Market Commentary
by Byron Wien

Bernanke’s Dilemma

Poor Ben Bernanke.  He could step down as Federal Reserve Chairman as soon as next year and he must be thinking about his legacy.  Everyone considers him a hero now because he’s adding a trillion dollars to the Federal Reserve balance sheet in this year alone and a good portion of that is finding its way into financial assets.  Ten-year Treasurys are yielding less than 2%, making the budget deficit cheaper to finance, and the Standard & Poor’s 500 has gained 10% in the first quarter alone, making investors feel better about their financial well-being.  It’s true, however, that the Federal Reserve has to buy 57% of all securities the Treasury issues in order to clear the market because overseas sovereigns have become less enthusiastic.  Unemployment is still high, but inflation is tame and there is a general feeling out there that the economy is improving.  America still has plenty of problems, perhaps, but it is doing better than any other major developed country.  In the first quarter the Morgan Stanley Europe and Far East Index, which measures the performance of the world’s developed markets, was only up 5.2%.  The Morgan Stanley Emerging Markets Index was down 2.1%.  All in dollar terms. 

Bountiful Ben learned what to do by being a student of the Great Depression.  During the 1930s, under the influence of John Maynard Keynes, government spending provided the stimulus to bring the economy out of its doldrums.  That option has not been available now because too many members of Congress are obsessed with cutting spending.  Monetary policy is the only alternative to keep the economy growing at a satisfactory pace.  Starting in 2008, the Fed has been increasing the size of its balance sheet from $1 trillion to the current $3 trillion.  When it was only $1 trillion, the assets were all Treasurys.  Today mortgage-backed securities make up 33% of the total, so the size of the balance sheet has increased and its quality has decreased, but yields on government securities are almost at a record low, so the man must be a genius.

The problem is that Ben knows this cannot go on forever.  His initial hope was that the liquidity he was providing would be sufficient stimulus to get the economy developing a significant amount of momentum on its own.  He is too learned and too experienced to have put all of his confidence in that, however.  He knew that much of the liquidity would be used to inflate asset prices and his expectation was that the increase in house prices and portfolio values would improve household net worth, encouraging consumers to spend and the economy to grow, perhaps as much as 3% annually.  Whenever that objective was in sight, he could dampen (not reverse) the monetary stimulus and watch the economy expand as a result of natural forces.  Since household net worth is almost back to its 2007 peak, he has reason to be optimistic.  The risk, of course, was that the economy would become dependent on the stimulus and once it was no longer there, the stock market would decline, household net worth would diminish and the positive mood now sweeping the country would evaporate.  If that happened, his legacy would be that he created an artificial prosperity that was followed by another period of dark reality.

Investors are well aware of the possibility of difficult times ahead if the Fed stops easing, but they believe that as long as money is flowing into the system at such a rapid rate, stocks are likely to move higher.  Many professional investors have a short-term orientation anyway.  Fifty years ago the average holding period for a stock bought on The New York Stock Exchange was eight years.  It is now eight months.  There is something else going on that is having a favorable effect on stock prices: investors are not selling.  Trading volumes are low because investors believe that the flood of liquidity from the Fed will drive equities higher.  As a result a marginal amount of buying has a disproportionate effect on prices.  We know from various measures of investor sentiment that a mood near euphoria prevails.  This is confirmed by the latest figures on margin debt.  At $364 billion it is almost one third higher than a year ago and only slightly below the 2007 peak. 

There is no question that the economic data for the first quarter has come in favorably.  In spite of the end of the payroll tax holiday as the year began, retail sales have been strong, automobile production is robust, industrial production is increasing and oil imports have not been this low since the 1980s.  Gasoline prices at the pump, however, remain relatively high at about $3.70 a gallon, not too far from the 2011 peak of near $4.00.  House prices in a number of areas are increasing at a double-digit year-over-year pace because demand is increasing and inventories of both new and existing homes are low.  Capital expenditures have been in a downtrend, but have hooked up recently.  Both chief financial officers and chief executives have been cautious about the overall outlook, but they, also, have become somewhat more positive lately. 

It may be important to remember that in the last two years, the first quarter has been strong, only to be followed by economic weakness later on in the year.  The February employment report was positive in those two years as it was this year.  This has reminded investors of the mantra “sell in May and go away” which most observers do not expect to apply in 2013.  At the end of last year many were worried that economic growth for 2013 would have trouble reaching 2% and the Bloomberg survey of forecasts was below that level.  The increased taxes and reduced spending represented by the deal on the so-called fiscal cliff and the sequester reinforced that view.  Now we are beginning to see forecasts approaching 3% on the basis of economic performance in the first quarter.  Earnings in the fourth quarter of 2012 were good, with 68% of all S&P 500 companies exceeding earnings expectations, but revenues were even better.  After two quarters when only about 30% of companies in the index exceeded revenue expectations, in the final quarter of last year 54% beat revenue projections.

