Revisiting My Bullish Thesis from August 2011

Two years ago, in August 2011, I joined the head of our bond area on a conference call that was broadcast to employees in my company.

The call was more popular than the organizers expected; shortly after we began our broadcast we received word via email that the phone system had crashed.  Still, a good portion of our fellow employees were able to hear our remarks.

At the time, the economic recovery which had began in June 2009 was showing signs of slowing, and the stock market was off about-5% for the first 7 months of the year.

As it turned out, however, we were on the verge of an explosive rally.  In the two years since our call, the S&P has climbed from just over 1250 to 1700 - a gain of +36% in just 24 months.

Two years ago I was one of the few bullish investors in my company.

As I recall, the problem was largely what behavioral scientists call "recency bias", or a tendency to predict the future based on what has happened most recently in the past.

For the 10 years prior to August 2011, stocks had been largely disappointing. 

After trading as high as 1550 in the middle of 2000, the S&P 500 stocks had stumbled badly in the next decade, most notably a -25% sell-off in the first quarter of 2009.  You were not much better off 10 years later if you had bought stocks in August 2000.

The lessons that most (younger) investors took from the market's action was that stocks were largely a trading vehicle, but bonds were the only place for longer term investments.

I have not been asked to do another call (fame can be so fleeting!) but with the market hitting record highs I thought I should revisit my bullish thesis from 2011, and see what changes I should be making in my investment thinking.

Here's an excerpt from a piece titled "Notes on the Market" I wrote on August 11, 2011 (I used the notes for the conference I mentioned earlier):

Here's why I think investors should be sticking with stocks:
1. The economic fundamentals are OK, even if recent data is pointing to a slowdown. For example, the Leading Economic Indicators (LEI) has risen almost without interruption since March 2009, according to Ned Davis Research, even though it has slowed in recent months. Other data points would include last week's employment report, which showed some modest improvement in job creation;
2. As I wrote on Monday, there have been 93 corrections of 10% or more since the beginning of 1928, according to Ned Davis. In 25 cases, those downturns turned into full-fledged bear markets, defined as a decline of 20% or more. Put another way, the historical odds suggest that 73% of the time corrections do not turn into long bear markets. With interest rates low, and corporate profits robust, it seems that a prolonged bear market is less likely;
3.Bloomberg indicated this morning that insiders (i.e. company executives) have been buying stocks at the highest rate since March 2009, when the S&P 500 hit a 12-year low. As former money manager Peter Lynch once observers, insiders can sell the stock of their companies for lots of reasons, but they only buy for one reason: to make money;
4. Three-quarters of the companies in the S&P 500 beat earnings expectations in the second quarter. True, guidance for future earnings was muted, but this too would be expected given the current market volatility;
5. The Fed just announced on Tuesday that short-term interest rates would remain at 0% for next two years. If you don't need to make any money, and are worried about the world, then banks are a good alternative. Otherwise you are going to have invest somewhere;
6. Bond yields are puny. Are you really going to invest your retirement assets at less than 1% for the next 5 years or so? Really?;
7. Unlike 2008, credit conditions are very accomodative. A recent survey of small business owners said that 93% reported no trouble in getting necessary credit. Coporate bond yields continue to hit record lows;
8. Corporate America is flush with cash - nearly $2 trillion worth. The Fed's move is try to make holding this cash "painful" so that managements will invest in new plants and create jobs. These funds can also be used for M&A activity;
9.JP Morgan indicates that the after-tax dividend yield on the S&P 500 is 12 basis points higher than US Treasurys. This is the first time this has happened since 1962. If you need income, stocks are the better alternative;
10. Valuation of stocks is attractive. The S&P 500 is trading at 12.3x trailing 12 month earnings, compared with its average since 1954 of 16.4x, according to Bloomberg. 


http://randomglenings.blogspot.com/2011_08_01_archive.html


So what has changed now?

I was struck when I looked at my list at how many of the bullish factors I discussed two years ago remain intact.

True, the valuation of the S&P is no longer at rock-bottom levels, but it still remains below the historic averages.

Interest rates, meanwhile, have moved higher since the lows in 2012, but interestingly they are basically back to the same level as two years ago:

 


I thought then, and continue to believe now, that bonds offer little appeal for longer term investors.

While there is much discussion about when the Fed might reduce its presence in the credit markets, no one believes that short maturity interest rates are headed much higher any time soon, regardless of who is named the new Fed chairman.

In short, bonds and cash still do not stack up well relative to stocks.

Corporate earnings have also continued to surprise on the upside.  Company managements have been cautious on their outlook for the remainder of the year, but in my opinion this is now the way the game is played:  set low expectations, and any reasonable results will be viewed favorably.

I am not wildly bullish, by the way.  I recognize that any time you have a strong market rally there is usually the tendency for a market "correction" of -5% to -10%  along the way.

