The Full Time Employment Act of 2013—Republicans’ First Assault on ObamacCare

Posted on May 6, 2013 by tomdoerflinger

You heard it here months ago, and now the mainstream media has figured out that ObamaCare’s 30/50 rule is creating a part-time workforce.  Employers must provide expensive health insurance if they have more than 50 “full-time” (over 30 hour per week) employees, so they are holding their workers to 29 hours or less.  This is a disaster for lower-income wage earnings who must hold two jobs to get a full week of work; it means more travel time between jobs, less time spent with their families, higher child care expenses, etc.  It hurts social mobility because, as Rush Limbaugh nicely put it, careers are being replaced by part-time work.  It also hurts productivity and overall economic growth.

I discussed this last November and again in February; The Wall Street Journal and others picked it up over the weekend; maybe we’ll eventually see some Wall Street economists take notice.  The April Non-farm Payroll Report showed a 278,000 increase in the number of part-time workers, and there was a two tenths of an hour decline in the length of the average workweek.  Why is this happening now when ObamaCare does not take full effect until next year?  Because, under the law, the official metric of full-time head-count will be the average number of full-time employees in 2013.

Crack Open ObamaCare and Focus on a Single, Comprehensible Issue

According to the WSJ, some Republicans want to push legislation to correct this specific flaw in ObamaCare while others want to repeal the entire law.  I favor eventual repeal rather than reform; it is no more possible to “reform” ObamaCare than to unscramble an egg.  But Republicans would be smart to push a “Full-Time Employment Act of 2013” that repeals the “employer mandate” as a way station to full repeal.  Here’s why.

The liberal media loves the idea of ObamaCare in the abstract, as a comprehensive package that supposedly helps the poor and uninsured.  If Republicans push for immediate repeal they will be characterized as heartless ideologues who don’t care about “working families.” The GOP needs to crack open the package and highlight a single, specific element of the legislation that is egregiously exacerbating the single biggest failing of Obamanomics—weak job growth and high unemployment.

The political genius of Obamacare is that it is too humongous and complex and technical for voters and reporters to understand; as soon as you mention “guaranteed issue” or “community rating” or “insurance exchanges,” TV viewers’ eyes glaze over and they reach for the remote.  But the evil effects of the 30/50 rule are so simple and obvious that it has already been mentioned several times on the Sunday shows, by George Stephanopolous and Chris Wallace.  And the topic will reappear at the beginning of every month, when payroll employment figures are released.

By attacking this specific element of Obamacare, as a down payment on full repeal, Republicans can focus attention on the law’s many odious unintended side effects.  Republicans will align themselves with the interests of lower-income workers (many of them blacks and Hispanics) struggling to make a living in the real world, and against elitist bureaucrats and academic ideologues such as Paul Krugman, who ignores
all factors impacting employment other than fiscal policy.

Copyright Thomas Doerflinger 2013.  All Rights Reserved.

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The PETRR Principal: How to Compare Growth Stocks and Yield Stocks

Posted on April 30, 2013 by tomdoerflinger

Today’s Wall Street Journal points out that despite weak EPS growth Procter & Gamble commands a higher PE ratio than Google because it has a juicy dividend.  Investors reaching for yield are piling into high dividend stocks without paying much attention to their growth prospects or valuation. Current income is all that matters to them.  How should investors think about this? Should they go along for the ride and buy the boring-but-now-hot high yield stocks like PEP, PG, JNJ, ATT, etc., or the neglected growth stock that don’t pay dividends?  To set up an “apples to apples” comparison, I use the PE to Total Return Ratio (PETRR) calculated as follows:

PETRR = PE Ratio / (long-term growth rate + dividend yield).

It is not as simple as it looks, because assigning the correct long-term future growth rate requires a deep understanding of the company and the industry, which few people have. (Analysts tend to extrapolate the recent past, which is what made Apple shares look cheap at 680 and expensive at 480.)  Let’s apply the PETRR to three stocks: PG, a slow-growing yield stock; GOOG, a growth stock paying no dividend; and AAPL, which is making an abrupt transition from “growth” to “value”:

Procter & Gamble: The PE on calendar year 2013 EPS is 18.8 and the dividend yield is 3.1%.  I give it a growth rate of just 4% (which could be generous), because growth has been poor and probably won’t improve much. So the PETRR is 18.8/(4+3.1) or 2.65.

Google:  The PE is 18.2x, it pays no dividend and I assign a growth rate of 12% (equal to its recent growth of 12%) because the company has a great core franchise and a track record of making smart acquisitions and finding new ways to make money on the Web.  GOOG’s PETRR is 18.2/(12+0) or 1.52.

