Follow US to Recovery
By: Jim Scheinberg – August 22, 2013
There can be no mistake that the United States is leading the global advance in stocks, and I theorize in a broader cyclical economic recovery as well. That would make sense, seeing that if we led the world into this mess in 2008 with the collapse in our real estate markets and related fallout, then a recovery in this area would be the driving force as we emerge back to more prosperous times. If our thinking is correct, then in the coming quarters we will see strength return to the consumer-sensitive global manufacturing regions such as China. Once they begin to thrive again, the U.S., Europe and Japan will benefit as a result of accelerating infrastructure spending. So be forewarned; as we report below on the dispersion of equity performance between the U.S. and the rest of the globe, don’t assume that this is a trend that will continue. In fact, we believe that there are bright days ahead for most all global markets.
So, just how did the Markets Fare?
Domestically, the stock market performed reasonably well, continuing the amazing rally of the First Quarter right through May. However, as concerns over high risk economic policies in Japan and a global slowdown in Asia and Latin America emerged, markets globally slumped into the final 5-6 weeks of the quarter. The net result here in the U.S. was that stocks added another few percent to their record breaking Q1 returns. Developed international markets in the EU and Japan ended with modest net losses. The emerging markets were hit hardest, with Asia finishing down over five percent and Latin America plunging over 15½% (led by declines in Brazil).
The long awaited rise in interest rates finally commenced during Q2. The yield on the 10-Year Treasury shot up from 1¾% to nearly 2½% during the quarter. High quality corporates, mortgages and agencies similarly saw a rise in rates. This led to a drop of over 2.3% in the BarCap Aggregate Bond Index. The bubble in Treasury Inflation Protected Securities (TIPS) that we have been commenting on for years may be deflating as well. The exodus out of TIPS forced prices down nearly 7½% in second quarter alone. This will certainly be a shock for unwitting TIPS investors that expect safety from these guaranteed government bonds.
REAL E(c)S T A T(ic)
As our regular readers know quite well, we have been forecasting a rapid recovery in residential real estate for over two years now. In fact, I coined a term for my expectations, a ‘check-mark recovery,’ hypothesizing that once the initial observation was made that prices had bottomed and turned ( v ), there would be a hurried stampede of buyers grabbing up the bargain prices, sending values up sharply off the bottom. As optimistic as I was at that point, even I under-predicted the pace of the advance. The recently released Case Shiller data for May showed better than a 12% year-over-year increase for prices for its 20 City Index. Southwestern markets like L.A., San Francisco, Phoenix and Las Vegas enjoyed 20% or better returns. Though shocking in magnitude of their advance, home prices still likely have a ways to go before gains moderate. This is largely due to continued tight supply. At the current pace of sales, there is presently less than 4 months of supply available on the market, compared to over 12 months at the peak of the crisis. Even with the recent price gains, still low home values and cheap mortgage rates are making buying the clear choice over renting for those who are inclined to commit. Further, The Federal Reserve quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices indicates that banks continue to ease on lending standards. Add this all together, and we are likely just at the beginning of this boom in real estate.
The Disposition of Acquisition
We are seeing US consumer confidence growing more and more optimistic these days. The Conference Board index for July was reported at 80.3. Though slightly down from a five year record of 82.1 in June, this still represents a marked advance from the 61.9 reading back in March. This follows logically since a main driver in this area is confidence in home values. The other key factor is conditions in the labor markets. Though not improving as rapidly as domestic real estate, the employment situation in the U.S. continues to improve steadily, if not monotonously. With the exception of a couple of outliers to the upside, we’ve added about 175,000 jobs, plus or minus 35,000, each month for the last year. This has helped the unemployment rate ratchet down to a post crisis low of 7.4%. More people at work and confidence in the stability of the jobs of those who are currently employed fuels spending. Since consumption accounts for nearly 7 of every 10 dollars of U.S. GDP, when people in the U.S. are spending more, it leads to adding more jobs, additional corporate profits, and increased tax receipts… a self-perpetuating cycle.
Back In Business
After a brief pause, the business-to-business sector appears to be back off to the races. The manufacturing component of the Institute of Supply Management’s July Report on Business (ROB) shot up to 55.4 in July (indicating robust growth) after hovering near 50 for the last three months. An explosive gain in new orders and declines in inventories led to the spike. A similar spike in new orders helped lift the non-manufacturing ROB to 56 from 52.2 last month. Confirming this optimism, the recent Vistage CEO Confidence Survey continued to exhibit optimism from business leaders about the coming period. If conditions on the ground hold or even improve, the International Monetary Fund’s widely accepted forecast of just 2¾% growth for U.S. GDP in 2014 should prove to be meaningfully underestimated. If the ISM data proves accurate, it suggests the coming year will see more than 4.0% growth in GDP, which is more in line with North Pier’s expectations. That type of upside surprise would bode well for not only the United States, but the global economy as a whole.
PIERing Ahead: Seems Pretty Fair To Me
The S&P 500 presently trades at 14.9 times expected consolidated earnings of $116 for the index’s coming year. That is about the normal high reached as market multiples expand (with the exception of the overvalued dot com era). However, with earnings expected to grow nearly 20% next year, this represents a big discount to normal PEG ratios (Price to Earnings Growth). If our theory holds, and the globe is at the dawn of a new cyclical economic expansion, earnings will accelerate and multiples will eventually expand beyond historic norms, not just to them. So the fair values that we find ourselves at today, in my opinion, are actually quite cheap at this point in an economic cycle.
Of course, this all depends on continued gains in real estate values, jobs, and resultant economic activity, which we believe is quite likely. The challenge will be in managing volatility when interest rates are eventually allowed to float back to naturally supported levels as the economy solidifies its footing. Note that I said volatility and not growth, which we think is assured. To illustrate my point, when interest rates jumped up nearly 0.40% over 6 trading sessions in mid-June, the equity markets sold off nearly 5% out of fear of what higher rates would do to the economy. This is clearly irrational thought, as we are still several percentage points below longer-term norms. However, the emotional impact of rates climbing is very real. It is my PIERspective that it’s not whether the economy and our equity markets continue their advance from here that is in question. It is how smooth or jagged this ascent proves to be, which remains unanswered.