Portfolio Manager and Principal Charlie Dreifus—whose approach combines classic value analysis, the identification of good businesses, and accounting cynicism—offers his observations on recent market movements, why interest rates are unlikely to rise in the short run, and why more and more companies are apt to give in to "the urge to merge."
Perhaps in revealing in their minutes that there were reservations about continuing QE (quantitative easing), the Fed was really only signaling that it will be mindful of using QE for too long. We will need real shifts in the Open Market Committee's actual statements and votes, not just changes in tone, before any policy changes actually occur. The end for QE is inevitable, but given the mess elsewhere in Washington, its end will be delayed.
In his semiannual Congressional testimony in late February, Federal Reserve Board Chairman Ben Bernanke went through a detailed analysis of the costs and benefits of QE while rejecting the notion that these costs are anywhere close to becoming unbearable. So there is little reason to believe easing will end soon, especially in the context of the sequester, the Continuing Resolution on the budget, the eurozone slowdown, and high unemployment.
It seems to me that an end to QE is likely only if the economy is on a promising trajectory (with sustained declines in unemployment) and fiscal issues are resolved without causing too much harm, which would entail Congress acting in a responsible fashion.
Whether bond yields advance sooner or later, one thing seems certain—the end of the bond bull market occurred in July 2012 when the 10-year Treasury yielded only 1.35% as a result of the statement from the European Central Bank (ECB) that it was "all in." Ultimately, I think the sustainability of economic growth will determine interest rates.
However, beneath the surface there does appear an increasing awareness that an exit strategy needs to be thought out. Further, President Obama seems to be in no hurry to strike a Grand Bargain that addresses structural deficits. It would appear that he is hoping to take back or make gains in the House of Representatives in the November 2014 mid-term election before cementing his legacy in his final two years. If this proves true, one should expect little to pass Congress in the next two years.
Inflation seems to be comfortably within the range that the Fed finds acceptable. There is no evidence of a wage-price spiral—the reverse of this caused more than a decade of deflation in Japan.
Money velocity also remains low, but bears watching if bank loans increase dramatically. There is a large output gap, and the U.S. is somewhat immune from a currency collapse due to the dollar still functioning as the global reserve currency.
Overall, then, the economy is currently doing okay; GDP probably grew about 2% in the first quarter. Of course, with the many headwinds and ongoing Congressional issues, it is too soon to give an all-clear signal.
One significant element offsetting these current headwinds is that global central banks still have more room to maneuver, particularly now that gasoline, oil, food, and other commodity prices have eased. The free market works. Higher prices bring demand destruction and supply increases. One could further ask if the decline in the price of gold is telling us that commodity prices have peaked.
Will consumers continue to deleverage? After going considerably above the trend line—U.S. consumer debt as a percentage of U.S. Nominal Disposable Personal Income—from the early 2000s to 2008, it is now below that line and could easily over-shoot and continue lower.
"Believe me, it will be enough" is what ECB President Mario Draghi promised on July 26, 2012 regarding the bank's actions to shore up European sovereign debt. In the more than seven months since, the euro has risen. One needs to wonder, however, if now is not the time for more easing in the eurozone and if a decline in the euro is necessary to improve its underlying economies. Italy's election results were a repudiation of its own austerity policies more of which may be needed to hold the eurozone together. This makes a stark contrast to what is happening in Japan after the nation forced its currency lower as we had several times suggested would be necessary. In China, a "too hot" housing market remains a prime challenge to any easy money policy while inflation in Brazil and India also bears watching.
U.S. consumer confidence, currently sending mixed signals, remains a critical data point. Consumer net worth has reached an all-time high, surpassing 2007 levels as a result of strong housing and stock markets. However, the mess in Washington and tax increases are offsetting some of this improvement.
The idea that the stock market has become more of a catalyst than a discounter seems especially true these days. Current and possibly future conditions continue to improve in the U.S. as a result of the vast improvements in housing as well as our manufacturing renaissance and our more recent energy renaissance.
The market's underlying strength may have been revealed on February 15, a Friday before a long holiday weekend, when an internal e-mail from a Wal-Mart executive described the current month's sales as "a total disaster." Yet the market closed flattish.