Apple:  The PE is 9.5x, the yield is 2.9%, and I think it can grow EPS 6% annually via new products, international expansion, and share buy-backs.  Obviously if new products are successful 6% growth could be way too low.  But conservatism is appropriate given the risk of margin compression in a commoditizing device market.  AAPL’s PETRR is 9.5/(6+2.9) or 1.07.

To put these metrics perspective, the PETRR for a diverse group of 40 stocks I follow is 1.3.  In that context PG is ridiculously expensive, AAPL is cheap, and GOOG is somewhat expensive but arguably reasonably valued given its superb position in the Internet economy.

The Next Mania?

PG’s sky-high valuation suggests the “search for yield” may be turning into yet another mania created by the Fed. Savers earning nothing on their CD’s are migrating to funds and ETFs stuffed with high-yield paper ranging from REITs to MLPs to junk bonds to high-yield stocks—without paying much attention to valuation or growth prospects.  What does this mean for stock selection?  I certainly would not indiscriminately sell high-yielding food, beverage, drug, and utility stocks; some are still reasonably valued, and the search for yield could go on for a long time.  But I would sell selected names with high PEs and mediocre fundamentals, such as PG.

Another implication: Investors should be searching for high growth companies that are being neglected because they don’t pay a dividend.  In a world of 4% nominal GDP growth and 1.7% bond yields, a company that really can grow 15% per year deserves a PE multiple well above 20x, but not many stocks trade at that level.

The Search for Yield Is Supporting Valuation Levitation

The willingness of investors to pay up for yield is clearly bullish for the S&P 500 as a whole.  The market tends to give investors what they want. If they want yield, they will get it – look at Apple’s 15% dividend hike last week.  This year S&P 500 EPS will be about $109 and DPS $35, for a payout ratio of 32%–very low by historical standards. Companies have plenty of room to raise dividends substantially, despite a weak global economy.

If we assume that, over the next three years, earnings grow a paltry 5% per year but the payout ratio rises from 32% to 38%, then S&P 500 DPS would grow 11% annually to $48 in 2016.  If the market’s dividend yield stayed at the current 2.2%, then at year-end 2016 the S&P 500 would be trading at 2400 (48/.022=2400).  That is not a forecast, but it is a potent illustration of why it is a mistake to expect stock prices to decline just because profits are uninspiring. It is why “valuation levitation,” which I have been correctly forecasting for many months, is likely to continue.

Copyright Thomas Doerflinger 2013.  All Rights Reserved.

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Pain Pay-off: Why Sequestration Is a Game-Changer

Posted on April 30, 2013 by tomdoerflinger

In the wake of the 1987 stock market crash, a wise and wily Wall Street executive told his troops “change only comes through pain and agony.”  By bringing a healthy dose of “pain and agony” to Washington, sequestration will introduce some sanity to the Federal budget.  It may seem modest to workers who have already endured years of pain in the corporate sector, but sequestration does alter the budgetary calculus.

Inside the beltway, consensus “thinking” has been:  “Everyone knows that the budget deficit is being driven by entitlements, not discretionary spending.  But we can’t cut entitlements because seniors vote, so we can’t cut Federal spending.”  The equally illogical corollary was, “We don’t need to set priorities; we’ll just spend more on everything next year.”

That all changed with sequestration.  Suddenly, the special interests that feed at the Federal trough—potent Democratic interest groups such as universities, government workers, scientists, and community organizers — are facing real cuts, relative to what they expected to spend.  They’re asking their rich Uncle Sam, “Why are you cutting my budget while leaving Medicare, Medicaid, and Social Security untouched?  My work is so much more important to the country than ever-expanding entitlement programs riddled with waste.”  The next step is obvious – entitlement reform.

Exhibit A is an open letter by Princeton University President Shirley Tilghman on “The Cold Wind of Sequestration,” which was published in the alumni magazine.  You can almost feel the pain as she denounces sequestration as:

…a bludgeon, subjecting both civilian and defense programs to indiscriminate reductions of roughly one trillion dollars over the next 10 years.  Not only does this approach unfairly target areas of spending that constitute only a third or so of the federal budget, it also fails to differentiate between programs we can reasonably curtail or eliminate and those that are essential to our nation’s future.  Among the latter are investments in higher education and fundamental research.  [emphasis mine]

“Curtail or eliminate” programs?  “Unfair” to leave entitlements unscathed?  She sounds more like Paul Ryan than Barack Obama (for whom just about every Princeton employee voted). A couple of things will intensify the pain.  This spring Republicans in the House will hold out for yet more cuts in return for raising the debt ceiling—one dollar of cuts for every dollar increase in the ceiling.  And yet another entitlement – Obamacare – starts to squeeze discretionary spending next year.  A military incursion in Syria or Iran could also be costly.

