Out From The Clouds

I have never piloted an airplane, but over the years I have picked up a few things from acquaintances that are pilots. Most beginners learn to fly a plane without relying on most of the instruments in the plane for navigation, orientation, and/or distance awareness. A pilot that primarily uses his observations through the plane window is said to be using Visual Flight Rules (VFR). Ultimately, a pilot gains enough experience to navigate a plane using only the instruments in the cockpit, which is otherwise known as Instrument Flight Rules (IFR). A pilot should be IFR-rated to effectively navigate a plane when visibility is poor.

Over the last several weeks, I have been thinking about how the market handled the uncertainty surrounding the theater in Washington, and I realized that it was very similar to a plane flying on instruments alone. We can never really see where the market is going, instead, we rely on indicators and instruments to navigate our way.

The uncertainty surrounding the shutdown and debt ceiling discussions filled an otherwise clear sky with ominous dark clouds. Making the job of piloting through those clouds even more challenging was that several of the instruments that market pilots rely on were not working properly, since several macro economic data points were not reported as a result of the government shutdown (i.e., non-farm payroll employment, unemployment rate). With only a few instruments working, the markets had to stay calm and confident that the plane’s speed, altitude, and orientation remained on course, which for the most part, it did. Now that the plane is through the clouds and all of the instruments are working again, how does the view look? In general, economic and corporate fundamentals are good and the skies look pretty clear, but as always, there could be some rough air pockets.

It seems like each day is a new high for the S&P 500 Index. From October 16th, the day before the perceived doomsday for the United States, to the 28th, the index has returned +2.36%, excluding dividends, as it hit a new all-time high of 1,762.1. Comparatively, the tech-laden NASDAQ has returned +2.62% and the Russell 2000 Index has returned +2.34%. Market breadth supports the healthy performance. The NYSE Advance/Decline Line, which measures the cumulative number of daily advance minus declines, has consistently increased since October 16th.

So, what is driving investors’ enthusiasm and confidence? There are multiple factors to support the positive investor sentiment. An important one is the removal of the uncertainty out of our nation’s capital for at least a few months. As important is the realization that corporate America and economic fundamentals are good.

Health of Corporate America

There are several factors that point to the good health of corporations. Cash on corporate balance sheets are at high levels. Many company management teams have, on their own, prioritized shareholder interests and have used cash to do one of the following: pay a dividend, raise the dividend, pay a special dividend, and/or buyback shares. While some have implemented these policies on their own, there have been some high profile investors that have ˜asked’ company management to put more emphasis on shareholder returns by using the cash and/or the low interest rate environment more effectively take actions to boost the stock price. Most recently, Apple has been in the cross-hairs of Carl Icahn, a prominent activist hedge fund investor. Icahn believes Apple’s stock price does fully reflect the company’s solid business model (i.e., the stock is undervalued) and he wants management to implement a $150 billion stock buyback plan.

Profit margins remain near all time highs and earnings per share have steadily increased in 2013 after declining in the fourth quarter of 2012. The third quarter ˜earnings season’ began a few weeks ago and it appears that earnings remain healthy and are continuing to grow using the constituent companies in the S&P 500 Index as the sample. Throughout 2013, corporations have been lowering guidance, which has resulted in analysts cutting earnings estimates. As a result of this lowering ˜the bar’, some market observers were not too excited about potential earnings surprises from the third quarter earnings season. On October 8th, Alcoa, a constituent in the Materials sector, started the earnings season on a positive note, with reported quarterly earnings that beat the consensus earnings estimate of eighteen analysts by 111.5%. Alcoa was not a fluke in actual earnings exceeding estimates; as of October 28th, 70% of the companies in the S&P 500 Index have beaten earnings estimates. However, Alcoa was a fluke in the level of the beat since the average actual vs. estimate earnings has been 4% for those reported. Based on the trend in reported earnings to date, JP Morgan Asset Management estimates the aggregate earnings per share (EPS) for the index for the third quarter will be $26.92. If this EPS estimate is realized, then the year-over-year EPS growth rate, based on third quarter of 2012 EPS of $24.0, will be 12.2%.

Economic Indicators

Economic growth in the United States and globally has been stable and is showing signs of improvement. There are many inputs to Gross Domestic Product (GDP), which is a quantifiable measure of the level of economic activity. However, one of the more important components in the GDP calculation is the consumption of goods and services. Accounting for approximately 68% of the level of GDP, consumer consumption has more significance than business or government consumption. With household debt service declining to all-time lows in addition to a dramatic increase in household net worth, the consumer appears to be healthy and able to support and increase consumption that will push economic growth higher.

Another positive is the growth in jobs. Some argue the job creation should be greater than it has been over the last four years of economic growth. While the economy has not averaged 200,000 jobs per month, the total job growth is respectable. Since July 2009, the U.S. economy has been expanding from the eighteen-month recession that ended at the end of June 2009 according to the National Bureau of Economic Research (NBER). During this expansionary period over the last fifty-one months, the U.S. economy has added nearly six million ˜non-farm’ jobs or approximately 112,000 jobs per month. When compared to the expansionary period after the recession that ended in November 2001, the job creation is better on a per month basis. From December 2001 to November 2007, nearly seven million jobs were created over the seventy-two months. However, the monthly average job creation was 97,000 jobs. Job creation is important for economic growth and it appears the market has taken notice.

There is some not-so-good news related to the job market. While the number of jobs added and the declining unemployment rate to the lowest level since December 2008 (7.2%) are positives, the declining labor force participation rate is a negative. The participation rate measures the number of people who are either employed or looking for employment. Many associate a declining participation rate as an indication that the job recovery should be better. Not only could it be better to include those who have given up looking for work because they cannot secure a job, a declining participation rate could result in a tight labor market. A potential consequence of a tight labor force is wage inflation. As the economy continues to growth and there is a marginal increase in employer demand for jobs, the labor force should have more bargaining power with wages. Labor is generally the largest cost for corporations and wage inflation would not only put downward pressure on corporate profit margins, but it also may contribute to a change in the Fed’s 0% fed fund in late 2014/2015. A change in the fed fund rate target, which should be viewed positively since it signifies the economy is improving more dramatically, could possibly lead to some rough air ahead.

Overall, the skies are clear and we do not expect any major turbulence in the near future. Economic growth, both domestically and around world, is expected to strengthen in the fourth quarter and into 2014. Stock prices should continue to benefit from the pick-up in global growth as well as more corporate shareholder friendly initiatives like share buybacks and increased dividends. Lastly, stocks should benefit from the relative attractiveness compared to other asset classes and the additional money coming into the asset class should provide support for higher prices.

Written by: Rob Little, CFA, CPA
Vice President, Investment Strategy & Research

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