Spillover and Cycles
The International Monetary Fund and the Blue Chip Economic panel of forecasters both cut their U.S. forecasts this week. The IMF cut the U.S. 2007 forecast to 2.2% from 2.9%, while the Blue Chip panel cut its forecast to 2.3% for the year, down from its 2.5% estimate in March. Both reports cite weakness in housing and capital spending as the main reasons for their downward revisions. But doom and gloom today can easily turn into bullish exuberance tomorrow, depending on what company is reporting and who you are asking. Just remember last Friday's job reports, which had "Goldilocks" written all over it. The problem is that investors react to high frequency data with frequent change of mind. Boom today; bust tomorrow. Is there no way to capture the long term trends that protect us from being whipsawed by our own emotions? I believe that there are tools that attempt to capture the essence of the markets. Today, we will discuss them again (we did so many times before). But first, let's savor a picture from a McKinsey study which depicts capital flows in 2004. It is interesting to visualize how much the U.S. is part of a global economy. Meanwhile, 40% of the S&P; 500 earnings are derived from activities outside of U.S. territories. Again, 40% of profits are derived through free trade with the rest of the world.
The IMF report with the title "Spillovers and Cycles in the Global Economy" said "While the U.S. economy has slowed more than was expected earlier, spillovers have been limited, growth around the world looks well sustained, and inflation risks have moderated. "... Among emerging market and developing countries, rapid growth was led by China and India, while momentum was sustained across other regions as countries benefited from high commodity prices and continued supportive financial conditions." In my humble opinion, this simply means that the US economy is entwined with the global economy and so are our stock markets. Inextricably so!
Back to our attempt to decipher the long term trends of the US equity market. We have been in a bull market since October 2002 (or March 2003 depending on who is counting) and some observers say that we are overdue for a bear market or a correction of significant size or duration or both. Fundamental weakness in the housing market and decelerating earnings will finally cause the markets to enter this corrective phase, so the theory goes. Let's look at the first exhibit that contradicts this assertion: "The animal spirits"
"Animal Spirits"or Investors Propensity to Take and Accept Risks
Stock prices are influenced mainly by two factors: Earnings and interest rates. Earnings are company specific, of course. Interest rates are system-wide and can either be taken by themselves as in the picture above or they can be incorporated into an earnings valuation model, like in the picture below. The picture above shows the current yields above 10-year treasury notes that investors are willing to accept for investment grade bonds and junk bonds. Both are trading at historic low levels, which means that their yields (and their yield difference over T-Notes) are at historically low levels. As of today junk bonds usually trade about 3% (300 basis points) above 10-year T-Notes (4.75%). This means that your average junk bond is trading at a current yield of 7.75%, which is the lowest it has ever been. As of last Friday there was no fear of debtor insolvency. We are on the verge of earnings season, with earnings growth rate to fall below 10% for the first time in 3 years. If there was ever any nervousness to be detected, it would have to be now. But there is no sign of earnings angst in the credit markets. Jason Trennert was interviewed this week in Barron's. He says: "Corporate balance sheets, by almost any standard, couldn't be in much better shape than they are right now. If anything, you could make the case that corporate balance sheets aren't leveraged enough. There is too much cash on the balance sheet, there is not enough debt. It is hard to get a recession when corporate balance sheets are this clean."
Even the weakness in the housing market and the anxiety about sub-prime mortgages does not seem to influence the pricing of corporate bonds, yet. Conclusion: If the upheaval in the mortgage markets has not affected the corporate bond markets even at the height of the hysteria two weeks ago, what are the chances, that any further news of doom and gloom in real estate land will do the job? I believe the chances are nil. Strength in the employment market has kept consumer spending strong and the credit markets have anticipated that. Animal spirits are stirring and private equity is on the prowl. Risk taking has not diminished.
The second component of stock markets driving forces are earnings. Jason Trennert expects S&P; 500 operating earnings to rise to about $93, which would give us a 4.9% year over year growth rate. Even though the absolute growth of earnings has declined to below 10%, the earnings yield of the S&P; 500 is still favorable compared to the current yield of 10-year T-Notes. The Fed Model, as it is called, compares the earnings yields of the major indices to the "riskless" earnings yield of 10-year T-Notes. The earnings yield of the S&P; 500 is calculated by taking the index level (roughly 1,450) and dividing the estimated earnings for 2007 (93$). The result of 15.59 is the PE ratio of the S&P; 500. The inverse of the PE ratio (1 / 15.59) is called the earnings yield. The earnings yield for the S&P; 500 is currently 0.064 or 6.4%, whereas the yield for your average T-Note amounts to only 4.75%. The relationship between the two is depicted above. Since earnings yield for stocks are generally higher than the yields for bond, we can assume that stocks are at least somewhat undervalued. And this, Ladies and gentlemen, is the second argument for our bullish predisposition. I believe that this bull market has further to go!
Wired Magazine: "Is one of the strengths of the American system that, relatively speaking, it's more comfortable with uncertainty?"
Nicholas Taleb: "Yes. People here aren't afraid of failure. They're willing to trade the possibility of failure for the chance at a big upside. No other country is willing to do this. What America does best is produce the ability to accept failure."