As evidence of a global economic slowdown accumulated, the stock market suffered a correction during the second quarter.  This is hardly surprising given the market’s strong recovery from the depths of the 2008-2009 financial meltdown.  After surging just over 100% from its low in March of 2009 and nearly 30% since August of just last year through the end of the first quarter 2011, the S&P 500 Index needed a breather.  The 7% correction that occurred from the April high through the June low looks relatively modest to us in light of how far and how fast the market has rallied. 

In analyzing the recent economic data it is helpful to look at both short-term and long-term factors.  Short-term factors contributing to the recent slowdown include a barrage of bad weather in the U.S., starting with snowstorms and ending with severe flooding.  As if that were not enough, several states were also battered by tornadoes.  According to The Economist, the U.S. “suffered five incidents of extreme weather this year, each inflicting at least $1 billion in damage.”¹

Second, the Japan earthquake, subsequent tsunami and nuclear damage severely interrupted key supply chains, especially for autos and auto parts.  This resulted in a manufacturing slowdown. 

Third, renewed concerns about Greece’s ability to reform and avoid a sovereign default spooked financial markets around the world.  As of this writing, it looks as if Greece may receive a bailout and avoid a full-blown crisis.  However, problems in Southern Europe will not magically disappear and Euro zone crises may become endemic.  When crisis points are reached, markets react negatively; when crises are avoided, markets recover.

Fourth, gasoline prices rose sharply from around $3.00 per gallon in January to around $4.00 per gallon in May.  Higher gasoline prices hit the consumer hard, siphoning off disposable income that could have been spent elsewhere. 

Fifth, growth in China and other emerging markets also slowed in the second quarter.  The cumulative effects of these one-off factors clearly depressed U.S. economic growth in the second quarter.  The good news is that these factors should all prove temporary in nature and their reversal should support higher growth rates in the second half of the year.

Nonetheless, these special factors played out against a backdrop of longer-term structural economic headwinds that are likely to impede economic growth for some time to come.  First, and most obvious, is the persistent overhang of foreclosed and soon-to-be foreclosed homes.  Until this massive over-supply of homes is finally absorbed, housing prices are likely to remain soft, hurting consumer spending and causing banks with shaky balance sheets to restrict lending.  Many observers do not believe that there is much hope for a housing recovery until 2013 at the earliest. 

To some extent, soft housing and construction activity have contributed to the second major structural headwind, namely unemployment.  At its peak in July 2007, construction² officially employed 9,785,000 workers or 7% of the labor force.  The actual number of people working in construction at the peak of the last cycle was likely much higher since unreported workers do not appear in the official statistics.  As of May 2011, the official numbers stood at 7,071,000  workers or 5% of the labor force.  No wonder the U.S. faces a sticky unemployment level of around 9%.  Under-employed and discouraged workers who have left the labor force probably push the real unemployment level higher – some estimate it may be as high as 16%. 

The only good thing about such a persistently high unemployment level is that it makes traditional inflation highly unlikely, as wage pressures are minimized.  Without strong wage demands, the usual wage-price spiral cannot gain traction.  The inflationary pressures we do see are more asset and commodity based.  Fortunately, commodity inflation can reverse quickly as demand shifts or supplies increase in response to the higher prices.

Constrained credit (i.e. restrained bank lending) has also become something of a structural headwind.  Despite extremely easy monetary policy, bank lending has been anemic.  This reflects a number of factors including bank exposure to questionable mortgage loans and a severe contraction in interbank lending.  So far this year, some 50 banks have failed, leaving those that remain acutely aware of the risk of lending to their confreres.  Bank credit is especially important to small and mid-sized companies, the usual creators of jobs in this country.  As a result, large companies, not small and mid-sized ones, have created the most jobs this cycle, a highly unusual phenomenon.

We have discussed most of these factors over the past several years and have long argued that they necessarily entail a sub-par and somewhat anemic economic recovery.  Such has been the case.  Offsetting this concern, however, has been a better than expected profit recovery for American corporations.  This can partly be explained by cost cutting or very effective cost controls, such that moderate volume gains have been translated into well above average profit gains because of great operating and financial leverage.

