Kathy Klein Presents Positive Case for Global Equities

On January 31, Marietta portfolio manager Kathy Klein presented an optimistic outlook for global stock markets to about 90 retirement professionals attending a luncheon sponsored by the Greater Milwaukee Employee Benefits Council.

Kathy opened with a brief review of the challenging market conditions of 2011, when a relentless flow of negative news events convinced many investors that Europe and the U.S. were headed for a double-dip recession. Most of the world’s stock markets declined: the All Country World Index excluding the U.S. slumped 13.7% and the leading emerging-economy markets crumbled more than 18%. The U.S. faired better, not so much because the U.S. economy was attractive, but rather because it was viewed as a safe haven in troubled times. Within the S&P 500 Index, the defensive industry sectors of utilities, consumer staples, and health care were the major winners, and the biggest losers were the economy-sensitive, cyclical industrials, materials, and financials.

Kathy then pointed out that conditions in early 2012 have improved dramatically. The U.S. economy is accelerating, the European policy-makers seem determined to deal effectively with their sovereign-debt crisis, and declining inflation in the emerging economies is permitting their central banks to adopt pro-growth initiatives. Market trends have correspondingly reversed. Global stock markets, led by the emerging-economies, have surged. Within the S&P 500, last year’s leading industry sectors are now the worst performers and vice versa.

The obvious question posed by this reversal is: can the positive market trends of January extend through 2012? Here, Kathy emphasized the importance of the current synchronized global accommodative policies of central banks. It was just such a synchronized global stimulus that was the most important catalyst in lifting the global economy out of the recession of 2008-09 and triggering a new bull market.

Kathy also noted that in many leading global markets the fundamentals and technicals are positive. Time did not permit her to explore these conditions in all of these markets, so she limited her discussion to the U.S. market. In particular, she identified nine indicators which historically have been associated with bull markets. These included GDP growth, strong corporate balance sheets, compelling valuations, subdued inflation, low interest rates, an accommodating Fed, and large cash reserves.

A very interesting and relevant observation made by Kathy was that sluggish GDP growth of 2-3% in the U.S. should not necessarily lead investors to conclude that prospects for U.S. stocks are at best modest. To the contrary, since 1960 periods of weak-to-moderate growth have provided the best S&P 500 gains.

Key to Kathy’s positive case for the U.S. market is continuing profit growth coupled with a very attractive valuation. A high-single digit profit gain in 2012 by S&P 500 stocks in combination with P/E multiple expansion to a non-recession level could produce a solid, double-digit advance for this benchmark index. P/E valuations for the international markets are even lower, and the prospect of a very considerable market advance in the emerging markets is pronounced.

Kathy pointed out that negative news events could again upset the positive case, but concluded with Marietta’s 2012 upbeat investment recommendations:

1.       Be open to the positive case for equities

2.       Take a longer-term view (avoid excessive responses to headline news)

3.       Adopt a global perspective (take advantage of international opportunities)

4.       Watch for risk-on, risk-off decoupling

5.       Beware of macro investing (watch the policy makers)

6.       Track closely the fundamental progress of your securities

Global Stock Markets off to Strong Start in 2012 Led by Emerging Markets

So far this year global stock markets have risen at a rapid pace; extending the rally begun in the fourth quarter of 2011.  Since January 1, the S&P 500 gained 4.5%, a starting year rally not seen since 1987. Over the same time period, the iShares MSCI Emerging Markets Index Fund (EEM) gained 9.1%, the fastest rise since 2001.

Articles in the Financial Times and Bloomberg have noted a pattern in this rally. The biggest decliners last year have led the charge this year. Year to date the EEM, which lost 21.1% in 2011, has gained twice as much as the S&P 500. On a sector basis within the S&P 500, financials, industrials, and materials have been leading the recent rally. These same sectors have greater exposure to emerging markets and were among the worst performers last year. Utilities, health care, and consumer staples had been the best performing sectors in 2011 but have been among the worst performing sectors in 2012.

Economists attribute the surge to a number of reasons:  in the U.S., positive economic data continues to flow, manufacturing is growing, jobless claims are falling, and the unemployment rate is ticking down. Corporate profits remain high and Fed policy continues to be accommodating. Earnings season has begun with 60% of reporting companies beating expectations. Many global central banks are lowering rates in order to promote growth after two years of raising rates. As mentioned in Marietta’s blog Promising News from China, recent events in China indicate that economic stimulus and easing will likely come soon to this engine of global economic growth.

