Since March of this year all the stock markets of the world have been in a new bull trend. Even after a gain of 60% from its capitulation low of 666 on the S&P 500, U.S. equities are still reasonably valued and right in the “sweet spot,” the period of strongest appreciation in any bull market. Indeed, history shows that during the first nine to twelve months of a new bull market, the broad market indexes typically achieve from one-half to two-thirds of their ultimate gain over the cycle. The reasons for this are really quite straightforward. Monetary policy has become extremely stimulative, and at the same time, households and businesses are both paying back their borrowings. There is little in the way of private sector demand for credit. Accordingly, the resulting surplus liquidity needs to find a home, and financial assets are always the logical first stop. The second factor is that after a lag of a year or so from the time monetary policy becomes stimulative, the economy bottoms out, and the outlook for economic recovery and ultimately expansion, becomes more clear. This is now happening on a global scale. Indeed, the economies of Europe, Asia and Latin America are already ahead of the U.S. in terms of recovery. This fact is not lost on those of us who have concentrated our equity investments on multinational U.S. corporations as the most efficient way to participate in economic growth abroad, particularly in the major emerging economies. The “sweet spot” is also fueled by massive short covering and the participation of relatively sophisticated day traders.
The great pity this time is that wealthy U.S. investors, having fared so badly during 2007-08, now see only the headwinds which will keep the U.S. recovery at a slower than normal pace for some time, but will not prevent it. What they neglect to accept is the disconnect between the U.S. economy and the profitability of U.S. multinational corporations in today’s world. Moreover, because many wealthy Americans have reached middle age or beyond, they are now determined to take no further risks and to hold on to that portion of their wealth which remains. This explains in part their willingness to accept the abysmally low returns offered by money market funds and short-term Treasury securities. My best judgment is that this generation will not return to equity investing in their lifetimes. The next generation of wealthy Americans is still one or two business cycles away.
So now the question arises: how far can this bull market run? There is no high conviction answer at this point, but what we do know is that as the global economy recovers and enters a new growth phase, the profitability of many U.S. corporations will enjoy a leveraged rate of improvement due in part to their exposure to faster growing foreign markets, and perhaps more importantly, to a new found emphasis on productivity, which was driven, or imposed upon them, by the sudden collapse of global demand in the wake of the Lehman Brothers bankruptcy a year ago. Corporations will in time begin to rehire workers, but the psychological impact of the trauma in the last quarter of 2008 and the first half of 2009 will not vanish quickly from the psyches of corporate managements, who are likely to keep a tight rein on costs for longer than usual. Therefore as revenues begin to pick up over the next few quarters, corporate profits will surge. Indeed, profits will rise far more than Wall Street securities analysts or the managements themselves dare to project.
Since our insight is no better than anyone else’s, we will continue to ride this bull as long as the numbers are favorable. At this writing, the Standard & Poors 500 Stock Index is at 1063, which represents a forward price/earnings ratio of 12.5x a conservative projection of $85 of mid-cycle operating earnings. Expressed differently, this represents a forward earnings yield of 8%, which compares favorably with current BBB Industrial Bond Yields of less than 6%. Of course, in order to outperform the overall market we need to focus on those sectors whose profit growth trends are likely to be more rapid than for the S&P 500 Index as a whole. We have been steadfast in our overweight of energy, materials, multinational industrials and transportation issues throughout this cycle. And with the exception of some exposure to selected healthcare issues, we have avoided consumer and financial issues for reasons which by now should be obvious to all our readers. On an individual stock basis, we will continue to maintain our positions until the so-called incremental profit margins decline down to a level equal to the overall corporate margins. These can be calculated on the basis of gross margins, operating margins or pre-tax margins. Once they reach parity with total company margins, the leverage to profit growth no longer exists, and the equities become market performers at best. We pay attention also to market technicals, and when overexuberance causes a stock price to rise parabolically, we are inclined to take profits as well.
As to the total environment for equities, we noted at the outset that this is a period of considerable surplus liquidity, as well as much doubt and skepticism in the face of improving fundamentals. The number one warning signal that the peak in liquidity has been reached will be when bank loans and non-financial commercial paper begin to rise and bonds are liquidated by the banks in order to fund loans to the private sector. This will begin to nudge up interest rates and shrink the excess liquidity pool. Moreover, as a new credit cycle gathers momentum, it is likely that the Federal Reserve Board will conclude that the recovery has become self-sustaining, and it too will begin to withdraw its monetary accommodation in order to forestall an upturn in inflation. None of this is on the horizon yet; neither a peaking of corporate profit margins nor an upturn in credit demands. In the absence of any unforeseen factors, this suggests that the current bull run has further to go.
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