Look for universities and other interest groups on the left to discern the wisdom of setting priorities and putting a brake on the mindless, remorseless, unmanaged, automatic expansion of Medicare and Medicaid.  Everyone, including most Democrats, knows that their costs are inflated by fraud, unnecessary medical tests, lack of means testing, absence of price incentives, etc.  While I don’t deny that medical inflation is hard to control, there is plenty of low hanging fruit to be plucked once Democrats realize that Federal dollars are a scarce resource.  There’s also a straightforward Keynesian argument: unlike cuts in current discretionary spending, entitlement reform reduces the deficit gradually without cutting government spending in today’s weak economy.

Copyright Thomas Doerflinger 2013.  All Rights Reserved.

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Profits: Good Enough for “Valuation Levitation” to Continue

Posted on April 25, 2013 by tomdoerflinger

First quarter earnings look OK but not great and broadly consistent with Wall Street strategists’ expectation of $108 for S&P 500 EPS this year.  That’s bad news for bears who expect weak profits to derail the rally.  Despite mediocre profits, the “valuation levitation” we have been writing about for months should continue, because the stock market rally is not being driven by “better than expected profits” but, rather, by the fact that stocks are “too cheap” in an age of sub-2% bond yield.  It’s a replay of the 1980s.  Look for the S&P 500 to be above 1650 by the end of this year, which would imply a trailing PE ratio of just 15.2x, and a prospective dividend yield on 2014 DPS of 2.4%– attractive when the 10-year Treasury bond yields 2%.

Though CEOs are no more clairvoyant than economists, they do have an insider’s view of order books, customers’ psychology, and the state of the world economy.  Here are seven themes:

  • Europe’s recession is severe and there is little reason to believe it will end later this year.  Companies are already cutting forecasts for H2 2013 sales.  As we have often noted, the continent is plagued by structural problems going way beyond a dysfunctional currency.
  • The U.S. is chugging along, powered by housing, autos, and energy production.  But higher taxes, sequestration, weak exports and Obama’s anti-growth policies are keeping the economy stuck in second gear.
  • Emerging markets are fairly healthy but, unlike 2010 and 2011, are not strong enough to power many positive EPS surprises.
  • Capital spending is soft, to judge by the reports out of IBM, Accenture, Caterpillar, the big Telcos, and others.  This does not bode well for hiring by large firms.
  • Despite the headwind of a strong dollar, many “defensive” companies in consumer staples and healthcare have come through with decent earnings, including Coke, Pepsi, JNJ, Abbot, Baxter, Philip Morris, KMB, etc.  Declining commodity input costs help.  (This does not mean they are necessarily great stocks to buy at today’s lofty PE multiples.)
  • Companies have become very good at scratching out modest profit growth in a weak macro environment via restructuring, acquisitions, share buy-backs, cost-cutting, and modest organic growth. Profit bears (such as Bill Gross and sundry Financial Times pundits) have been worrying for years, if not decades, that profits’ share of national income was “too high” and would decline as wages rebounded and margins were squeezed.  It will happen eventually, but maybe not any time soon.
  • In this tepid environment, there are not many fast growing markets, or large companies with solid double-digit revenue growth.  Exceptions are U.S. housing, on-line advertising, biotechnology (if you have the right drugs), fracking, and a few exceptionally well-positioned consumer companies—think EBAY, GOOG, GILD, SBUX, etc.

Weak Commodity Prices—Negative for Profits Short-term, but Positive Long-term

For this year lower prices for oil, copper, and other commodities are bearish for profits, because they shift national income from companies to consumers—when oil prices drop ExxonMobil earns less but Jane Doe spends less at the pump.  But although it may take a dollar or two off of 2013 S&P 500 EPS, the recent drop in oil prices is positive in that the consumer relief allows the economy to keep growing; it cuts the risk we will tip over into recession.  Thus weak commodity prices increases the probability that profits will keep growing in 2014 – which is more important to investors than whether profits this year are $107 or $110.

The drop in oil prices is positive for airlines and broadly positive for consumer-oriented companies (particularly vendors of commodity-intensive products such as soap), both because their customers have more discretionary income and because input costs decline.  The profit impact is not huge but does help companies like P&G “make their numbers” in a soft economy. In addition to energy producers, lower commodity prices hurt industrial companies that supply compressors, trucks, graders and other equipment to energy and mining companies.