Three weeks do not make a year, but a continuation of current trends could result in 2012 being dramatically different from 2011.

U.S. Economy: The Good and The Bad

Investors over the past few weeks have been beset by a strong dose of volatility in both news reports and stock markets. Economists disagree on where the U.S. economy will go from this point forward and their forecasts seem to get increasingly divergent by the day. A recent Bloomberg article, “It’s the Dog Days of Summer, Shall We Take a Double Dip?: The Ticker,” discusses varying views on the likelihood of a double dip recession. The article enlightens both the optimistic and pessimistic sides of the issue. Their conclusion indicates that although the U.S. and global economies are clearly moderating, the consensus scenario is that recession will be avoided.

The Bad:

Polls conducted recently by the Wall Street Journal and USA Today reveal that the consensus on the likelihood of the U.S. entering another recession has risen to 30%, twice as high as a few months ago. Economists generally accept that U.S. growth will be slower and unemployment will remain inflated for a longer period of time than previously thought. On August 22, Citigroup, Goldman Sachs, and JPMorgan Chase cut their 2011 and 2012 GDP projections. Finally, the need to reduce government spending will handcuff legislators from adopting stimulus measures and the Fed has few tools left to jump-start growth.

The Good:

The consensus on the likelihood of entering another recession is still below 50%. Bob Doll, the chief equity analyst at BlackRock, states: “Stocks have fallen 15% or more in the past few weeks, but since the Great Depression there have been 30 market declines of 15% -- but only two of those predicted a recession.” Even with their reduced U.S growth outlook, Citigroup will projects a 20% stock increase over the next 12 months. The jobs picture is discouraging, but is still strong enough to avoid recession. To be sure, the 12-month data regarding new jobless claims has improved and bank lending conditions have eased. Credit flows, an indicator of reinvested savings, continue to be adequate. Corporations are generating strong profits and carry record cash holdings. Recessions are usually associated with having a negative bond yield curve (whose short-term rates rise above long-term rates), and right now the U.S. has the opposite. Schwab economists sum up these positives with the observation that the U.S. will avoid recession “due to continued positive leading economic indicators, an improving jobs picture, solid corporate balance sheets and a still-steep yield curve.”

The slowing U.S. economy is expected to have only a limited impact on global growth. For example, Morgan Stanley recently cut global estimated GDP growth in 2011 to 3.9 percent from 4.2. The dramatic fall of world stock markets in the past few weeks, which we consider excessive, discounts a much greater than 0.3 percent drop in global growth. For a more in-depth view of Marietta’s opinions on this issue, please refer to earlier posted blogs “Clouds Gathering on the U.S. and International Economic Horizon” and “Financial Market Turmoil.”

China Watch Update

Over a year has passed since we posted a blog “International Stock Markets: Searching for Goldilocks” (5/12/2010) in which we commented on the rising inflation problem in China and the damage it was inflicting on the Chinese stock market. More recently, on March 22, we issued a blog “China Watch: Is Goldilocks Waking Up” in which we pointed out that continuing stock market underperformance was a consequence of increasing concern among investors that the government would go too far and inadvertently cripple economic growth. We drew 3 conclusions:

• Chinese stocks would continue to languish (at best) as long as inflation continued to rise and policy makers continued to impose additional restrictive measures.

• Eventually the government and the central bank would be successful in piloting a “soft landing,” i.e. they would slow the economy and usher in a period of healthy and sustainable growth with reduced and controlled inflation.

• The “soft landing”would spark a strong stock market rally.

Fear of inflation and possible asset bubbles continues to be the central focus of investors and the Chinese government. Since the start of 2010 the People’s Bank of China (PBOC) has hiked bank reserve requirements 12 times, and on 4 occasions it raised the base interest rate. Nevertheless, inflation has risen steadily and is now, at 5.5%, above the government’s 4% target.

The latest important development was an article “How China plans to Reinforce the Global Recovery” in The Financial Times (6/23/11) authored by Chinese Premier Wen Jiabao. After touting the considerable strengths of the Chinese economy and the government’s achievements in promoting social reforms, implementing massive infrastructure programs, and sponsoring scientific and technology initiatives, he made remarkably confident statements regarding inflation:

There is concern as to whether China can rein in inflation and sustain its rapid development. My answer is an emphatic yes…China has made capping price rises the priority of macroeconomic regulation and introduced a host of targeted policies. These have worked…We are confident price rises will be firmly under control this year.