Many investors appear to be entering the market by buying on the dips, perhaps finally acknowledging, when it comes to equities, the "T.I.N.A." Principle ("There Is No Alternative"—an idea first advanced by Jason Trennert of Strategas Research Partners).
Getting paid (and getting paid increasingly more) from long-duration assets like equities that have some inflation hedge built in has always looked like a sound approach to me.
So far, as it relates to mutual funds, we have not yet seen the rotation from fixed income to equities that we believe will eventually occur; instead, we have seen cash moving from the sidelines—that is, out of money market funds—into equities. Good news, and even no news, pushes the market higher while only some unexpected negative jolts are able to drive the market lower.
As is typically the case, investor expectations have risen with stock prices. I have often pointed out how odd the stock market is compared to all other economic behaviors. In most economic areas higher prices ward off buyers while lower prices attract buyers. In the stock market, the reverse occurs.
Ned Davis Research, commenting on the difference between economic logic and stock market logic, recently said, "Investors are not risk averse, they are pain averse. They fear the pain of losing money and the pain of not making money when others are." That too captures the upside down actions by investors in the market.
The T.I.N.A. Principle continues to move equities higher. With returns for other investment vehicles unattractive and plenty of liquidity, equity prices can go higher. Financing remains inexpensive. This is one of the reasons for increased M&A (mergers & acquisitions) activity, including recent deals involving Dell, Heinz, and Comcast and NBC.
We still expect to see an increasingly active merger environment. Finally, there is talk of what we have believed for a while—that strategic mergers must occur for earnings to increase at individual companies. Now there is more talk about combining with competitors to eliminate excess costs.
The sequester, along with the payroll tax hike and the dovish Fed, will likely delay any rise in interest rates, as much as that has become a much-embraced view. Because of the very long bull market in bonds, adding equity exposure to a portfolio only marginally increased returns while also increasing risk since the end of 1981.
Is this more than 30-year love affair with bonds ending? The answer clearly seems to be "yes." However, we may currently be merely at an inflection point. While the stock market has experienced a major rise, and is certainly not table-pounding inexpensive, it also is not yet at euphoric levels.
A study by the Dreyfus mutual fund organization was cited in the March 4 issue of Barron’s. The study showed that over the 40-year period from 1972 through 2011, "Dividends payers in the S&P 500 returned an average of 8.6% per year versus 1.4% for non-payers. The study also found that companies that raised their dividends did even better, returning 9.4%."
I do believe the market is headed higher mostly because of T.I.N.A. plus the added push from the underinvested equity positions of institutions and individuals. Yet it is difficult in today's world to hold any kind of strong conviction about estimates looking out, either on EPS or a change in P/E.
In the second half of February, as noted by ISI, eight marquee companies announced large dividend increases averaging in excess of 28%. These names have outperformed the index.
Companies and their CEOs are seeing that dividend increases seem to be rewarded. ISI asks if there is a sea change toward dividends. This is not an unrealistic question given the still near record low payout ratio for the S&P 500 and the cash-rich state of so many corporate balance sheets.
The market is wise. So, hopefully, are we. The market is not favoring the highest dividend yielding names, but rather those with the longest history of dividend increases, those initiating dividends, and those that have declared large increases in dividends.
With increased M&A activity likely and overall market correlations low, we believe the current environment favors active management. Companies will be under intense pressure to boost top-line growth. Many will buy growth through M&A in this scarce organic growth climate.
What everyone knows, or believes they know, is in my opinion near worthless as it has already been discounted into the market or individual stocks. This helps to explain why our perennial contrarian bias to think differently while still holding to our time-tested, conservative discipline remains relevant and, we believe, should continue to be rewarding.