But until the factors I first listed in August 2011 change significantly, I would stick with a full allocation to stocks.

Welcome to the Depressing Future?

Yesterday's report that the U.S. economy expanded by +1.7% in the second quarter was largely greeted as "good news" by Wall Street.

Here's an excerpt from what the New York Times reported this morning:

The mixed picture facing the country was evident on Wednesday, as the Commerce Department reported that the economy, adjusted for inflation, expanded at a better-than-expected annual rate of 1.7 percent in the April-June quarter, even as inflation-adjusted growth in the first part of the year now appears slower than first thought....

Optimists point to improved levels of job creation in recent months, a more robust housing sector and a surging stock market that has lifted the value of investment and retirement accounts for millions of consumers. Pessimists focus on the fact that the estimated economic growth rate of about 1.4 percent so far in 2013 is well below last year’s levels of 2.8 percent, even as automatic cuts in federal spending and higher taxes continue to bite. 

http://www.nytimes.com/2013/08/01/business/economy/us-economy-grew-by-1-7-in-2nd-quarter-faster-than-expected.html?ref=todayspaper

We are now in the fourth year of an economic recovery that started in the summer of 2009.  However, real wage growth remains non-existent for a large part our country, and the unemployment rate hovers at levels (7.6%) that would have been unacceptable a generation ago:
 

 The growth of real GDP remains depressed, and has never reached the levels seen in the 1990's; note the general decline in the following chart:




Many analysts blame today's subdued growth rates on the large amounts of debt accumulated in the past decade.  Growth will remain depressed until this debt burden is reduced, they argue, but will once again return to previous levels once more funds are flowing back into investment rather than debt repayment.

Others blame Washington's obsession with deficit reduction, and are urging a new round of government fiscal expansion. Austerity policies are killing the economy, in this view.

But there is another more depressing possibility: Perhaps there are structural reasons that the growth rates that were experienced over the past couple centuries were historic anomalies, and that we are not likely to return to robust (+4% or higher) growth rates for decades.

In this view, there is nothing that any policy changes can do to alter the subdued future.

An aging population, coupled with declining birth rates in many industrialized countries, could be the real culprit for anemic growth. If this is the new reality, no amount of government intervention can make a material difference in the economy.

That's the suggestion that Robert Gordon, a well-respected economist from Northwestern raised in a paper published last year.  The story was picked up by New York Magazine last week.

I hope Gordon is wrong, of course, but this is not another wild-eyed pessimist calling for doom-and-gloom.  Instead, Gordon argues that for much of human history economic growth was fairly minimal.  It was not until the industrial revolution beginning in the 1840's that any significant changes in the human condition occurred.

Subsequent improvements in the global standard of living followed technological breakthroughs. The discovery of ways to distribute electricity, for example, completely changed society, as activities no longer had to be structured around sunlight.

More recent technological innovations have been exciting, but not "game changers" when it comes to the way that most of us live our lives.  Air conditioning may make summers more bearable, but they do not appreciably change our lives in the same way that improvements in public health facilities once did.

I could go on, but here's an excerpt from the New York article:

Then two things happened that did matter, and they were so grand that they dwarfed everything that had come before and encompassed most everything that has come since: the first industrial revolution, beginning in 1750 or so in the north of England, and the second industrial revolution, beginning around 1870 and created mostly in this country. That the second industrial revolution happened just as the first had begun to dissipate was an incredible stroke of good luck. It meant that during the whole modern era from 1750 onward—which contains, not coincidentally, the full life span of the United States—human well-being accelerated at a rate that could barely have been contemplated before. Instead of permanent stagnation, growth became so rapid and so seemingly automatic that by the fifties and sixties the average American would roughly double his or her parents’ standard of living. In the space of a single generation, for most everybody, life was getting twice as good.

At some point in the late sixties or early seventies, this great acceleration began to taper off. The shift was modest at first, and it was concealed in the hectic up-and-down of yearly data. But if you examine the growth data since the early seventies, and if you are mathematically astute enough to fit a curve to it, you can see a clear trend: The rate at which life is improving here, on the frontier of human well-being, has slowed.

http://nymag.com/news/features/economic-growth-2013-7/?mid=longreads

There are numerous investment implications if Gordon is right.

It is widely assumed, for example, that interest rates will spike higher once the Fed begins to "taper" its presence in the credit markets.  However, an aging population with a need for fixed income in retirement may continue to keep interest rates lower than the levels seen during more robust growth periods. What if rates stay below 3% for years to come?

The growth companies of the past were companies who offered goods and services to a growing and dynamic population.  However, while there has been no lack of retailing activity, retailing companies themselves are struggling, as more of shopping is done on-line.  Just look at how few of the companies in the consumer discretionary space in the S&P 500 are growing revenue at reasonable growth rates.  And shopping malls - once a mecca of suburban activity - are seeing dramatically lower traffic levels, or are even going out of business.

Worth a read if you have the time.