Investors Look on the Bright Side

After six long years US stocks, as measured by the S&P 500 index, are poised to reach new heights. The last record high was set October 12, 2007 at 1,561.80, on the eve of the financial crash and Great Recession. After rallying 123% from its low of 683 set March of 2009, the index looks ready to make some fresh tracks. Our VTI, which represents the Total US Stock Market Index, reached its new high on February 1st of this year.

Stocks’ strength can be traced to several powerful forces including; artificially low interest rates maintained by the Federal Reserve (drives investors to risker stocks in search of yield), sustained corporate earnings growth, the dawning reality of US energy independence in 5-7 years, relatively steady strength in economic indicators, and reduced (somewhat) policy uncertainty from Washington.

Corporate Earnings Continue to Surprise Analysts

Corporate earnings, while not robust by any measure, have held up and continued to beat analysts’ projections. With 334 of the S&P’s 500 companies reporting 4th quarter earnings, 72% have beaten analysts’ earnings estimates, well above the average of 67%. Earnings are 3% ahead of last year’s Q4 and ahead of analysts’ estimates for 2.6% growth as recently as December 31, 2012.

But managers are tempering investors’ optimism with their forward-looking earnings guidance. Of those companies offering a look ahead for the current Q1 13 quarter, 63 have issued negative EPS guidance, and only 17 have provided positive guidance.

Despite some guidance pessimism, stocks appear reasonably valued on an historical basis. The current 12-month forward P/E ratio is 13.5 according to Factset. The ratio is based on yesterday’s closing price of 1521.38 and forward 12-month EPS estimate of $112.77. This 13.5 P/E is above the prior 5-year average forward of 12.8, but below the prior 10-year average forward 12-month P/E ratio of 14.2, according to Factset.

Companies have found a way to maintain profitability despite weak demand and policy uncertainty. But the days of easy and low-hanging fruit are largely behind them. Cost-cutting through layoffs and reduced spending and improving productivity have largely run their course. Between 2008 and 2009, productivity surged by 6%, according to data compiled by the St. Louis Fed. The rate of productivity increases since then has slowed to less than 1% annually by the end of 2012, according to Bloomberg.

Business leaders must find new ways to maintain shareholder loyalty. In the last couple of weeks we have seen their answer – mergers and acquisitions. Acquisitions announced since January of nearly $160 billion represent the fastest start to a year since 2005, according to Dealogic. M&A volumes historically follow the lead of the stock market, and the 6.67% increase in the Standard & Poor’s 500 Index this year suggests more are on the way, according to Bloomberg.

The deals include Berkshire Hathaway’s and 3G Capital’s $23.6 billion takeover of HJ Heinz Dell’s $24.4 billion bid to take the company private, Comcast’s $18.1 acquisition of NBC Universal Media, an $11 billion merger between American Airlines and US Airways Group, and a reworked deal worth $4.75 billion between Anheuser-Bush InBev and Constellation Brands.

Given the huge levels of cash on corporate books it is inevitable that acquisitions will increase. A recent Bloomberg article quotes chief financial officer William Shea of as he described how their balance sheet had changed since 2008. Back then, he said, the company had about $130 million of debt. Today, the sum is around $20 million. That being the case he said, “We’re not afraid of making acquisitions, but during this past period of time, that wasn’t the right thing for us to do…We think we can get organic growth rates moving north of where they are today…And if we can find the right company and strike the right deal, we will do that.”

Economic Indicators: So Far So Good

There’s also strength in economic indicators of the economy. According to James Picerno, of (as reported in a recent Bloomberg Brief), two economic indexes with impressive records of tracking the business cycle’s major downturns since the early 1970s indicate recession risk is low, based on a broad reading of economic data through December. While January’s profile has yet to be fully determined, the early numbers so far look encouraging.

The Economic Trend Index (ETI) remains well above its critical 50 percent mark, having risen above 90% at 2012’s close. The Economic Momentum Index (EMI) settled at 6% in December, a comfortable margin above the danger zone of zero and below. The ETI is a diffusion index of changes in 14 indicators that represent a broad cross section of the U.S. economy and key markets. Calculated as a rolling three-month moving average, ETI tracks the economy’s broad trend with the explicit goal of quantifying recession risk. EMI uses the same 14 indicators, but measures median changes, also in terms of a rolling three-month moving average.

Picerno argues that many analysts fall into the trap of relying on too few indicators, focusing on recent history, and/or looking too far into the future. Economies don’t turn on a dime, but the further out one peers, the greater the risk of error. (We agree with his perspective).

“A better approach he says is to analyze a broad set of financial and economic data that collectively suggest when recession risk is high. ‘Nowcasting,’ as some call it, is a process, not a point forecast. By updating the analysis as new data arrives, a ‘nowcast’ evolves. Tracking the evolution is valuable in its own right. Indeed, the onset of recession is usually connected with a rising number of deteriorating indicators that reach a tipping point overall.”

Energy Independence? The Answer to our Problems?

Another striking bit of good news for our economic wellbeing is the rapidly increasing domestic supply of oil. According to Bloomberg News, US crude output grew by a staggering 766,000 barrels per day in 2012, the biggest jump since 1859. Through the first 10 months of the year, the US met 84% of its own energy needs and is now the world’s largest fuel exporter.

The tectonic shift was apparent in December trade data which showed the US deficit arrowed by 20.7%. Even if the current pace since 2011 of a 15% increase in the domestic supply of oil and a 52% decline in new oil imports is significantly reduced, it would still result in the US becoming energy independent in the next five-to seven years according to Bloomberg. They go on to say, even with little policy support from Washington, the increasing supply of domestically produced oil is changing the economic landscape. Should policy makers turn their attention toward supporting the domestic production of oil and energy, these baseline estimates will probably be too conservative.

Meghan O’Sullivan of Bloomberg points out “just as the financial crisis hurt the US abroad by projecting weakness, our rising energy fortunes strongly counter the now-common global narrative that the US is in decline. Europe, China, Japan and other large economies face futures of ever-growing dependence on imported energy. Even though the US is highly unlikely to become completely self-sufficient, it will spend less acquiring energy from abroad. For China, on the other hand, importing energy will become a greater obsession. Although it is hard to quantify just how this will influence foreign affairs, it will certainly change the tenor of diplomacy.”

“Some exports of liquefied natural gas from Qatar and elsewhere originally destined for the US have been diverted to Europe. Moreover, if the US begins to export natural gas in meaningful quantities and European nations invest in more LNG terminals, their vulnerability to Russian political pressure could ease. They might be able to depend on the US as an energy supplier in times of duress, as during the Suez crisis of 1956. Japan has also made its desire to import American gas very clear. Doing so would help it curb reliance on nuclear energy without having to turn to greater volumes of gas imports from volatile markets.”

What Washington?

Finally, Washington doesn’t dominate the front pages of the financial press, at least for now. With the cliff avoided and the landscape shaping up to resemble a more classic form of gridlock, investors have been able to turn from political drama and focus on the real drivers of markets – economy and earnings.

While considerable policy uncertainty remains regarding what our leadership will do to address sluggish economic growth, investors have chosen to accept that the coming debt ceiling negotiations will be resolved short of technical default, sequestration (automatic spending cuts) will take effect to some degree, and that traditional gridlock will prevent any major policy tilts capable of derailing the economy.

For now, the breeze is a bit fresher outside of Washington, in the real world of life and commerce. The best leading indicators, the capital markets are making a case that our economy is heading in the right direction. After four years of recession-like conditions, optimism, while not completely strangled from our hope for our future, has been all too rare. At least in the stock market, optimism is on the rise.