The Economy
The sequester adds to the economic headwinds caused by ending the payroll tax holiday and the boost in tax rates. However, even with the sequester, total federal government outlays will rise this fiscal year. Finally, after more than a month of daily increases for a gallon of unleaded gasoline, prices are now declining. This has been of concern as rising oil and gasoline prices were yet another headwind facing the U.S. economy. (Oil prices have also declined.)Perhaps in revealing in their minutes that there were reservations about continuing QE (quantitative easing), the Fed was really only signaling that it will be mindful of using QE for too long. We will need real shifts in the Open Market Committee's actual statements and votes, not just changes in tone, before any policy changes actually occur. The end for QE is inevitable, but given the mess elsewhere in Washington, its end will be delayed.
In his semiannual Congressional testimony in late February, Federal Reserve Board Chairman Ben Bernanke went through a detailed analysis of the costs and benefits of QE while rejecting the notion that these costs are anywhere close to becoming unbearable. So there is little reason to believe easing will end soon, especially in the context of the sequester, the Continuing Resolution on the budget, the eurozone slowdown, and high unemployment.
It seems to me that an end to QE is likely only if the economy is on a promising trajectory (with sustained declines in unemployment) and fiscal issues are resolved without causing too much harm, which would entail Congress acting in a responsible fashion.
Whether bond yields advance sooner or later, one thing seems certain—the end of the bond bull market occurred in July 2012 when the 10-year Treasury yielded only 1.35% as a result of the statement from the European Central Bank (ECB) that it was "all in." Ultimately, I think the sustainability of economic growth will determine interest rates.
However, beneath the surface there does appear an increasing awareness that an exit strategy needs to be thought out. Further, President Obama seems to be in no hurry to strike a Grand Bargain that addresses structural deficits. It would appear that he is hoping to take back or make gains in the House of Representatives in the November 2014 mid-term election before cementing his legacy in his final two years. If this proves true, one should expect little to pass Congress in the next two years.
Inflation seems to be comfortably within the range that the Fed finds acceptable. There is no evidence of a wage-price spiral—the reverse of this caused more than a decade of deflation in Japan.
Money velocity also remains low, but bears watching if bank loans increase dramatically. There is a large output gap, and the U.S. is somewhat immune from a currency collapse due to the dollar still functioning as the global reserve currency.
Overall, then, the economy is currently doing okay; GDP probably grew about 2% in the first quarter. Of course, with the many headwinds and ongoing Congressional issues, it is too soon to give an all-clear signal.
One significant element offsetting these current headwinds is that global central banks still have more room to maneuver, particularly now that gasoline, oil, food, and other commodity prices have eased. The free market works. Higher prices bring demand destruction and supply increases. One could further ask if the decline in the price of gold is telling us that commodity prices have peaked.
Will consumers continue to deleverage? After going considerably above the trend line—U.S. consumer debt as a percentage of U.S. Nominal Disposable Personal Income—from the early 2000s to 2008, it is now below that line and could easily over-shoot and continue lower.
"Believe me, it will be enough" is what ECB President Mario Draghi promised on July 26, 2012 regarding the bank's actions to shore up European sovereign debt. In the more than seven months since, the euro has risen. One needs to wonder, however, if now is not the time for more easing in the eurozone and if a decline in the euro is necessary to improve its underlying economies. Italy's election results were a repudiation of its own austerity policies more of which may be needed to hold the eurozone together. This makes a stark contrast to what is happening in Japan after the nation forced its currency lower as we had several times suggested would be necessary. In China, a "too hot" housing market remains a prime challenge to any easy money policy while inflation in Brazil and India also bears watching.
U.S. consumer confidence, currently sending mixed signals, remains a critical data point. Consumer net worth has reached an all-time high, surpassing 2007 levels as a result of strong housing and stock markets. However, the mess in Washington and tax increases are offsetting some of this improvement.
The idea that the stock market has become more of a catalyst than a discounter seems especially true these days. Current and possibly future conditions continue to improve in the U.S. as a result of the vast improvements in housing as well as our manufacturing renaissance and our more recent energy renaissance.
The Market
There was no doubt that the market's huge run that began in mid-November left it overextended. The recent raggedness in the market has many asking, "Is this the pause that refreshes or something different?" The debate currently centers on whether this pause is short term or not. We side with those who believe it is short term and will have more to say on that below.The market's underlying strength may have been revealed on February 15, a Friday before a long holiday weekend, when an internal e-mail from a Wal-Mart executive described the current month's sales as "a total disaster." Yet the market closed flattish.
