23 Apr 2004 Little By Little, One Travels Far
J. R. R. Tolkein reminds us that patience is integral to any great undertaking and accomplishment. For the past year, we have watched almost every notable statistic available to determine the current and likely future health of this economy. Most have been mixed to mildly positive with just enough question marks to keep overconfidence in check. The past twelve months are remarkable in their stark contrast to the mood and assumptions of the late nineties, when virtually everything was rosy beyond historical precedent.
The progress of our journey these past four years is now becoming evident in the government and corporate numbers reported recently. Just this morning the government reported that U.S. orders for durable goods rose 3.4% in March, almost five times economists’ forecast. The results were led by autos, metals, and business equipment. Retail sales last month rose the most in a year, while regional factory surveys found increases in orders and employment in April. Large and small manufacturers are boosting sales forecasts, suggesting business investment will help drive the economy the rest of the year.
So far this corporate earnings reporting cycle, 606 of the 1,632 companies in the Dow Jones US Total Market Index have reported their quarter’s results. Net income on continuing operations is up an average of 25%. The Technology sector leads the charge with an average increase of 103%, followed by Energy and Basic Materials at 82% average increases each. What’s more, corporations are garnering the largest share (10.7%) of national income since the late 1960s on a pre-tax basis. After-tax profits as a share of GDP hit a record 8.5% in the fourth quarter. Corporations are well positioned to benefit from strong economic growth.
The big worry on investors’ minds is when and by how much the Federal Reserve will raise interest rates. In the minds of the experts we follow, the worries are overblown. The Fed has been unusually clear in stating its intention to wait for improvement in jobs and the reduction of manufacturing capacity before abandoning its current simulative stance. The important thing to remember is that the Fed moving to reduce the stimulus of historically low rates does not necessarily mean moving to an economically restrictive policy. In other words, at some point in the future the Fed will indeed take its foot off the gas, but tell us they see no reason to hit the brakes. While Greenspan said that the risk of deflation seems to have passed, the threat of inflation at present is benign.
Caroline Baum of Bloomberg points out that history offers some examples of stocks and interest rates moving in the same direction for extended periods. “Interest rates started rising in 1945 in the U.S. and stocks went up right along with them. In Japan, rates fell and stocks went down for 13 years. Real estate, another asset that presumably suffers in a rising rate environment, saw prices soar in the post-1945 rising interest-rate environment. Real estate became even more attractive when inflation accelerated: Investors prefer hard assets when money is losing its value.”
The white knight throughout this difficult economic period has been strong productivity. Manufacturers are producing more with less at rates that rival past economic periods. Prolonged cycles of rising productivity eventually lead to improved hiring and rising standards of living. For a number of reasons this time has been different, until recently. It now looks like job creation is becoming a reality in this recovery.
We have indeed come far in the past four years but some of the fears remain. Investors believe rates are going up substantially and they are discounting stocks accordingly. While the near future remains murky, there are some interesting possibilities ahead. What if job creation and economic expansion prove to be non-inflationary? The Fed would presumably leave rates in a neutral position allowing growth to continue. If that happens, stocks appear undervalued. Corporate earnings are currently outpacing stock growth. One of two things must happen given this disequilibrium; stocks must rise to reflect earnings growth or earnings will fall to match stock prices. We believe the evidence is on the side of the former. Corporate earnings growth looks strong indeed.