If you were an equity investor in the first half of 2010 you may not feel optimistic about the equity markets or the economy as a whole. We do, however, find reason to remain optimistic about both. The economy is growing, albeit slowly, and earnings estimates for S&P 500 companies are strong.
ECONOMIC OVERVIEW
The US economy officially exited the “Great Recession” one year ago. For the past three consecutive quarters (through Q1 2010) GDP has increased and is expected to increase again in Q2 2010. Admittedly this increase in GDP has been slow and modest in size, but positive none the less. We see an economic environment that should foster continued economic growth; namely business inventories are historically low, manufacturing productivity and output have increased significantly over the last several quarters, inflation remains abated, money supply is increasing, interest rates are at historic lows and we even see some positive signs in the employment picture.
ECONOMIC POSITIVES
Business inventories have decreased significantly since Q1 2009. This decreasing trend has continued each and every quarter since that time and continued through Q2 2010. Business inventories are now at the lowest they have been in nearly a decade. This is significant and a major positive for the US economy as any demand by consumers will force manufactures to ramp up production in order to meet demand.
After significant decreases in manufacturing output for most of 2009, the last three quarters have shown increases in manufacturing output. An increase in manufacturing output is an obvious positive for the economy but in addition, manufacturing productivity has show dramatic increases for the last several quarters. Manufacturing productivity is a good indicator of future economic growth as productivity can only increase to a point before additional labor must be added.
At this time, inflation seems to remain in check. Both the Consumer Price Index (CPI) and the Producer Price Index (PPI) have remained low. In fact, the last two months of data available (APR and MAY 2010) reflect negative annualized numbers for each of these indices. So far, flat consumer goods prices have helped to relieve any would-be wage hike demands.
The money supply in the economy continues to increase. This should be viewed as a positive for economic growth as eventually US consumers should find more money in their possession which will lead to increased demand of goods and services by these consumers.
In addition to more money in the economy, interest rates are at historic lows. Short term interest rates (3 month US T-Bills) have been at historic lows for nearly a year and a half. During this time, longer interest rates (10 year US Treasuries) remained significantly higher. This resulted in a relatively steep yield curve. Recently we have seen long rates decrease which has flattened the yield curve. These low rates should entice consumers to borrow funds in order to make purchases of higher end goods, thus promoting economic growth.
EMPLOYMENT
Although unemployment remains high (9.5% as of JUN 2010) we do see some positive signs on the employment front. First, the unemployment rate has decreased from its high of 10.1% in OCT 2009. Secondly, the number of individuals newly unemployed has been decreasing modestly. It should be mentioned that although the unemployment rate has been decreasing, the duration of those unemployed has increased significantly.
ECONOMIC DETRACTORS
Not all economic data is positive. The growth in GDP has been spurred mostly by government investment while investment by the private sector remains weak. The record deficits the federal government has been recording cannot continue forever and the servicing of that debt detracts from the government’s ability to inject capital into the markets at a later date.
Despite record low interest rates, increasing money supply and a decreasing unemployment number, private investment into the economy remains elusive. Instead, we have seen individuals reduce debt and increase their savings rates. The Financial Obligations Ratio (FOR), a ratio of a household’s total financial obligations compared to their disposable income, has decreased each quarter since Q1 2008. The FOR is now at lows not seen since 2001. In addition, personal savings rates remain relatively high. It has been a commonly held belief that many households were over leveraged and not saving enough, so a decrease in household debt and an increase in savings by households should be viewed as a positive for the long term as household balance sheets become more secure. However, in the immediate future, saving and paying down existing debt detracts from the growth of the economy. Every dollar saved or used to retire existing debt is a dollar not used to stimulate the economy through the purchase of goods or services.
It should also be mentioned that bank’s excess reserves have increased dramatically since Q2 2008. While this has negative short term implications (banks are not loaning money that would stimulate economic growth) it is a positive in the long term (more stable financial institutions).
INVESTMENTS
Through the first half of 2010, all types and maturities of fixed income have posted positive returns while all equity asset classes were negative.
For the first half of 2010, US Government backed fixed income securities have outperformed their corporate counterparts, both investment grade and high yield. Longer maturities have outperformed shorter maturities due primarily the recent decreases in long interest rates.
While all asset classes of equities have posted negative returns, some equity asset classes have performed better than others. Domestic equities have outperformed foreign equities. Small and mid-cap equities have outperformed large equities and value investing has slightly outperformed growth investing.
For the past fifty years the Price to Earnings Ratio (P/E Ratio) of the S&P 500 has averaged 18.95. Earnings estimates for Q2 2010 would value the current P/E Ratio of the S&P 500 on 6/30/10 at 14.32, significantly below this fifty year average. Analyst’s estimates of earnings for the S&P 500 continue to improve rapidly each quarter through the end of 2011. In fact by Q2 2011 analyst estimate the earnings of the S&P 500 will reach an all time high surpassing the previous high mark made in Q2 2007 (the S&P 500 was 1503.35 at that time). Based on the closing price of the S&P 500 on 6/30/10, the PE Ratio would be 10.87 on 12/31/11 if analyst earnings estimates are met.
While earnings estimates are just that, estimates, it is one of the best tools we have at our disposal to see the potential profitability of equities in the near future. It should also be pointed out that analyst have recently been increasing their earnings expectations.
CONCLUSION
The first half of 2010 has been difficult for equity investors, but there is reason to be optimistic. The US economy continues to show signs of economic growth. GDP has increased for four consecutive quarters. In addition, there appears to be many macroeconomic signs that the economy will sustain this positive momentum and will continue growth. Business inventories are at historic lows, manufacturing productivity and output have increased for the last several quarters, inflation remains at bay, money supply is increasing and interest rates are at extreme lows. There are even signs that the employment picture is beginning to improve.
In addition to a positive economic outlook, there appears to be evidence that equities are currently undervalued. Analyst’s estimates reveal that they anticipate earnings for the S&P 500 to increase rapidly each quarter for the next six quarters. In just four quarters from now the analyst estimate the S&P 500 will earn more per share than it ever has. If corporate earnings met or nearly met the analyst’s estimates, the S&P 500 is trading at evaluations that are significantly below historic norms.