Many investors appear to be entering the market by buying on the dips, perhaps finally acknowledging, when it comes to equities, the "T.I.N.A." Principle ("There Is No Alternative"—an idea first advanced by Jason Trennert of Strategas Research Partners).
Getting paid (and getting paid increasingly more) from long-duration assets like equities that have some inflation hedge built in has always looked like a sound approach to me.
So far, as it relates to mutual funds, we have not yet seen the rotation from fixed income to equities that we believe will eventually occur; instead, we have seen cash moving from the sidelines—that is, out of money market funds—into equities. Good news, and even no news, pushes the market higher while only some unexpected negative jolts are able to drive the market lower.
As is typically the case, investor expectations have risen with stock prices. I have often pointed out how odd the stock market is compared to all other economic behaviors. In most economic areas higher prices ward off buyers while lower prices attract buyers. In the stock market, the reverse occurs.
Ned Davis Research, commenting on the difference between economic logic and stock market logic, recently said, "Investors are not risk averse, they are pain averse. They fear the pain of losing money and the pain of not making money when others are." That too captures the upside down actions by investors in the market.
The T.I.N.A. Principle continues to move equities higher. With returns for other investment vehicles unattractive and plenty of liquidity, equity prices can go higher. Financing remains inexpensive. This is one of the reasons for increased M&A (mergers & acquisitions) activity, including recent deals involving Dell, Heinz, and Comcast and NBC.
We still expect to see an increasingly active merger environment. Finally, there is talk of what we have believed for a while—that strategic mergers must occur for earnings to increase at individual companies. Now there is more talk about combining with competitors to eliminate excess costs.
The sequester, along with the payroll tax hike and the dovish Fed, will likely delay any rise in interest rates, as much as that has become a much-embraced view. Because of the very long bull market in bonds, adding equity exposure to a portfolio only marginally increased returns while also increasing risk since the end of 1981.
Is this more than 30-year love affair with bonds ending? The answer clearly seems to be "yes." However, we may currently be merely at an inflection point. While the stock market has experienced a major rise, and is certainly not table-pounding inexpensive, it also is not yet at euphoric levels.
A study by the Dreyfus mutual fund organization was cited in the March 4 issue of Barron’s. The study showed that over the 40-year period from 1972 through 2011, "Dividends payers in the S&P 500 returned an average of 8.6% per year versus 1.4% for non-payers. The study also found that companies that raised their dividends did even better, returning 9.4%."
Conclusion
Corporate guidance is poor and continues to deteriorate, which in turn is causing analysts' 2013 estimates to be lowered. Recently reviewing the more than 60 years of data on the S&P 500 annual price return divided into two components, EPS (earnings per share) growth and percent change in P/E (price-to-earnings ratio), it struck me how volatile the data is.I do believe the market is headed higher mostly because of T.I.N.A. plus the added push from the underinvested equity positions of institutions and individuals. Yet it is difficult in today's world to hold any kind of strong conviction about estimates looking out, either on EPS or a change in P/E.
In the second half of February, as noted by ISI, eight marquee companies announced large dividend increases averaging in excess of 28%. These names have outperformed the index.
Companies and their CEOs are seeing that dividend increases seem to be rewarded. ISI asks if there is a sea change toward dividends. This is not an unrealistic question given the still near record low payout ratio for the S&P 500 and the cash-rich state of so many corporate balance sheets.
The market is wise. So, hopefully, are we. The market is not favoring the highest dividend yielding names, but rather those with the longest history of dividend increases, those initiating dividends, and those that have declared large increases in dividends.
With increased M&A activity likely and overall market correlations low, we believe the current environment favors active management. Companies will be under intense pressure to boost top-line growth. Many will buy growth through M&A in this scarce organic growth climate.
What everyone knows, or believes they know, is in my opinion near worthless as it has already been discounted into the market or individual stocks. This helps to explain why our perennial contrarian bias to think differently while still holding to our time-tested, conservative discipline remains relevant and, we believe, should continue to be rewarding.