Investors in Chinese stocks interpreted the Premier’s confidence as a signal that the period of restrictive credit policies was over and China was headed for the desired “soft landing.” Since June 20, the Shanghai Stock Exchange Composite Index (CSEX) has rallied 4.1%, but is still down -10.6% since April 15 and over 50% from its peak in October of 2007. If the government can convince investors that it is correct in its claim that inflation can be kept below 5% and GDP growth over 8% for the foreseeable future, then the Shanghai market recovery has only just begun. The market’s P/E valuation, at 11.6 times estimated profits, is the lowest since the global financial crisis in November of 2008 and, according to research analyst estimates compiled by Bloomberg (6/27/2011), Shanghai index profits are expected to soar 32% in the next 12 months.

Bond Market Considerations

At the beginning of the year, we alerted readers of our Outlook to be sensitive to the risks of investing in U.S. Treasury, corporate, and tax-exempt bonds. Our view rested on the historically low yields provided by these bonds at a time when the economic expansion was maturing and inflation was looming. We were also concerned about the U.S. government’s massive budget deficit and approaching debt ceiling deadline, highlighted recently by warnings of potential downgrades from credit agencies, and the very weak fiscal circumstances of many tax-exempt issuers. Our advice was to keep credit high and maturities short.       

                 

To our surprise, the yield on the benchmark 10-year U.S. Treasury note has declined from a high of 3.74% on February 8 to 2.95% on June 8, and corporate and tax-exempt yields have correspondingly declined. We attribute this drop in yields (and rise in prices) in part to growing uncertainty regarding the duration and severity of the current global economic “soft patch,” which has triggered an exodus from equities and a flight to the perceived safety of bonds in general and U.S. Treasury securities in particular. Another contributor to sliding yields has been the determined effort of the Federal Reserve to alleviate fears of inflation and keep rates low in hopes of accelerating economic growth.

Our forecast, shared by a consensus of economists, is that the “soft patch” will be relatively short and innocuous, as was the case with a similar “soft patch” at this time last year. A restoration of more healthy economic growth will most likely heighten inflation anxieties. We also expect the Federal Reserve’s “quantitative easing” policy (QE2) of purchasing Treasury securities to support low yields to expire in June and not to be extended.  Further, we expect worries about the U.S. government’s deficit to intensify as the debt ceiling deadline approaches. As a consequence, we reiterate our strategy of maintaining high quality and short maturities in U.S. bonds even though lower quality and longer-maturity bonds currently provide higher yields. We also suggest that readers consider the appeal of international bonds as an addition to U.S. bonds.

Our recommendation is echoed by Bill Gross, the celebrated manager of Pimco’s Total Return Fund, which is the world’s biggest bond fund. Gross, who according to  Bloomberg (6/9/2011) has outperformed 99% of his rivals over the past 5 years, eliminated U.S. government debt from his portfolio in February. Stating yesterday “I certainly don’t have any regrets,” he repeated his prediction that the 30-year bull market in bonds is over. Rather, he encouraged investors to consider the bonds of other countries with stronger balance sheets and half the debt. In particular, he cited the bonds of Germany, Canada, and Brazil, which have higher yields and he believes are safer credits, as “better opportunities.” 

We point out that many factors need to be considered in evaluating the appropriateness and desirability of international bonds, and currency fluctuations will have a significant impact. Investors who want to control risk should favor intermediate-maturity, attractive-yielding sovereign bonds of countries with strong economies and currencies. We are currently reviewing portfolios on a client by client basis, and we strongly advise other readers to seek professional assistance in diversifying their bond holdings by taking a global perspective.                                                                                                                  

Growing Optimism for Global Equity Markets

Expectations that the global economic expansion will continue through 2011 is prompting Wall Street investment strategists to predict robust stock market gains next year.

The rosiest forecasts are for the markets of the leading emerging economies (China, India, Brazil et.al.), where economic growth is expected to be strongest. A mid December Bloomberg survey of stock strategists at UBS, Citigroup, JPMorgan Chase, Credit Suisse, and Morgan Stanley foresee, on average, a 30% jump in the emerging markets as a group. These same gurus also predict a 14% advance for the Stoxx Europe 600 Index even though the continent will likely continue to suffer from a sovereign debt crisis and government austerity programs that will further retard already sluggish economic growth.