Copyright Thomas Doerflinger 2013.  All Rights Reserved

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Jews Against Free Speech

Posted on April 16, 2013 by tomdoerflinger

On Sunday we drove down to a synagogue in Edison, NJ to hear a talk by Pamela Geller, a controversial anti-Jihad activist.  I counted four police cars outside because the Rabbi had received death threats and someone shot pellets at his garage door. He has been attacked previously. Geller had been scheduled to speak at a synagogue in Great Neck, Long Island but was disinvited, according to the Great Neck synagogue, because of “legal liability and potential security exposure of our institution and its member families.  In an era of heightened security concerns it is irresponsible to jeopardize the safety of those who call Great Neck Synagogue home, especially our children, . . . “

That is pathetic.  The synagogue caved in to the forces of political correctness to prevent its members from hearing Geller’s views on Sharia law. There are two possibilities. Either the leadership of the Great Neck synagogue was lying, and there was not really any “potential security exposure”—it just didn’t want to take the heat of sponsoring a controversial speaker—or, on the other hand, there was indeed a security risk, in which case Geller’s warnings about the “Islamification of America” are correct.  Neither possibility is acceptable.

Like a well trained poodle, the mainstream media – CBS, the Star Ledger, News 12, etc. — unthinkingly side with the apostles of political correctness.  They ignore the simple, crucial distinction that Geller makes between coercive, violent Jihad—the ideology that brought down the twin towers, bombed subways in London and Madrid, led to a massacre in Fort Hood, planted a bomb in Times Square, etc.  – and the religion of Islam, most of whose adherents are nonviolent. Reporters gravely note that the Anti-Defamation League and the Southern Poverty Law Center have branded Geller’s organization a “hate group,” which is like reporting that Starbucks thinks two cups of coffee in the morning are better than one.  The ADL and SPLC are in the hate group business; the more the merrier. No need to grapple with complicating complexities, such as the fact that the jihadists Geller criticizes systematically oppress  women and gays, Jews and Christians. (If they had been around in the 1830s, ADL and SPLC might have branded William Lloyd Garrison’s American Anti-Slavery Society as a “hate group” that vilified southern whites.)

A Great American and His Dead Son

The first speaker on Sunday was Gregory Buckley Senior, whose son, Marine Lance Corporal Gregory Buckley Junior, was murdered in Afghanistan last year.  In a moving and courageous speech Mr. Buckley made a very convincing case that the U.S. should withdraw all troops from that country as soon as possible, if not sooner.  Our troops there are treated as second class citizens who are not permitted to possess their weapons when they sleep and at other times of the day.  Greg Jr. wrote his father several prescient letters predicting his own murder, which was carried out by a sixteen-year-old while Greg and his buddies were lifting weights (weaponless) in a gym.  It has been obvious for at least a couple of years that U.S. troops can achieve nothing positive in Afghanistan and should be brought home. Back in the autumn of 2010 I heard that point persuasively made by Bing West in a lecture, complete with video of fire fights he had been in a couple of months previous.  Neo-cons like Bill Kristol who talk about victory in Afghanistan are misguided.  Greg Buckley Sr. states that, because he has spoken out against our pointless presence there, the Pentagon has failed to provide a full report of his son’s murder in a timely manner.

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Q1 Profits: Soft, but Good Enough for Further Valuation Levitation

Posted on April 9, 2013 by tomdoerflinger

The media does a terrible job of covering profits.  Here are a few tips.

First, forget about the percentage of companies beating consensus, which is always way above 50% because companies guide estimates to a number they can beat. (Some managements get mad at analysts whose estimates are too high.) Even when profits are collapsing there are “more beats than misses.”  It’s meaningless.

The real question is whether Q1 results and Q2 guidance are good enough to convince investors 2013 S&P EPS will be around $108.  That’s bullish, even though it would imply profit growth of just 4%.  The analysts’ Q1 bottom-up consensus is now $25.75 which should rise during earnings season (because of all those “positive surprises”) to around $26.50.  If you just annualize that (multiply by four) you get to $106.  But the first quarter is seasonally weak, so you need very little growth during the rest of the year to get to $108.  Currently the bottom-up estimate is $111.50, so estimates can fall a bit over the next three quarters and we’d still get to $108.  Investors already know analysts’ estimates are “too high,” so modest estimate cuts are not bearish.

What It Means for Stock Prices – “Valuation Levitation” to Continue

Isn’t “below normal” growth of 4% or 5% profit growth bearish for stock prices?  No, not at all, because stocks are not trading on near-term profits.  As I have discussed ad nauseam, we are in the middle of a “valuation levitation” where investors are gradually, belatedly, begrudgingly, unenthusiastically pricing in the reality that stocks offering 2% yield and 10% annual DPS growth are too cheap relative to cash, bonds, commodities, hedge funds, and vintage baseball cards. So PE ratios are rising.  PE expansion and modest profit growth is a potent combination. If profits rise 4% and the PE rises from 13x to 15x, stock prices rise 20%.

