As we write, the Dow Jones is off some 353 points, and many are questioning whether we’re coming into a major economic correction. We don’t see things that way. We still firmly believe the market for equities ultimately reflects the fundamentals of the economy and the strength of the companies’ profits which those stocks represent, and both fundamentals and profits are good right now. Accordingly, much of the movement in the markets (up, then down, then back up, etc.) is often white noise, even movements of 300+ points as we’re seeing today.
To get a sense for that, let’s revisit briefly what’s happened over the just the course of the last year. The fundamentals back then predicted what we’ve just seen over this last year – a plow horse type economy, growing slowly but steadily, and weakness in fixed income or commodity type investments.
Treasuries: one year ago the yield on the 10-year treasury was 1.5%; today the yield is about 2.2%. Had an investor purchased that 10-year treasury one year ago, he would have earned 1.5% in interest, lost 6.5% in value, for a net loss of 5% on his investment.
Gold: one year ago the price was $1,600 per ounce; today the price is about $1,300. Purchasing gold one year ago would have caused an investor to lose about 16%.
Stocks: the S&P 500 one year ago was 1,340; today (even with today’s losses) it’s at 1,586. Investors who purchased the S&P 500 index one year ago would have earned 18% in appreciation, plus 2%ish in dividends, for a total return of about 20%.
It’s easy to get caught up in the hard headlines, so it’s important to realize what history really shows and to understand what the fundamentals are saying about the future.
Going Forward: (as all the details below evidence), the fundamentals are trending the same way as they have for the last year or more. The economy will continue to grow, corporate profits will rise, and, yes, interest rates will begin to rise. Our estimate of the fair value for the S&P 500 today is based on existing profits (not the higher projected profits mentioned above) and on a 10-year treasury rate of 4.5% (not the current 2.2%). There’s a fair amount of conservatism in this estimate; it assumes profits don’t rise and that interest rates do rise by 2%ish. Nonetheless, with those assumptions, we realistically see the S&P 500 as fairly valued at about 2,100. That’s represents a 30% upside from today’s level. In the past, we’ve shared that calculation on the Dow, but we thought applying it to the broader-based S&P 500 would help.
The bottom line is that stocks will get less cheap over time (because they’re going to continue to rise), but right now they still remain cheap, even if still highly volatile.
To the central question on so many minds – should someone buy stocks now or not – the answer is a resounding yes. Of course, the flip side of that – should someone get out of stocks right now? – is no. Will there be volatility? Of course, look at today’s volatility. Will the intermediate term be good for investors? Absolutely. Will investors make money in bonds? There’s always the interest rate they pay, so there will be income; but the big question is whether there might be any significant losses in value due to a sudden breakout of inflation.
Cash would be “safe” in the sense that there won’t be any volatility. But in lost opportunity costs and in exposure to inflation when it hits, cash isn’t a good place economically. This is not a time to bail, lighten or change strategic directions.
To support the summary above, we thought it would be helpful to summarize some of the key economic data point which have been released recently.
Details And Numbers To Reference:
Existing Home Sales Rose 4.2% in May to an Annual Rate of 5.18 Million Units
June 20, 2013
The housing recovery continues to pick up steam. Existing home sales rose 4.2% in May, reaching the fastest pace since November 2009, when sales were artificially boosted by an $8,000 homebuyer tax credit. Sales are now up 12.9% from a year ago and look to have renewed an upward push. On the pricing front, median prices for existing homes were up a whopping 15.4% from a year ago. In general, it still remains tougher than normal to buy a home. Despite record low mortgage rates, home buyers face very tight credit conditions. Tight credit conditions explain why all-cash transactions accounted for 33% of purchases in May versus a traditional share of about 10%. Those with cash are able to take advantage of home prices that are extremely low relative to fundamentals (such as rents and replacement costs); for them, it’s a great time to buy.
Manufacturing Index Rises Substantially
June 20, 2013
On the manufacturing front, the Philly Fed index, a measure of activity in that region, rose to +12.5 in June from -5.2 in May, the best reading in more than two years.
