Posted: May 11, 2012
Economic hope springs eternal
But don't expect any market highs in 2012By KC Mathews
The other day, a friend of mine asked me when the stock market might test its high water mark, which was set in October 2007. The question is understandable given the
robust performance of the domestic equity markets in the first quarter of 2012—and given, the market is currently only 13 percent away from that 2007 high.
We think the following five things need to happen for us to see a new high:
• Economic growth over 3 percent
• A period of multi-year double-digit earnings growth
• Price/earnings multiple expansion
• A workable plan in Europe
• Fiscal certainty here in the U.S.
Therefore, we believe the probability of the U.S. equity markets setting a new high this year is relatively low. The question does, however, warrant a closer look. In the last 12 years, the market has developed two “tops,” one in March 2000 and another in October 2007.
Review of the macro conditions around those time periods reveals that there were some similarities to our current environment as well as some notable differences. History reveals a bit of a mixed message. There are certain facets of the current economic environment that are more favorable than in 2007.
Our economy is growing at a more robust clip, and we expect GDP to be up 2.5 percent this year. The Federal Reserve is more accommodative with historically low rates and valuation (based on price/earnings multiples)at 13 times earnings is much more attractive. Global economic headwinds continue to limit expansion by curbing consumer confidence and preventing the market from moving higher.
The global economy is a complicated puzzle; consequently, the lesson here is that no singular variable independently drives stock prices. After 27 weeks of stronger U.S. economic data, we are starting to see a pause. The stock market followed suit and launched a significant march higher starting in October 2011.
There is an old adage on Wall Street, “Invest until May, and then go play.” Given the robust economic data and the rally in the market, this adage may once again come to
fruition. All things considered, we don’t believe the market will establish a new high this year primarily because of employment and housing issues.
Recent employment data indicates that the economy is healing. However, given the very modest pace of the recovery, we believe the data supports our claim that the market will not re-test its old highs. The trend is very positive, but it’s the trend and the level that ultimately determines outcomes in the financial markets.
The trend alone is very important in the political arena, and improving trends (regardless of the level) could keep the incumbent in the White House.
Recently the newspaper ran an annual insert called, “What People Earn, Then and Now.” Perhaps it’s human nature, but I’m always interested in reviewing what people make in different industries. This year I found the data to be very telling and supportive of our conclusion.
After omitting the compensation data on athletes and actors (one could argue those who are egregiously paid), I found that many participants, especially those who own their own business, are making less than several years ago. I realize this data is far from scientific; however, it supports the government’s alternative measure of employment called the U6.
This index measures the unemployed, the marginally employed and part-time workers. At the end of March, this index suggested that 14.5 percent of our labor force is under-employed. The other employment issue, which doesn’t seem to make headlines, is the length of time one is unemployed. Workers are experiencing durations of unemployment that are the longest since the Depression.
Average and median duration reached levels about twice as high as those seen in the early 1980’s downturn, 40 weeks and 21 weeks respectively. In addition to financial hardship, these workers also are seeing their skill sets and competencies erode as they are out of the workforce longer. This situation potentially creates less desirable candidates when the economy expands.
Housing typically leads us out of a recession. Why? Because every 100,000 new housing starts adds approximately 315,000 new jobs. And, this is just the direct influence – we can infer a secondary influence that is estimated to create another 300,000 jobs.
In the current cycle, housing was nowhere to be found on the recovery radar until recently. Housing starts have been on the rise since mid-2011 and continued into the first quarter of 2012. However, the strength visible from the November through February period may be due to a mild winter. Weather most likely had a “pull forward” influence on demand, and we expect to see some softening over the summer months.
It’s the shadow inventory that continues to cause concern. We estimate that there are 3.5 million homes in the U.S. that are in foreclosure or headed in that direction. This supply could be a game-changing impediment, spoiling any hope of a recovery and perhaps sending home prices lower.
The Case-Shiller index, which measures home prices across the country, is showing signs of stabilization. This means that the rate of price decline is slowing, a critical step in forming a bottom. The latest reading indicates prices are down 3.8 percent in the past 12 months. We think the housing market’s healing process will continue for at least another year. Again, supporting our theory that the stock market will not surge to a new high in 2012.
KC Mathews, CFA is executive vice president and chief investment officer of UMB Bank.