Green shoots for investors?
Joel Dresang: Bob, the Gross Domestic Product grew only 0.1% in the first quarter this year. That doesn’t sound so good.
Bob Landaas: Joel, it wasn’t so good. We’ve known for a long time now that economic recoveries after a financial crisis tend to take much longer and, by their very nature, are much weaker. Gross Domestic Product has averaged 2.2% ever since the recovery began five years ago.
And, Joel, I’ve always been suspicious of anybody that blames weather for financial results. I’ve always been suspicious of retailers blaming either the weather is too hot for people to shop or it’s too cold for people to shop. But this past winter, it actually was pretty accurate. It was miserable – Milwaukee’s coldest in 32 years, snowiest in 27 years.
And now, we’re starting to see the green shoots.
As much as we spend time in our gardens this time of year looking for anything that resembles new growth, we’re seeing that in the economy. Job creation has been on the mend. Business spending has been improving. And across the board, we’re seeing better economic signs.
Joel: So we’re seeing better economic signs. What about the stock market? It went up 30% last year. So far in 2014, it’s pretty even.
Bob: You know, Joel, I’m thrilled that we broke even for the first quarter of this year when you consider the backdrop of all the bad news. We start with disappointing results out of China at the beginning of the year. Their export numbers came out in February. They were terrible. Their exports fell 18% year over year. That’s bad no matter how you try to sugarcoat it.
We saw problems, of course, in the Ukraine with the potential for escalated conflict there. And after a huge run-up last year, the fact that the market broke even for the first quarter, to me, shows underlying support and strength for stock prices.
Joel: You talk about earnings and interest rates. What are earnings doing right now?
Bob: When you look at earnings, of course, it’s a function of how much do you have to pay for them. Investors are being asked to pay about 15.5 times forward earnings, a little bit above average. Price-to-book, price-to-sales, price-to-cash flow were roughly average for valuations.
Markets don’t die at fair value, they die at excess.
Think P/Es. When P/E ratios get into the upper teens or low twenties, markets tend to run out of gas. Markets tend to run out of gas when investors are focused in on just a handful of stocks. Think 2007, before the sell-off. If you weren’t in bank stocks or oil stocks, you weren’t making any money. Think back late 1999, if you weren’t in a handful of tech stocks, you weren’t making any money.
Last year, nine out of 10 S&P sectors made money, so you really saw broad-based participation among all of the sectors. That’s healthy for stock prices.
When you look at earnings, they’re widely forecast to improve 7.5% this year; 11% plus for each of the next two years.
So the point is, if we’re not overpaying for those earnings and they’re anticipated to grow above average, stocks should do fairly well.
I’m always intrigued by profit margins. And that’s one of the unusual things that’s happening right now, Joel. Ten cents on the dollar is profit for the average S&P company. That’s the highest it’s ever been. Typically, at this point in the business cycle, profit margins get squeezed because companies are paying more for labor. You’re no longer in hiring from the ranks of the unemployed. You’re taking workers from other companies. You’ve got to pay for that.
And also commodities are firming up at this point in the cycle. Commodities have been going down now for the better part of 25 months. So, as a result, margins are the highest they’ve ever been.
And now this is the fourth year in a row where we get to say that S&P profits are the highest they’ve ever been.
Joel: And what about interest rates? You talked about five years of the expansion of the economy. It’s been about that time that we’ve been expecting interest rates to go up. They’ve actually been going down this year.
Bob: You know, Joel, in a normal economic cycle, if the Fed quadruples their balance sheet from $1 trillion to $4 trillion, inflation would have done one of those (Bob gestures with his hand rising).
The problem, of course, is that the banks aren’t lending. The average credit score in the United States is 620. That’s subprime. The average American can’t get a traditional fixed mortgage. You want to know where housing’s going? That’s the answer. It can’t go much of anywhere. Household formation continues to decline. We’ve pretty much sopped up the excess inventory of housing this last year, and as a result, housing has been holding the economy back somewhat.
But if you look at the markets overall, the profit margins are so high. Along with 60% of the earnings now are coming from outside the United States. China was meowing about their lackluster growth. It came in at 7.4% in the first quarter of this year. That’s three- to four times what we have been experiencing on average here in the United States.
Joel: With the interest rates, why does that matter to investors?
Bob: With interest rates, Joel, it’s all a function of making sure that when you look at future earnings for a company, you want to discount those earnings back to a current value. If you think interest rates are going to go up, you’re going to use a higher discount that would result in a lower valuation for a company.
If you don’t think interest rates are going to go up a whole lot, as I do, we’re going to use a lower discount number to discount future earnings for a company, resulting in a higher valuation.
Interest rates are going to go up a little bit, but the big surprise for the first quarter of this year clearly is that most investors made more in bonds and bond funds than they did in stocks – just a mirror opposite of what happened last year.
Inflation, as you know – you follow the numbers pretty closely – is barely measurable. Year over year, inflation is at 1.2%. The Fed’s trying to get it to 2%. They can’t. When the Fed announced their minutes yesterday, they made it real clear that they’re going to wait for the unemployment rate to go down, they’re going to wait for the economy to improve, before they start increasing the overnight rate – the Federal Funds rate.
So I think it’s going to be a while yet for interest rates really to take off. And as a result, that provides underlying support for the market.
So we’re not here to be cheerleaders for stocks. We’re just trying to interpret which way the winds are blowing. But the market is selling for a fair valuation. Earnings are supposed to grow at above-average rate for the next three years. And as a result of the broad-based participation in the stock market, the fact that we have a fairly accommodative interest rate policy, I’m pretty optimistic for stocks for the foreseeable future.
Bob Landaas is president of Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May
(initially posted May 2, 2014)