Fed Slightly More Optimistic
June 19, 2013
The Federal Reserve made only slight changes to the text of its statement, but those it did make signal slightly more optimism. It said labor market conditions show “further improvement,” rather than “some improvement” and sees “diminished” downside risks for the broader economy.
In the press conference following the release of the statement, Chairman Bernanke provided some clarification of the current policy consensus at the Fed.
• First, the Fed views a 6.5% unemployment rate as a “threshold” for raising the federal funds rate, not an automatic trigger. So, for example, if the jobless rate drops to 6.5% and the Fed’s inflation projections remain below its long-term target of 2%, it will be slower to raise rates than if its inflation projections were running at or above 2%.
• Second, quantitative easing would end when the jobless rate falls to 7%.
• Third, there would be a “considerable” time lag between the end of quantitative easing and deciding to raise the federal funds rate. The use of the word “considerable” probably refers to a period somewhere from six to twelve months.
• Fourth, the Fed believes once it starts raising rates it will do so gradually, which probably means 25 basis points per meeting (2 percentage points per year), or less.
The Fed also made several notable changes to its economic forecast. It very slightly reduced real GDP growth this year, but added that growth into 2014. It made larger changes to its unemployment projections, cutting the rate for the end of this year to about 7.25% and cutting the rate at the end of next year to about 6.65%.
Taking the Fed’s new economic projections at face value, it appears it now expects to end quantitative easing around May 2014 and start raising rates around April/May 2015. But we’re planning on these events happening earlier. We believe unemployment will improve to a 7% rate by December 2013 and hit 6.5% by the third quarter of 2014. We also believe quantitative easing should be announced in the Fed’s January meeting. Meanwhile, we are projecting a 6.5% unemployment rate in the third quarter of 2014.
Nominal GDP – real GDP plus inflation – is already growing at around a 3.5% annual rate. At that pace, the economy can already sustain a much higher federal funds rate than now prevails.
The Consumer Price Index (CPI) Increased 0.1% in May
June 18, 2013
For now, all continues to be quiet on the inflation front. Consumer prices rose a tepid 0.1% in May and are only up 1.4% from a year ago. The slight rise in May was due to rent (both actual rent and owners’ equivalent rent) as well as energy costs. Food and medical care each declined 0.1%. “Core” prices, which exclude food and energy, were up 0.2% in May and are up 1.7% from a year ago.
Given today’s news it looks like “real” (inflation-adjusted) consumer spending is growing at a 2.5% annual rate in Q2, consistent with an earlier forecast of 2.5% real GDP growth – the economy is not slowing down.
Industrial Production was Unchanged in May, Capacity Utilization Declined to 77.6%
June 14, 2013
In general, this is properly categorized as a lackluster report on overall industrial production. The details are consistent with continued plow horse growth in the economy. Output at factories, mines, and utilities was unchanged in May as utilities held down the overall figure. Manufacturing production rose 0.1% (0.2% including revisions to prior months). Production is up only 1.6% over the past year and down at a 0.8% annual rate over the past three months. The auto sector has led the manufacturing gains, up 6.7% in the past year, but even manufacturing outside the auto sector has done OK, up 1.4% in the past year. We expect the gap between those two growth rates to narrow considerably in the year ahead, with slower growth in autos and faster growth elsewhere in manufacturing. Capacity utilization did fall to 77.6% in May, but this is pretty close to the 20 year average of 79.0%. Continued gains in production should push capacity use higher, which means companies will have an increasing incentive to build out plant and equipment. Meanwhile, corporate profits and cash on the balance sheet are at record highs, showing they have the ability to make these investments.
Closing Thoughts
That’s the quick recap of the last several days of important economic data. It’s only a week’s worth, but it all remains consistent with reports from previous weeks, months and quarters. The economy is growing, profits are accumulating, balance sheets are strong. There is no real sign of a recession or a substantitve interruption in these trends. Stocks will always have their tantrums, but the fundamentals are good, and prices are fair.