There is also some evidence that this better than expected profit growth also reflects some long-term structural tailwinds.  Sometime ago we discussed the new “platform” company, such as Dell Computer, that is more capital efficient and less cyclical than the traditional manufacturing enterprise.  The new platform company essentially develops, designs and markets its products.  It outsources manufacturing (say, to China) thereby shifting the most capital intensive and most cyclically volatile part of its business offshore and onto the shoulders of another enterprise.  This is part of the story.

The other part may very well be a long-term upward shift in corporate profit margins as a result of several other factors.  In a very well reasoned piece, Bank of America Merrill Lynch argued that there are six structural reasons why margins are unlikely to revert to a lower level.  They are:

 

1. Lower effective tax rates vs. history due to higher foreign profits

2. Lower net interest expense vs. history due to less debt usage

3. Higher foreign pre-tax margins vs. history due to scale achieved abroad

4. Higher Tech operating margins and Tech is a bigger part of S&P 500

5. Higher Energy operating margins due to higher oil prices

6. Margin uplift from small improvement and mix shifts at other sectors

 

It then states that there are four reasons why margins may climb higher:

 

1. Higher margin foreign sales growth is outpacing lower margin domestic sales

2. Higher margin sector sales growth is outpacing lower margin sector sales

3. US corporate tax reform would likely cut corporate taxes

4. Financial margins could surprise to the upside from current levels

 

It further states that there are three common misperceptions about margin gains:

 

1. High commodity prices are detrimental to S&P 500 margins

2. The margin rebound has come from aggressive labor cost-cutting

3. Dollar weakness has been a big boost to margins  

 

Source:  Bank of America Merrill Lynch U.S. Strategy Update:  Equity Strategy.  6/2/2011, Page 1

In looking at the arguments above, it is clear to us that growth in emerging market economies is having a long-term salutary effect on U.S. corporate profits, as is the gradual shift of the U.S. economy from traditional manufacturing to high tech.

From an investment perspective what does all of this mean?  First, we believe that the second quarter economic slowdown is temporary, and not the beginning of a new recession.  The stock market was due for a correction and the recent slowdown, coupled with renewed stress in Euro-land, provided a good excuse.  Second, we believe emerging markets should continue to grow and this should allow U.S. companies to benefit.  Third, as the temporary factors that hurt growth in the second quarter reverse, U.S. growth rates should rebound.  Stocks are not particularly expensive in our view.  So as profits grow, stocks should become progressively cheaper.  If the current consensus estimates for the S&P 500 are to be believed, the market is now trading at the lowest P/E multiple for the market since 1991, with the exception of a brief period in 1995 and, again, in the six months following the collapse of Lehman Brothers.  At some point, this should whet investors’ appetite for owning shares.  Meanwhile, we are already seeing evidence that companies that are now flush with cash will likely step in and repurchase shares.  This could have the long-term effect of accelerating growth in earnings per share, which should also stimulate investor appetite.  In addition, if stocks stay too cheap, they will likely attract not only portfolio investors, but also financial and strategic buyers.

We, therefore, remain reasonably constructive on the outlook for U.S. equities, but would make the point that in an era of anemic economic growth, active portfolio management may be more important than usual both in terms of buy and sell discipline as well as stock selection.  In the absence of strong economic growth, buying stocks during periods of market weakness and selling during periods of strength may prove more effective than a strict long term buy and hold strategy.  Likewise, stock selection is also likely to be more important over the next couple of years than in the early phase of the recovery from the 2008 crisis or in a period of strong economic growth.  We will continue to focus on companies engaged in strategic and financial restructurings that we believe are both underappreciated by the market and material enough to drive earnings and cash flows forward, even in a sluggish economic environment.  We think that large cap stocks may have an edge going forward because we believe they are cheaper than small and mid-caps, and often have greater exposure to emerging markets and so may be able to sustain better growth rates.

             

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¹Excuses, excuses, economist.com 6/2/11.

²Includes construction & extraction occupations

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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 Index is an unmanaged index which is widely regarded as the standard for measuring large-cap U.S. stock market performance.  This index includes the reinvestment of dividends.  The index does not incur expenses and is not available for investment.

 

Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.

 

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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