One of my biggest concerns is that earnings are going to be disappointing.  In a market where the S&P 500 was up 16% (total return) last year and 10% so far this year, that could be meaningful.  The consensus is for operating earnings for the index to be $110 in 2013, up from about $100 in 2012.  I think earnings could be flat to down, which is clearly a contrary view.  A study by Strategas Research Partners shows that the market is likely to look beyond current lackluster earnings performance if the following year is going to show improvement.  We are now in the fourth month of the year, so analysts are willing to make a preliminary estimate of earnings for 2014 and they see another year of improvement, which increases investor confidence that stocks are headed higher this year.  Another study by Strategas shows that market performance is negative 19% of the time when earnings performance is positive and 8% when earnings performance is negative.  Positive earnings comparisons only drive the market higher half the time.  The market rises 23% of the time when earnings are negative (a recession) because investors are anticipating a recovery.  Thus the market rises almost three quarters of the time no matter what earnings do.  That is why the short-sellers have such a tough time of it. 

Another study by Bianco Research shows that both strategists and analysts have consistently overestimated the earnings performance or the S&P 500 and I believe that could be particularly relevant this year.  While Nike has reported better than expected earnings, that was because of the success of certain new products.  Federal Express has disappointed and that may be more indicative of the performance of the overall economy; however, cost consciousness and increased competition may have played a role.  Competition may also have hurt Oracle, which also disappointed. 

The foundation of my thesis is that corporations have worked exceedingly hard to squeeze every bit of profitability out of their existing operations.  As a result, from the recession trough, profits for the S&P 500 improved faster than sales for the first time ever in the post-war period.  A recent Smithers & Co. study showed profit margins before depreciation, interest and taxes as a percentage of output were at 36%.  That hasn’t happened since World War II.  Nominal economic growth for the U.S. economy is only likely to be 4%–5%.  That is not strong enough to provide revenue increases large enough to offset margin pressure.  The first quarter earnings season is upon us and it will be important to see how the results come in.  If shortfalls dominate, the animal spirits in the market may cool down. 

Adding to fundamental concerns is the situation in Europe.  The tax being imposed on bank deposits in Cyprus should unsettle depositors in other European Union countries like Spain and Italy.  Everyone argues that Cyprus is a small economy and relatively unimportant but, like a few other countries in Europe, it had substantial bank deposits from overseas investors (primarily Russian) because it is a tax haven and the interest rates Cypriot institutions were willing to pay were much higher than those paid in countries with stronger finances like Germany or the United Kingdom.  When weaker countries in the periphery get into financial trouble, they seek help from the European Central Bank in the form of “Emergency Lending Assistance.”  This allows public employees to be paid and countries to appear to be solvent.  The problem in Europe is that in spite of all the talk about austerity, very little has been done to reduce the government expenditures of the weaker countries.  Most of the measures that have been taken are tax increases or deposit haircuts and bank closings (Cyprus) which are aimed at the wealthy.  Apparently none of the weaker countries are willing to take on the political risk of broad-based expenditure reduction which would have the effect of weakening these economies further.  In any case Europe remains in recession and that clouds the outlook for world growth and could put further pressure on the earnings of U.S. multinationals. 

The European Union has always depended on Germany’s resources and that country has been the primary beneficiary of the common currency.  In spite of its commitment to austerity, Germany has compromised its principles and let the weaker countries make demands on the private sector rather than reduce the size of government, according to Encima Global.  Europe has also been slow to make progress on moving toward a banking union or other forms of convergence.  Encima points out that euro-zone banks have three times the assets and liabilities of U.S. banks even though the European economy is smaller.  The Cyprus initiative and other events in Europe will put more pressure on the Bundesbank and increase the possibility of instability on the continent.  Monetary policy in Europe has followed the accommodative policy of the United States.  The European Central Bank balance sheet has grown from less than €1 trillion in 2008 to €3 trillion now.  Mario Draghi has abandoned the hypersensitivity about inflation that characterized the thinking of his predecessors.  Europe has chosen temporary solutions to its problems similar to the United States and failed to move meaningfully forward in making structural changes.  Getting to tomorrow has been the objective; doing the right thing is too difficult there as it is here.

Federal Reserve Chairman Bernanke can take some pride in the improved tone of the U.S. economy, but he can only feel his positive legacy is secure if the growth path proves to be independent of the extraordinary monetary expansion currently underway.  Market timers can continue to ride the liquidity wave hoping they are smart enough to get out gracefully, but Ben is counting on creating a positive set of economic conditions that lasts beyond his tenure, and it is still too soon to know whether he has done that.

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