01 Jun 2007 Has the Fed actually done it?
Have they executed a perfect landing by slowing the economy just long enough to wring out inflation while keeping growth alive? After slowing steadily for the last four quarters, the economy is giving strong signs that it may be back on a growth track. Today’s report from the Labor Department shows that employers added 157,000 jobs in May. It demonstrates that employers are optimistic about their businesses and it makes consumers feel better about their own jobs. Another report showed that personal spending rose in April by .5% following a .4% increase in March. Corporate earnings from S&P 500 companies gained 11.6% in the first quarter, which is three times more than analysts’ estimates at the start of the reporting season. As the data shows an economy resuming healthy growth, inflation remains tame.
The Fed’s preferred inflation measure, which excludes food and energy showed only a .1% increase in spending patterns in April while flat in March. For the past 12 months inflation has increased by only 2.0%, the smallest year-over-year gain since February 2006. Fed officials say they are comfortable as long as inflation remains in the range of 1 to 2%.
Private and public investors definitely recognize the benefits of a growing economy with low inflation as they fuel a record level of corporate takeovers totaling about $1.7 trillion so far this year. That level breaks the record set in 2000, according to data compiled by Bloomberg. Announced mergers and acquisitions are 61% ahead of last year’s pace.
Even as public companies are going private at a record pace, stock values remain attractive. Perhaps public investors are realizing what private investors have been saying with their money. Stocks are cheap. According to Bloomberg, the S&P 500 members are 45% less expensive relative to historical profits than they were when the index last peaked in 2000, and 30% cheaper than they were when the index fell to its decade low in October 2002. Price-to-earnings ratios have actually declined after companies reported 14 straight quarters of 10%-plus profit growth, the longest streak since 1950. The price to earnings multiples from the peak to the low in the S&P 500 went from 32.8 times in March of 2000 to a 25.7 times in October of 2002. The multiple is 18 today.
Compare the yields of companies’ earnings to the cost of borrowing money and you can understand the record takeovers. Estimated profits for S&P 500 companies yielded 6.53% at the end of the first quarter. Place those returns against a cost of funds of 4.65%, the yield on the 10-year U.S. Treasuries, and you can reveal a gap of 1.88%.
Another bullish sign for stocks is the number of investors betting against the market is at a record high for the S&P 500. Short-sellers borrow stock from owners and then sell them at current prices with the idea that they can buy them back cheaper at some point in the future. Regardless of whether they will be right or wrong, they will eventually have to buy the stock back in order to settle up with the owners of the stock. The idea that short-sellers can be good for bulls comes from the idea that the shorts eventually have to replace the shares they sold. If prices rise quickly or persistently they may panic and start a buying frenzy driving stock prices higher than they would otherwise go. They may be inclined to pay any price just to stop the bleeding.
It is curious why short-sellers and other pessimists do not accept the stocks-are-cheap argument. They are very smart people and it is not that they are short on reasons to support their case. They abound: continuing problems in manufacturing and housing, wars in Iraq and Afghanistan, as well as other serious hotspots, deteriorating relations withRussia, tight energy supplies, and even the simple fact that this bull market is getting old by historical reference. But the sum of these concerns has failed to stall the advance of stock prices. It seems that only some unforeseen event can derail the current charge, but that’s always the case.
For now, it appears that the value argument is more powerful than the worry argument. In fact, the very presence of worry is good for bull markets as it keeps speculation and stock prices in check. Balance in the economy and in the markets continues to bode well for investors.
