28 Oct 2005 Market Remains a Value Due To Near-term Uncertainty

The rear-view mirror shows the economy continued to expand in the third quarter.  US Gross Domestic Product increased to a 3.8% annual rate, more than predicted, despite higher energy prices, rising interest rates, and two devastating hurricanes.  Consumer purchases of automobiles and slower growth in imports contributed to the increase.  Housing was also a significant contributor, but it is slowing.  Residential fixed investment grew 8.9% in the third quarter, down from 10.9% in the previous quarter.  Federal government spending went up 7.7% in the third quarter, significantly higher than the 2.4% growth in each of the previous two quarters.  

Yesterday’s report that Durable Goods Orders were down 2.1% in September, more than forecast, sent stocks lower for the day.  The number suggests that the economy probably slowed in the last month of the third quarter.  However economists suggest that inventory replenishment and the rebuilding of infrastructure along the Gulf Coast will likely spur growth.

Not surprisingly, consumer confidence measures took a dip in October.  The Conference Board’s measure of confidence fell further than predicted to a two-year low and today’s release of theUniversityofMichigan’s confidence measure fell to the lowest level in 13 years.  High gasoline prices, heating bills, and borrowing costs may be finally giving the consumer pause, but true impact won’t be know until this Christmas.  The average price of a gallon of gasoline is 38% higher than it was last year this time.  Utility bills are estimated to rise anywhere from 30% to 70% this year.

Wage increases and low interest rates have enabled the consumer to continue spending, but interest rates are beginning to rise faster of late.  The Fed’s intention to quell inflation before it becomes systemic will take rates higher and further squeeze the already extended consumer.  On the other hand productivity gains continue to produce rising wages for consumers.  We expect productivity to continue to rise, but perhaps not at its ten-year average of over 3%.  Even at half that it is far better than it was in the 70’s and 80’s and likely enough to keep the American consumer out of financial trouble.

With almost half of the companies in the Dow Jones Total Market Index reporting, the picture of corporate earnings has improved this week.  Net on continuing operations is up an impressive 24% over the same period last year.  Standout companies include telecommunications equipment, biotechnology, specialized consumer services, paper, and Internet.  Lagging the pack were property insurers, containers and packaging, and medical equipment companies.

So why is the stock market stuck?  Corporate earnings are good, valuations are at historic levels, and cash is everywhere.  Our market expert Don Hays points out that the earnings yield of the S&P 500 is 20% higher than that of corporate bonds – a condition which has persisted for over a year and a divergence that has not been this wide for over 20 years.  The divergence explains why we see so many private equity and leveraged buyouts going on today.  The lower corporate bond rates also allow corporations to buy back their own stock to make a positive return without taking new risks.  Microsoft for example is selling at a P/E not seen since 1994 while their CEO says the company has some of the most significant product announcements it its history coming just months from now.  They just announced an acceleration of their of $19 billion stock buyback to complete by December 2006.

Investors shy away from stocks now because of fears earlier discussed, but as our friend Don Hays points out these issues will be trumped by the continuing massive effects of globalization.  The supply constraints that have largely caused the meteoric rise in energy prices will be resolved in time; additional supply will come on line.  Employee wages should continue to rise faster than their costs and inflation will likely not become systemic as it was in the 70’s and 80’s because of global competition.  Don quotes a recent speech from Dallas Fed Governor Fisher to further his point:

Prices for goods and services not internationally traded and not subject to foreign competition have risen since 1997: college tuition and fees, up 63%; cable and satellite television, up 43%; dental services, up 42%; prescription drugs and medical supplies, up 40%.

But prices of goods subject to foreign competition have fallen over the same period: by 88% for computers and peripherals, 70% for video equipment, 39% for toys, 13% for women’s outerwear, 16% for men’s shirts and sweaters.  Services prices have been impacted, too, by cheaper software programmers inRussia, call centers inIndiaand other processing that can be shifted offshore.

While globalization has had numerous ill effects on our economy the advantages will continue to eclipse its disadvantages.  The challenge for American business, service and manufacturing, is to continue to gain competitive advantage through efficiency and innovation.  The challenge for government is to stay out of the way and to avoid measures of protectionism or socialistic tampering.  If they do, the potential for long-term global growth is impressive indeed.

Now, the fog of uncertainty holds stock prices at very reasonable levels.  Dividend yields on many excellent growth companies in our portfolios are at our near their five and 10-year highs.  The 12-month forward price to earnings ratio of the S&P 500 is at a ten-year low.  Valuations are compelling and downside risk is mitigated as a result.  Several questions remain to be answered concerning the consumer, the Fed, energy prices, and inflation, but favorable trends on most of them should be evident by early to mid next year.  In the meantime we’ll continue to pick up the bargains.