Back to the Future—Weak Profits, Strong Stock Prices

We’ve been here before. Don’t forget that during the valuation levitation of the 1980s profits were poor.  Looking at S&P 500 GAAP EPS on a rolling four-quarter basis, they peaked in the fourth quarter of 1984 at 16.64 and then, during an industrial recession caused by a super strong dollar, profits declined 13% to 14.52 by first quarter 1986.  They did not hit a new high until the fourth quarter of 1987.  But despite these punk profits (far worse than today), stock prices rose 48% between year-end 1984 and year-end 1987.  That should scare any strategist arguing that today’s moderate profit growth will crater stock prices – especially when dividend growth is much faster than profit growth.  (In Q1 dividends rose 12% yr/yr.)

The biggest risk to profits is Europe, which accounts for about 15% of S&P profits.  (A precise figure does not exist.)  Companies and analysts have been assuming Europe’s economy will recover in the second half, but that is looking less and less likely.  Quite a few multinationals in such areas as technology, industrials, chemicals, beverages, food, healthcare, and consumer discretionary will be shaving guidance on weakness in Europe.

Stockman Psychosis—a Bullish Sign

You have to hand it to David Stockman.  He has grabbed a second “15 minutes of fame.”  ABC, NBC, NPR, CSPAN, Bloomberg—he is more ubiquitous than the GEICO gecko.  Peddling insights like, “Let’s go back to the good old days of the 19th century, with the six-year depressions” and “Nothing bad would have happened to the U.S. economy if Goldman Sachs, Morgan Stanley, Merrill Lynch, Citigroup, AIG, and sundry giant European banks had been allowed to go bankrupt.  The rest of the banking system was in fine fettle.” The eagerness of the mainstream press to ingest these pearls of wisdom shows how skeptical the public is about the sustainability of the Obama quasi-recovery.  This pervasive skepticism constitutes the Wall of Worry that stock prices will climb over the next couple of years.

As an aside, Stockman equates the “stock market bubbles pumped up by the Federal Reserve” in 2000, 2007, and 2013.  For the record, the PE ratio of the S&P 500 at the peak of these supposedly equivalent bubbles were 26.3x, 16.8x, and 14.8x.  The 25-year average of this valuation metric is 18.1x.  No matter, if the Fed is easing it must be a “bubble.”

Copyright 2013 Thomas Doerflinger.  All Rights Reserved.

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Stockman’s Scary Sundown – Five Lessons for Long-term Investors

Posted on April 2, 2013 by tomdoerflinger

If you want to know why, for most people, their house is a better investment than stocks, read David Stockman’s New York Times jeremiad “Sundown in America.”  It is alarming articles like this that convince investors to avoid buying stocks until they have climbed a lot and look “safe” — and then to sell them during recessions after they have plunged in price. The result is terrible long term performance.  Call it the “liquidity trap.”  People don’t sell their home during a recession because it is illiquid and they need a place to live.  Stocks, by contrast, are easy to buy near the top and sell at the bottom.

Stockman’s article is full of mistakes.  For example, “the Fed’s unforgiveable bailout of the hedge fund Long-Term Capital Management” never happened.  Wall Street firms, not the Fed, provided liquidity to unwind the fund, and the original investors lost all their money. Another mistake: he forgets that debt/GDP accelerated in the 1980s because inflation and therefore nominal GDP growth—declined.  Obviously disinflation was positive, not negative. But Stockman’s scary sundown story is instructive nonetheless because its omissions and distortions illustrate five important lessons for long-term investors:

The “Good Old Days” sucked too.  Stockman portrays the century before 1980 as saner and safer because debt / GDP averaged just 160%, versus 350% now.  Alas, according to the National Bureau of Economic Research, there were 24 “contractions” (recessions or depressions) during that century, so the economy was contracting a third of the time. Believe me, the “good old days” did not seem so good to investors during the financial panics and wars of 1893, 1907, 1914, 1921, 1929, 1937, 1945, 1950, 1970, 1974, and 1981.

Stocks Can Survive Government Mismanagement.  According to Stockman the “sundown” started in 1982, when debt growth accelerated and the U.S. fell into a hopeless abyss of crony capitalism.  Nevertheless since 1982 stock prices have climbed 1,302% (8.9% CAGR) while paying an average dividend yield of 2.6%.  The 2013 dividend represents a 31% yield on the March 31, 1982 price.  This is a disaster you can retire on.

S&P Is Not GDP   Stockman claims today’s “bubble” was inflated by Fed liquidity “rather than real economic gains.”  Wrong; earnings have climbed as much as stock prices since 2009, as detailed in our latest post.  More broadly, the woes of the “main street economy” are not strictly germane to equity investors, who mainly own giant multinationals which are faring much better than small business because:  A)  instead of being hurt by the Internet, giant firms build, own, and operate the web;  B) they have high exposure to fast-growing emerging markets;  C) they have more capital equipment per worker, and therefore higher labor productivity and faster productivity growth; D) they are better able to fight through Washington’s reams of red tape; E)  they have excess capital and cash flow, permitting share buy-backs and acquisitions.  These factors account for strong recent profit growth despite a weak U.S. economy.

