You could say that my generally bearish stance on the markets causes me to seek out data points that purposely support my case. In fairness, I’m sure that I’ve been guilty of this sin from time to time. I suspect we all are at one time or another. That doesn’t make it right, but it’s a reality that we each must confront and overcome on a regular basis. But as this melt up in equity prices has continued, I’ve been forced to reexamine my thesis numerous times and from many different angles to ensure that my objectivity has not been compromised by my desire to be correct. I would much prefer to make money than to be proven correct; just like I would rather be lucky than skilled. So with this introspection in mind, here’s an overview of the three pillars of my bearish viewpoint along with what I believe is a synopsis of the bullish counterpoint. By laying out these items out side by side, a clear view the strengths and weaknesses of each argument will materialize and provide some insight on just how rationed my current views are and whether they are worth altering.
1. The U.S. economy remains on shaky ground and still unable to grow organically. Since the dramatic contraction in GDP in late 2008, central bankers and politicians have been pumping all the monetary and fiscal stimulus they could get away with into the economy as a means of staving off another Great Depression. While there is considerable debate around the structure and effectiveness of individual stimulus measures, it is clear that their central purpose of stemming the downturn has been achieved. However, too many investors, in my opinion, are viewing these stabilizing effects as indications of imminent economic expansion. The fact is that while GDP is no longer falling, last quarter’s growth rate of 1.7% (in real terms) was far below the 2.5% - 3.5% trend line rate that has characterized an expanding economy over the past 25 years and marked a significant decrease from the 3.7% rate seen in Q1 of this year. For an economy that has received historically large amounts stimulus and remained unable to grow at or near trend, this is a concern that should be at the forefront of investors’ minds. It should also raise doubts about the effectiveness of additional stimulus since the original program appears to have had a desirable, but fleeting, impact on growth. Couple this with the resultant stagnation of job creation, wage compression, and deflationary concerns that are now lingering in the marketplace, and the prospects for growth appear all the more dim for at least the next several years.
Bullish Perspective: By acting in a particularly aggressive manner, both the Federal Reserve and Congress enacted sufficiently stimulative measures to stave off another depression. And just as those measures helped to avert disaster, so too will additional stimulus revive growth and propel the economy back to more ‘normal’ growth rates. Interest rates, in particular, are driving down the cost of investment, which should entice companies and investors alike to begin redeploying capital into new projects that will create jobs and provide a boost to overall economic activity. Furthermore, increased export activity, particularly due to weakness in the U.S. Dollar, should prove to be one of the central drivers of growth. Individuals, who were highly leveraged at the outset of this crisis, are continuing to refinance their debts and, thereby reduce the incidence of default and free up additional discretionary income. With personal consumption currently comprising about about 68% of the economy, any reduction in the amount of income needed to service/reduce these obligations should help boost economic activity. Additionally, economic recoveries have typically been characterized by periods of slow, uneven growth. The weakness in recent economic data is merely another manifestation of this bottoming process and could even be viewed as confirmation of an imminent pickup in economic activity.
2. Corporate revenue growth will remain stagnant, thereby capping the rate of growth in earnings, equity valuations, and equity market prices. Much has been said of Corporate America’s ability to trim operating costs over the past two years. Dramatic headcount reductions, the implementation of new technologies, and divestitures of non-core assets have been among the most common means of achieving these cost savings. By managing their businesses in such an aggressive fashion, most companies managed to survive the dramatic drop in business activity in hopes of brighter days materializing sometime in the near future. And as the U.S. economy has recovered, so too have revenues and earnings. That said the U.S. economy is not likely to return to trend line growth for some time and, as a result, sales will remain constrained as consumers struggle to obtain wage growth, reduce their debt load, and find/maintain a job. And while emerging economies are diversifying corporate revenue streams, the United States remains the economic engine of the world and will certainly impact corporate sales growth. This top line constraint, therefore, will have to be overcome either by gaining market share from competitors or through additional cost savings. However, both methods have a point at which no additional benefit can be obtained. And given the historic scale of the recent cost reductions, it’s difficult to believe that there are still significant cost savings yet to be achieved. This is to say nothing of the negative feedback loop that would occur as a result of additional layoffs. Another round of position reductions would have the effect of further compressing consumer demand (through reduced consumer discretionary income), which would then necessitate additional cost saving actions. The result of all this, therefore, would be an environment in which earnings are unable to grow at or near historical rates, which would put significant downward pressure on the multiples (valuations) investors are willing to pay for shares. Needless to say, such a scenario would be detrimental to the major indices like the Dow Jones Industrial Average or the S&P 500.
Bullish Perspective: With the integration of the global economy over the past two decades, U.S.-based companies are no longer fully dependent upon U.S.-based economic growth as the primary means of expanding sales and earnings. In fact, most of the country’s most successful firms (Coca Cola, Procter & Gamble, Microsoft, McDonalds, etc.) now derive a plurality of their revenues and earnings outside of North America. As a result, firms should be able to grow revenues as a result of their exposure to emerging economies that are continuing to expand at robust rates. As an added bonus, the cost savings that were implemented during the global financial crisis will only enhance this new found revenue growth and provide the means to generate consistent earnings expansion. Furthermore, with the financial markets still smarting from the dramatic downturns of recent years, investors have pushed share valuations down to levels that are no longer consistent with the underlying fundamental outlook. As a result, as investors begin to reevaluate share values in light of a more positive economic outlook share prices should rise to pre-crisis levels. This improved economic outlook will aid in domestic job creation that should ultimately prove additive to earnings.
3. Tax rates are primed to move higher, which is currently paralyzing investment and will constrain consumer demand in subsequent years. Higher taxes result in less disposable income for tax payers. Less income for tax payers results in lower rates of domestic consumption. Reduced consumption results in negative GDP growth unless investment, net exports, and government spending collectively expand to make up for this loss. It’s just that simple. And with government spending levels stoking concerns within the electorate, it’s hard to imagine a scenario in which government expenditures (outside of the Federal Reserve) are able to increase meaningfully. Therefore, economic activity will be negatively affected by rising tax rates. As an added headwind, Congress’ unwillingness to enact definite rules surrounding tax rates for at least the next year is causing both individuals and companies to postpone investment activities until some level of tax policy certainty is achieved. As a result, economic activity will continue to be constrained and have the effect of exacerbating the weakness in consumption that is already occurring.
Bullish Perspective: All indications are that there will be some sort of tax relief passed by Congress before the end of 2010. While these measures will likely extend current tax policy, the fact that taxes won’t move up in the near term should keep the economic recovery on track and enable consumption to pick up. Furthermore, the proposed changes to the tax code are focused mainly on those individuals who earn at a high rate. Therefore, the marginal cost of this policy change should be minimal as the majority of tax payers will not be affected. Also, since a large portion of corporate earnings are now generated abroad, estimated taxes are now less dependent upon U.S. tax code changes than at any time in the past.
Tomorrow should be an interesting day. Initial jobless claims, continuing jobless claims, the Producer Price Index, and trade deficit numbers are all due out. As I mentioned in a previous post, these data points are likely becoming less of a focus in the marketplace now that earnings are rolling out. That said, anything in these reports that could be construed as providing a reason for the Federal Reserve to not move on its stimulus measures could turn things sour in the equity markets pretty quickly. On the earnings front, Advanced Micro Devices, Google, and J.B. Hunt will likely prove the most watched reports and will shed further light on the kind of economic environment companies are operating within. But as is usually the case, the outlook will probably mean a lot more than the actual numbers.
Until tomorrow.....
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