Equity Investment Outlook
Osterweis Capital Management
By Team
January 19, 2011
During the fourth quarter, the stock market staged a strong rally, reflecting both growing evidence of a sustained economic recovery and the reversal (thanks to the Republican victory in November) of the seriously anti-business tone in Washington. These two factors enabled investors to begin thinking not just of a recovery from the recent crisis and recession, but of a more sustainable and enduring expansion. As a result, they were able to bet on a longer stream of favorable corporate earnings.
For some time, we have written about the serious structural problems facing the economy and have cautioned that the current recovery/expansion would be anemic by historical standards. We continue to hold this view but still believe a positive case can be made for equities.
Two other factors also help make a constructive case for the stock market. First, stocks, even after the recent rally, are not expensive in our view. Although not dirt cheap, they are certainly reasonably priced. The market as a whole appears to be trading toward the lower end of its historical range when looking at the price/earnings ratio (P/E) multiple of the S&P 500 Index. Second, the great bond market rally is in all probability over. Interest rates are extremely low and unless the economy heads into deflation, rates are far more likely to move up than down. Thus, from a technical or flow of funds perspective, we would expect money to start flowing from bonds into stocks. In fact, recent mutual fund data suggest this is already happening.
To underscore this point, we would suggest that owning shares in a rock solid company yielding 3.4%, that has a history of growing its earnings and dividend over time, is considerably more attractive than owning a 10-year Treasury bond yielding 3.3%.
- The housing morass
- Persistent high unemployment
- The need for the consumer to deleverage – hence, a rising savings rate and lower consumer spending
- Constrained credit availability because of the banking system’s need to deleverage and rebuild financial strength
- Anti-business attitude in Washington that discourages investment and hiring
- The Euro crisis
- Government deficits
Below is an update of our thinking on these major economic headwinds, but we note that we are far from alone in worrying about these trends. As a result, a case could be made that these concerns may already be largely discounted in share prices.
Over the past few months the housing mess has gotten worse. Now that the government housing stimulus is over, housing has slipped back into decline and many observers are warning of a double dip.
Unemployment remains sticky at just below 10%. Long-term unemployment is a serious problem. A staggering number of workers have been out of work for more than 99 weeks and are now facing the end of unemployment benefits. Under-employment is also a problem.
Holiday spending was actually fairly strong, suggesting that consumers are more confident (at least the 90% who have jobs). The latest savings rate number actually fell slightly. Short term, this is bullish for the economy. On the other hand, we should point out that much of the recent strength in spending was concentrated in the high-end consumer and was not wide spread. The long-term consequences of a dichotomous economy are not favorable and could lead to a populist backlash in the future if we cannot expand the economy for the majority of Americans.
According to the 12/29/10 Wall Street Journal, banks are beginning to “open [the] loan spigot,” and the “uptick in lending to businesses is expected to accelerate” into 2011. This is particularly meaningful to small businesses, which historically have created the most jobs, but have not done so this cycle. Credit has been available to larger companies via the capital markets (stock and bond markets). As a result, big business has expanded faster than small business thus far in the economic cycle. Now perhaps small business can kick in.
The November Republican victory has proven to be a dramatic wake-up call for the Obama administration. The result was a tax compromise devoid of “tax the rich” rhetoric and rates. We expect the pace of business re-regulation to slow. Both the near-term tax certainty and the slower pace of regulation should help energize small business investment. Not only has Obama been forced towards the center in order to work with the Republican House, but also has gotten the message from business that the corporate bashing has to stop if he wants business to feel confident enough to invest and thereby create jobs.
The Euro is again facing a crisis. This time the markets are less spooked than during the Greek crisis. While the fate of the Euro is still in question, some parts of Europe, especially Germany and other Northern European nations, are doing well and the ultimate fate of the Euro seems to be less of an issue around the world.
Government deficits are still a great worry. The Federal deficit is a long-term issue that will engender much political debate and will probably spark a financial crisis of some sort in the future. Numerous state and local governments face severe budgeting problems and are continuing to lay off workers. This is an immediate problem and one not easily solved because of growing pension and retiree health care costs. We expect numerous mini-crises at the state and local levels. Sustained economic growth would go a long way to ameliorate government fiscal problems, but it is hard to predict enough growth to avert a crisis or two at the state and local levels.
Lastly, emerging markets, the recent stars of the global economy, are showing some evidence of overheating. Food and commodity inflation, rate increases and capital controls are signs of stress in those regions. How the leading emerging economies (China, Brazil, India) deal with these challenges will be very important for the growth and profitability of many U.S. and European companies.
Looked at all together, it seems that many longer-term problems tied to excessive financial leverage, and government intervention and profligacy, continue to fester and may create unpredictable challenges over the next few years. Nonetheless, recent economic trends suggest that the recovery is intact and that corporate profits should continue to grow. Modest growth coupled with ample liquidity should provide a favorable backdrop for public equities, provided of course, that the rate of growth is sufficient to enable companies to maintain their profit momentum. Despite the all too real longer-term problems facing the economy, stocks may continue to perform well for the foreseeable future. As always, though, we remain highly selective in those equities we choose to hold or add to client portfolios.
We thank all of our clients for your loyalty and encouragement over the past years, and we wish all of you health, happiness and prosperity for the coming year.
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1 Ruth Simon, Banks Open Loan Spigot, wsj.com, 12/29/2010
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Past performance is no guarantee of future results. This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The S&P 500 is a market-capitalization weighted index of five hundred unmanaged common stocks and is widely recognized as representative of the equity market in general. The index includes reinvestment of dividends. This index does not incur expenses and is not available for investment.
Price/Earnings Ratio (P/E): The price of a single share of a security, divided by the amount of earnings per share.
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