The Financial Economy is not the Real Economy  Stockman gleefully details the misadventures of Wall Street without mentioning the extraordinary achievements of other industries – the Internet, the fracking revolution, the railroad renaissance, biotech’s transformation of healthcare and agriculture, or the rise of potent consumer franchises such as Wal-Mart, Costco, McDonalds, Nike, Starbucks, Panerra, Amazon, and Wynn Resorts, to name a few.

Known Risks Are Less Dangerous.  After a tedious tour of five decades of financial folly, Stockman gets to his main point: “when the Fed….even hints at shrinking its balance sheet, it will elicit a tidal wave of sell orders” in the bond market.   In contrast to the housing bubble, everyone—even the Fed—knows this is a risk and will behave accordingly.  As noted in my last post, the stock market is not assuming bond yields stay at 2% forever.  In fact a bond bear market could scare some money into equities, which are more reasonably valued than bonds.

Macro Policy Is Improving

Stockman studiously ignores the good news. Belying Keynesian orthodoxy, GDP is accelerating despite the tax hikes and sequester because House Republicans have put Obamanomics on hold.  Obama’s warnings that modest spending cuts would spell disaster look ridiculous to workers in the real world beyond the Beltway who have endured five years of austerity.  Washington is finally considering policies that would actually boost growth, such as immigration reform, entitlement reform, and tax reform.  Eventually Obamacare will be reformed because it is unworkable and unpopular.

Bottom Line

Buy and hold is difficult and unfashionable, but it works.  It works even better if you use dollar cost averaging and avoid dumb fads, such as energy stocks in 1979, biotech stocks in the early 1990s, tech stocks in the late 1990s, and housing stocks in 2007.  The dumb fad to avoid now, after stocks have gone nowhere since 2000 and look, at worst, reasonably valued while economic growth and economic policies are improving, is Stockman’s Scary Sundown.

Copyright 2013 Thomas Doerflinger.  All Rights Reserved.

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Not a Bubble; Earnings Are Rising Nicely

Posted on March 27, 2013 by tomdoerflinger

Stocks are behaving as I expected.  On Jan 18 I highlighted “valuation levitation,” writing “the market senses that, with rates so low and dividends set to keep growing, investors could decide that stocks deserve a materially higher valuation despite slow economic growth, recession in Europe, Barack Obama in the White House, etc.”  On March 6 I noted, “We may well exceed the current year-end targets of bullish strategists, of around 1600.”  Since then four or five strategists have raised their targets. When the bears finally capitulate and raise targets, it may be time to take some profits.

Inexpensive versus 2004-2006, When Rates Were Much Higher

I keep hearing pundits gravely declaim that we are in a “stock market bubble” engineered by the Fed.  They are dead wrong.  Stock prices are up a lot, but so are profits.  Since the end of Q1 2009, stock prices are up 94% but profits are up 88%.  Valuations are very reasonable and still lower, by 1 or 2 PE points, than their 2004-2006 average:

  • The S&P 500 PE on trailing pro forma EPS is 14.9x versus a 2004-06 average of 16.9x.
  • The S&P 500 PE on forward pro forma EPS is 14.0x versus a 2004-06 average of 15.1x.

The average 10-year Treasury bond yield, 2004-2006, was 4.5%, or over twice current levels.  So investors are not valuing stocks as though yields will stay at 2%, which means that when yields rise there is no reason for stock prices to fall.

Plus ca change, plus c’est la meme “jobless recovery”

The misperception that we’re in a stock market bubble is understandable because: A) Bernanke has cut short rates to zero and is aggressively buying bonds,  B) Stocks are doing well while the U.S. economy has 7.7 % unemployment.  This situation seems weird but is actually normal.  Back in 2009 we correctly predicted that we were likely to have yet another weak “jobless recovery” made worse by Obama’s regulatory onslaught, but stock prices would rise nonetheless, with everyone wondering why profits and stocks were rising when the economy was weak.  So it has come to pass.

We are in a replay of the “jobless recoveries” that followed the 1991 and 2001 recessions, when unemployment was distressingly high for extended periods, the Fed drove short rates to surprisingly low levels, but profits recovered and stock prices soared.  Economists should do more research on why, starting with the 1991 recession, employment has been so slow to recover.  One factor is globalization; during recessions companies cut costs by shifting operations overseas, so when demand recovers it is met with production in China and Mexico, not Ohio and Illinois.