Most notable is the rising optimism for the U.S. stock market as represented by the Standard & Poor’s 500 Index. The general view is that Congressional and Federal Reserve initiatives to accelerate economic growth will boost corporate profits and result in a 3rd consecutive positive year for this benchmark. A survey of 11 strategists by Bloomberg in December shows an average rise of 11% in 2011 for the S&P 500. Among the most optimistic are Deutsche Bank and Goldman Sachs with anticipated jumps of 25% and 20% respectively, whereas Barclays and BofA Merrill Lynch forecast advances of 15% and 14% respectively.

We wish our readers a happy and healthy holiday season and a profitable New Year.

U.S. Corporate Profits and Stock Prices

Our forecast for the U.S. economy, corporate profits, and stock prices in 2011 supports a positive if cautious outlook:

• The U.S. stock market’s rally since 3/9/09 rests on a solid foundation of rising corporate earnings.

• The market is not currently overvalued, and there is room for a further advance if the 2011 profit expectations of market strategists and research analysts are valid.

•  We caution that these 2011 earnings estimates underlying a further U.S. bull market advance rest on shaky economic ground. If the economic outlook deteriorates further, companies with excessive exposure to the U.S. and other developed countries may report earnings disappointments and suffer stock price declines. We recommend investors take a global perspective and emphasize markets in fast growing economies and the stocks of multinational companies in the developed countries that have strong business opportunities in these fast growing economies.

Despite an anemic, subpar economic recovery, the Standard & Poor’s 500 Index has soared 74.9% since hitting bottom on March 9, 2009. The headwinds have been and remain formidable: weak consumer spending and confidence, sky-high unemployment and underemployment, a soggy housing market flooded by foreclosures, a troubled financial system that continues to restrain credit, and a nagging fear in business circles that Washington not only can’t remedy the problems but may make matters worse. On the other hand, the roster of positives boosting the market has evidently more than offset these negatives. These include strong corporate profits, low inflation and interest rates, a very accommodative Federal Reserve policy, an attractive market valuation coming off recession lows, and the relative lack of appeal of money market funds, bonds, and real estate.

In our view, the most important ingredient in the bull market recipe has been surprisingly robust corporate earnings. According to First Call, the trailing 4-quarter earnings per share (EPS) for S&P 500 companies rose from $62.85 as of March 31, 2009 to $79.05 on September 30, 2010, which is an increase of 26%. This includes an estimated 13% gain in year-over-year profits for this year’s 3rd quarter. Bloomberg reported on October 4 that more than 70% of S&P 500 companies have exceeded the average analyst profit projection for 4 consecutive quarters, which marks the longest streak since Bloomberg began tracking corporate earnings in 1993. We are convinced that positive earnings surprises and upward revision of future earnings estimates are the most powerful catalysts in lifting stock prices. The jump in earnings also keeps the market’s valuation attractive despite the huge run up in stock prices: the P/E ratio of the S&P 500 Index based on trailing 4-quarter earnings was 15.0% on September 30, which is close to the long term norm.

The key question now is whether 2011 profits will be strong enough to sustain the bull market. Clouding our optimism is that many economists are now predicting GDP growth next year to slow from its current sluggish rate. In The Economist’s latest polling of economists (10/23/2010), the consensus trimmed its 2010 U.S. forecast to 2.6% and predicted a further slide to 2.4% in 2011. We pointed out in our October 21 blog that in early October the International Monetary Fund (IMF) issued a similar 2011 GDP slowdown to 2.2% for developed countries as a group (the U.S. Europe, Japan, Australia, et.al.). As the IMF sees it, the economic recovery over the past 15 months has been driven by fiscal stimulus and inventory accumulation, and both are coming to an end. In the future, growth will have to come from consumption and investment, which in the developed countries are weak and not expected to improve much. A possible income tax increase in the U.S. and budget austerity programs in Europe would exacerbate the already meager 2011 prospects for growth.

There are two ways to measure 2011 S&P 500 profit expectations. A top-down forecast of market strategists, based on fundamental economic and financial market assumptions, is rosy: experts canvassed by First Call foresee a 14% advance, whereas the participants in Bloomberg’s poll anticipate a 9% rise. Even more optimistic is the bottom-up aggregate outlook provided by research analysts estimating company profits: 8,500 analysts tracked by Bloomberg expect a 15% increase. It is noteworthy that these 3 EPS estimates, which range from $87.34 to $95.95, are all above the pre-recession level of $86.20 reached in 2007. Also noteworthy is Bloomberg’s assessment that the S&P 500 is currently valued at 12 times projected income for 2011, which is “the cheapest level since 1988 (excluding October 2008 to March 2009 after New York-based Lehman’s bankruptcy), relative to reported profit from the past 12 months.”