we aren't even sure when the first hike will occur).
- Furthermore, there is evidence in Ms. Yellen's remarks that she isn't aware of market reactions to Fed rate hikes. She asserted that the term premium should rise when the Fed begins raising rates. In theory, long-term interest rates are simply the add up of short-term rates over time with a premium for the uncertainty of the holding period. In a rising interest rate environment, bond holders need additional compensation for the uncertainty of increasing interest rates. Yet, despite such theory, bond market reality is quite different. At the SIC2015, newly crowned bond king Jeffrey Gundlach asserted that: "Whenever the Fed starts raising interest rates, the yield curve always flattens." Note that Gundlach made this statement on May 1st, 5 days prior to the Yellen assertion that the yield curve should rise when the Fed begins its rate hiking cycle. In addition, economist Rosenberg, in his May 8th daily missive, specifically discusses the fall in the term premium and flattening of the yield curve in the '04-'05 cycle.
- Given that the Chairwoman was unaware of such recent yield curve history, much less how bond markets have traditionally reacted to the first rate hike, what are we to make of her suggestion that equity prices are "quite high?" Research shows that, while there may be an initial reaction from the equity markets to the first rate hike, there is really nothing to fear until a recession is approaching, generally after several Fed hikes.
Conclusion: any equity market correction remains a buying opportunity. And, equity market conditions appear even more favorable in some international markets.
Robert Barone, Ph.D.
Robert Barone (Ph.D., Economics, Georgetown University), an advisor representative of Concert Wealth Management, is a Principal of Universal Value Advisors (UVA), Reno, NV, a business entity. Advisory services are offered through Concert Wealth Management, a Registered Investment Advisor. Dr. Barone is available to discuss client investment needs. Call him at (775) 284-7778.
Statistics and other information have been compiled from various sources that Universal Value Advisors believes to be accurate and credible but makes no guarantee to their complete accuracy. A more detailed description of Concert Wealth Management, its management and practices is contained in its "Firm Brochure" (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.