Profit Scorecard—Bottom-up versus Top-down

You need a scorecard to follow Wall Street’s take on profits.  The Street has two estimates of S&P 500 EPS —  the “bottom-up” estimate reflecting analysts’ estimates for 500 individual firms, and the “top-down” estimate of strategists, which is based on macro variables.  It is widely assumed on the Street that analysts are too bullish and, as the year progresses, will cut their estimates toward the strategists’ top-down figure.  Because it is generally assumed the bottom-up number is too high, it is not bearish if it gradually declines.  Currently the U.S. economy is doing better than expected, and the bottom-up estimate is trending lower from $115 six months ago to below $112. Meanwhile strategists are raising their numbers modestly, to $108-110, implying profit growth this year of around 5%.  If we hit that figure and profits look set to grow again in 2014, it will be positive for stocks.

Positive Message from the Early Reporters

A few years ago we started to analyze results of companies that report earnings in the third month of the quarter; these “early reporters” provide clues as to how good or bad the upcoming earnings season will be.  Now several Wall Street firms monitor early reporters.  (Thanks for the imitation; I’m flattered.)  What the early reporters reveal now is that Q1 earnings reported in April will be fine but not super-strong.  Fifteen major firms reporting over the last couple of weeks divide into three groups:

  • Five (Costco, Nike, Discover Financial, Adobe, and Dollar General) had genuinely strong results.  My takeaway: the U.S. consumer is in decent shape despite the tax hikes.
  • Three (Oracle, FedEx, and Jabil Circuit) were quite poor.  However, two reflect problematic business models, not weak demand. Oracle is losing share to cloud-based software providers and FedEx is hurt by customers opting for slower but cheaper shipment methods.
  • Six were basically in line with forecasts—Factset, Williams-Sonoma, Lennar, Tiffany, Darden, and KB Home.

These results and decent U.S. macro data suggest that first quarter profits, and guidance for the second quarter, will be reasonably good.  But with the dollar strengthening and Europe’s recession hurting multinationals, results will be only good, not great.

Not Straight Up; Beware Euro-pain

I have no opinion on near-term stock prices.  Consult your local astrologer.  But after a big move up investors have big profits to protect, so a 5% dip could occur at any time.  As I have warned in the past,  the most likely trigger is Europe, where we see an ever wider and more dangerous chasm – between jobless voters in Portugal, Spain, Italy, Greece and now Cyprus (can France be far behind?) and a bumbling, disjointed, fragmented elite in Brussels and Berlin that is focused on austerity and political integration, not economic growth.

Copyright 2013 Thomas Doerflinger.  All Rights Reserved.

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Letter from London

Posted on March 20, 2013 by tomdoerflinger

It’s a little weird.  Central London is booming.  Fancy restaurants are packed on Tuesday night.  Puny Chelsea townhouses sell for $8 million.  Tourists throng Picadilly and Regent Streets.  Chippendale mahogany and Tudor oak sell briskly at the BADA antiques fair.  You’ll find more Italian shops in the Knightsbridge fashion district than the Piazza della Republica.  Chic Sloane Rangers and their immaculately clad kids, walking to school past ornate Victorian mansions, look like they stepped out of a Ralph Lauren ad – all they need is polo mallets and an Irish setter.

But, back in the hotel, the telly tells a different story.  On BBC and CNN it’s all gloom and doom—talk of a triple dip UK recession, intractable budget deficits, a bond rating downgrade by Moody’s, the Tories “staying the course” with politically suicidal fiscal austerity.

Why the Disconnect?

To some considerable extent London is more tied to the global than domestic economy.  It attracts tourists from around the world.  Capital flight from France, Russia and the Middle East supports real estate values and high-end consumption. Many multinational companies select London for their EMEA (Europe, Middle East and Africa) headquarters because of its convenient time zone, propinquity to Africa and the Middle East, historical ties to emerging markets (imperialism’s afterglow), sophisticated financial system, and appealing lifestyle (weather notwithstanding). As an extra double bonus, the lingua franca of global business is English, and Britain doesn’t use the Euro.

But if London, which constitutes a big slice of the UK economy, is booming, then why isn’t the overall economy doing well?  To read the Financial Times and New York Times, it’s all about misguided fiscal austerity.  Rather than revisit that tired topic, consider some other factors weighing on growth.

  • If you scrutinize the specific components of GDP, the weakest is not government spending but exports; a depressed Europe is not buying as much stuff from Britain.
  • Two long-time growth drivers are fading:  North Sea oil (reserves are running down) and financial services (10% of UK GDP).
  • The financial sector’s problems are exacerbated by ruinous regulations coming from the European Union, including a cap on bonuses at 100% of salary (200% with the okay of shareholders) and a transaction tax.  Singapore and Hong Kong, here we come!
  • Lending to small business is weak because the UK is dominated by a few giant banks, two of them partially owned by the government, that are under regulatory pressure to delever.
  • Consumers are overburdened with debt after 25 years of borrowing to buy costly real estate in a crowded country.
  • Over-regulation.  If you listen to Parliamentary debates, there seems to be a government “scheme” for everything – a “funding for lending scheme,” a “back to work scheme,” a “solar scheme,” plus schemes to reduce drinking, police the media and create apprenticeships.  One failed scheme is an energy policy emphasizing costly and erratic wind and solar at the expense of coal, which is hurting real growth and depressing living standards by raising inflation.

