After screeching to a halt in July and early August, as the debt ceiling debacle was unfolding, the US economy has been gaining traction on many fronts despite a number of persistent headwinds, none of which are likely to abate any time soon. The fears and uncertainty caused by these factors, together with the volatility created by high frequency, computer-driven trading, are keeping a lid on the valuation of equities despite very low interest rates, solid gains in corporate earnings and good prospects for 2012. In the absence of these forces the S&P 500 Stock Index might well have ended the year with a multiple of 15x-16x 2011 earnings instead of the roughly 12x at the close of trading in a year when the Index was flat.
Despite a litany of uncertainties, cost burdens and sometimes irrational regulatory impediments, US corporations are continuing to achieve revenue, profit margin and earnings growth at rates of progress that range from worthwhile to outstanding. There is no question that continuing caution and deleveraging by American households and a negative wealth effect, coupled with slower growth in the major emerging economies, as well as the recession now underway in Europe and continued stagnation in Japan are having an adverse impact on American multinationals. In addition, a dysfunctional Federal government, including both the Administration and the Congress, have hindered corporate investment and job creation. The gridlock in Washington will not be alleviated during this election year. Other macro uncertainties such as the volatile situation in the Middle East, fiscal drag at both the Federal and state levels and fears of a financial crisis triggered by European banks also weigh on economic activity, as well as on the valuation of equities.
Even with these headwinds, the inherent resilience of American corporations continues to enable them to grind out increased profits. Also, there have been signs in recent months that job creation has begun a meaningful improvement. If this trend is sustained, a rise in consumer purchasing power, together with even modestly relaxed bank lending standards, should enable some of the pent up demand for automobiles and housing to begin to impact the economy in a meaningful way. It probably will take a change in the Administration to remove the handcuffs from the energy industries, which have the potential to create large numbers of well-paying jobs. Likewise a solution to the vast and complicated home mortgage problem has so far eluded implementation, but significant improvement here would have a huge ripple effect throughout the economy.
Thus, we believe the year 2012 will see modest 2%-3% real GDP growth, provided none of these impediments becomes more acute and assuming no “Black Swan” events, nor a financial meltdown stemming from a European sovereign debt and banking crisis. In this environment corporate profits (excluding those of large financial companies, which remain a wild card), should improve at a near double digit pace for the year as a whole. It is unlikely that there will be any expansion of equity valuations as long as this litany of overhanging uncertainties and burdens remains in force. Furthermore, the volatility of the marketplace is unlikely to be mitigated as long as short term traders react disproportionately to macro events. Therefore, while 2012 should produce moderate appreciation in the S&P 500 by year end, progress will by no means be linear.
As the year progresses we will do our best to use periods of stock market weakness to add well-positioned companies to our portfolios, particularly industry leaders with solid balance sheets, strong market shares and histories of good execution, including regular increases in cash dividends.
Comments