||A Chorus of Cynics
By Jeff Korzenik, Chief Investment Strategist, Fifth Third Private Bank
The 19th century writer Oscar Wilde famously defined a cynic as one "who knows the price of everything and the value of nothing." We are reminded of this phrase as new all-time highs in U.S. stock markets have unleashed a chorus of naysayers. To our ears, these pessimists obsess on the price of equities, without an appreciation for their value.
The cynics point to the two periods in the last 15 years when the markets soared to these heights – and subsequently failed – the spring of 2000 and the summer of 2007 (see chart below). Wall Streeters who once missed the looming risks of the dot-com bubble and the housing bubble, now have apparently resorted to numerology, imputing mystical knowledge to price alone.
When one looks beyond the faulty assumption that all insight is contained in price, the comparison with past market peaks makes a more engaging case for today's stock investor. Even the numerologists acknowledge that the valuations of today represent far better value than the wild excesses that led up to the 2000 dot-com bust.
Less obvious, but just as real, are today's attractive values compared to the highs of six years previous; to cite but a few measures for the S&P500 index today relative to its 2007 peak:
||Dividend yields are 29 basis points higher while treasury yields are 298 basis points lower |
||S&P profits are 14.5% higher and, with the leverage of the companies in the index halved, those earning are of better quality |
||Stocks are 19% cheaper than the 2007 peak on a Price/Earnings basis, 14% cheaper comparing enterprise value to cash flow (EV/EBITDA), and 21% cheaper measured by Price/Book value ratio |
||Short term interest rates reflect years of Fed easing, rather than 2007's culmination of years of Fed tightening |
||Far from being late in the economic cycle (as defined by human and industrial capacity usage), we are mid-cycle|
The Calendar Effect
These valuation arguments certainly support the resilience we have witnessed in U.S. stock markets in recent weeks. However, the cynics are not retreating, but appear to be moving away from their adherence to numerology and toward an embrace of paganism's focus on seasons. Ecstatic chants of "sell in May and go away," seem to echo in the canyons of Wall Street.
It is true that the past several years have witnessed weak mid-year growth, but the disparate reasons for those slowdowns – notably, the Japanese earthquake and tsunami in 2011, and the European debt crisis in 2012 – suggests there is no inherent danger tied to calendar months.
If Pro is the Opposite of Con...
Even on the legislative front, we seem to be making progress. Little noticed has been the significant contraction of the federal deficit, and the sense of normalcy returning to Washington. While the three current budget proposals do not represent any sort of bipartisan consensus, their very existence represents a structural move forward after four years in which our federal enterprise had no budget.
This is not to argue that the coming months will not show slowing economic activity. In fact, the greatest threat to the market near term may be changing perceptions about U.S. economic growth. We expect the next month, and perhaps the entire second quarter, to be one of greater challenge for the economy as the sequester and higher tax bills begin to bite. The second coldest spring in over 100 years is also contributing to weak early economic releases as snows and chilling temperatures slowed construction and retail activity.
Our investment thesis continues to focus on a recovery shaped by the special nature of the '08-'09 downturn, a financial panic, rather than a traditional recession. Historically, this has resulted in the sort of "half-recovery" that the U.S. has experienced for the past few years, but Wall Street wrongly continues to look for the old binary paradigm of either robust upturn or double-dip recession. To the degree that the Street was beginning to interpret the early 2013 strength as a rapid growth environment, the stage has been set for disappointment. The path out of a financial panic is one of growth constrained by deleveraging, and in an environment of constrained inflation and monetary easing, it is a profitable one for investors.
A Bull Market?
We stand firm in our belief that the U.S. remains in a slow, but positive growth environment that offers ample upside for shareholders today. To the degree that the long-term fundamentals have altered in recent months, we believe that the recovery is becoming more persistent and sustainable, even if not immediately more rapid. Our thesis is based on housing, energy, manufacturing and a slowly improving global situation. Many of these positives will not manifest themselves until late in the year or will move so incrementally that the trend may be visible only in hindsight.
Wall Street recognizes many of these positives, but, in our opinion, does not fully appreciate the persistence and potential of these factors. For example:
- Those who view the housing upswing as a mere rebound miss the demographic support that will drive new household formation for the next decade.
- Those who think the reshoring of manufacturing is vulnerable to a 10% or 20% dollar rebound, miss the fact that Chinese labor costs have risen roughly 370% since the start of the last decade versus a gain of only 35% for U.S. workers
- They also miss the fact that our energy costs are literally a fraction of those abroad.
- Even those who recognize the relative attraction of U.S. natural gas prices are missing the magnitude by which this will spur infrastructure growth and revolutionize transportation.
Investors should be more fearful, not of stocks, but of missing the opportunity in stocks. What should we call a stock market making new highs, with corporate earnings continuing to grow, inflation tame, and an economic outlook of accelerating, albeit restrained, growth? Dare we say "bull market?"