Why Should We Care?  It’s Not All About the Euro

For investors a basic question is:  How much of Europe’s economic malaise can be attributed to a dysfunctional currency, and how much to structural problems such as adverse demographics, excessive government spending and regulation, and a misguided energy policy?  The case of Britain suggests that structural problems are critically important. After all, Britain does not have the Euro and benefits from London’s prosperity, and yet the economy languishes.  Some of the weakness can be attributed to cyclical problems (such as consumer debt) that should correct over time, but the structural problems are deep-seated and impossible to solve without a lurch toward economic freedom that seems unlikely.

Which makes it hard to be bullish about a European economic revival—particularly because debt phobia prevents Germany from doing its part. While the Eurozone desperately needs a step-up in demand from its solvent “locomotive,” Germany is rushing to balance its budget ahead of schedule even though it is under-investing in infrastructure to the point that the Kiel Canal (which links the Baltic and North Seas and is said to be one of the most heavily trafficked canals in the world) was shut down recently because two locks broke due to inadequate maintenance.  The truth is  that you can’t have currency integration without financial, fiscal, political and social integration, and Europe is not there yet—not even close.

Copyright 2013 Thomas Doerflinger.  All Rights Reserved.

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Valuation Levitation Continues

Posted on March 6, 2013 by tomdoerflinger

As we expected, stocks are rising.  Here are key themes to remember, which we have discussed before:

  • Stocks are rising because they are attractively valued versus bonds and cash, and investors are more confident we won’t have a financial disaster.  S&P EPS this year will be about $108 and the average trailing PE in recent decades has been around 16.5x, implying a year-end price of 1782.  No, we probably won’t get that high, but we may well exceed the current year-end targets of bullish strategists, of around 1600.
  • The U.S. economy is doing fairly well, to judge from important indicators like the ISM indices, auto sales, and the housing market.  But employment will lag because Obama has done so many things (notably Obamacare) to discourage hiring.  Don’t listen to Keynesians using single-variable models who claim weak hiring reflects weak demand.
  • As in the mid-1980s, this rally is being driven by PE expansion, not earnings.  The fact that earnings are rather weak (but not disastrous) does not matter when stocks are so cheap relative to bonds and cash and investors are becoming more confident we won’t have a financial disaster (the main reason to own bonds).
  • Corporate America has rarely beeing  better managed and more share-holder friendly, which supports PE ratios.
  • As we warned, the problems in Europe continue to be severe because the real economy is in terrible shape despite Draghi’s efforts to support the financial economy.  Elites in Brussels, Frankfort, and London may be happy, but citizens in the real world are not, which is why Grillo got 25% of the vote in Italy.  I am suspicious that Europe will start to grow soon, given its anti-growth policies and dysfunctional currency arrangements that prevent weak economies from devaluing.
  • A pleasant surprise is U.S. politics, where Republicans have been out-playing Obama for a change.  By calling his bluff on sequester, they have focused attention on the specific absurdities of the Federal budget.  For the first time, the media is asking why we have to have many troops in Germany, Korea, etc., and why we have so many overlapping programs.  Interest groups burned by sequester (like academics) may start to appreciate the need to reform entitlements.  Obama is wrong-footed and trying to figure out how to make a deal with Republicans, which will be difficult after he arrogantly dissed them for the last couple of years.  His effort to blame Republicans for a law he conceived of and signed into law, and his effort to turn sequester spending cuts into tax hikes has undermined his credibility.  (The notion that the sequester could involve tax hikes is particularly absurd because it was inspired by the 1980s Gramm Rudman legislaton, where sequester was very clearly about spending cuts, not tax hikes.  If you don’t believe me, just google “Gramm Rudman Sequester.”) Budgetary fisticuffs will tie Obama down until this summer.  Meanwhile budgetary sanity is gradually being forced upon Washington by the adults in the Republican party.
  • The best kept secret on Wall Street is dividend growth.  Major companies like QCOM and HD (which I own) are growing dividends 30-40%.  SPX DPS this year will grow over 10%, which is very attractive in a 4% nominal GDP growth world.  Investors should buy high quality companies with good dividend yields (2% or more) and dividend growth.  There are plenty of no-load mutual funds containing these stocks.
  • We will get a “correction,” and a mishap like a war with Iran is always possible, but U.S. stock prices are headed signfiicantly higher over the next couple of years.
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