Sunday, November 20, 2011
- In the midst of the pessimism, we remain optimistic – even if only temporarily so.
- Sector leadership messages support the argument that the markets are trending higher, with the Industrial sector exhibiting positive seasonal potential.
- While not likely to be the largest price gainers in a market rally, Dividend Payers offer the safest capital appreciation potential among equity choices.
On the latest round of European debt worries, Spanish bond yields have followed Italian yields to new highs. The worries help explain why the global stock market recovery is less decisive than it was just a month ago, when the indicator improvement encouraged us to feel more constructive regarding the Risk vs. Reward possibilities for the stock market.
In the midst of the pessimism, we remain optimistic – even if only temporarily so. In assessing the price action of the major benchmarks, developed and emerging markets, sectors, and individual stocks, the breadth message tells us that the markets are trending higher at a time when season influences are turning decisively positive. December has tended to be the best month for stocks on an absolute basis and relative to Treasury bonds. (The seasonal influence is especially favorable for emerging markets, which will stand to benefit from their high beta tendencies if the global stock market advance continues into year-end and 2012, as we expect.)
The markets will tell us where they are going (i.e. the trend trumps fundamentals, as John Maynard Keynes said, “the market can remain irrational longer than we can remain solvent”). For sure, the messages can be difficult to detect in the midst of a steady stream of alarming headlines and the corresponding gyrations in day-to-day market activity. Like animals that move in herds for protection, investor herding is evident in the unprecedented number of lopsided trading sessions over the 75 trading days since early August, when global markets descended into a waterfall decline. In about one of every three days, more than ninety percent of U.S. multi-cap volume has moved in the same direction, and more than eighty percent of global stock prices have closed on the same side of the ledger. We can find no record of the market experiencing such a frequency of one-sided days.
With relatively few falling stocks offsetting the gainers on rally days, and a lack of gainers offsetting losers on down days, the S&P 500’s daily changes have been much greater than normal. The S&P 500’s average daily change over the past one hundred days has reached a level exceeded for only six percent of the time since 1928, usually around market bottoms. (The volatility has been global.)
Keeping in mind that the stock market leads the economy, continuing evidence of economic resilience would be added confirmation. Having priced in recession and now climbing the proverbial “wall of worry” the market may gain earnings confidence if surprisingly positive economic reports become more the global norm than the exception. As stated earlier, in the midst of the pessimism, we remain optimistic – even if only temporarily so. If worry fades, investors deploy their cash hoards, favorable seasonal forces kick in, and stocks trend higher into 2012, we will be watching for evidence of excessive optimism and overvaluation. But currently, the sentiment and valuation indicators are favorable. The indicators tell us that the market wants to go higher. Until the indicators (or the trends) warn otherwise, we expect to remain aligned with the developing uptrend.
Sector Leadership Messages
The leading tendencies of sectors and industries often provide clues around economic and market events. Listening to their relative performance since the early October market bottom, we hear several “messages”:
- Confidence Improving. Leadership has shifted from defensive (August 8th to October 3rd) to more cyclical / higher beta sectors (since the October 3rd low). Our historical studies show this is consistent with the confidence building that is part of the post-waterfall healing process.
- Mean reversion turning on. Mean reversion has occurred with Industrials and Financials, which were among the most beaten down sectors during the waterfall decline (along with commodity sectors). This is consistent with the factors we find following bear market bottoms.
- Emerging market commodity demand still intact. Commodity sectors have been leaders, consistent with our long-standing emerging market commodity-demand theme.
- No recession…for now. The “we are not in recession” message is confirmed by Energy rebounding relative to consumer sectors. Nonetheless, we will keep a close watch on this relationship, as a recession is probable in 2012 if additional stimulus is not forthcoming.
The recession call is important, as stocks lose their post-waterfall recovery bias when recession is afoot. The trajectory of the post-waterfall cases associated with recessions is much weaker relative to non-recession cases.
- Current Market Message. Longer-term secular themes continue to play out within the Industrials space. These industries are benefitting from the move to more efficient processing and transportation, as well as continued strong demand for heavy machinery from emerging markets as they build out their infrastructures. This is translating into strong pricing power and margin growth for these companies.
- Historical Market Message. Seasonality for this sector also comes into play for the remainder of the year. Of all ten S&P 500 sectors, the S&P Industrials sector has the strongest seasonal trend in December, and on an equal-weighted basis (as opposed to a market capitalization weighted basis) is second only to Health Care.
The Dividend Payer Story
The Federal Reserve is engaged in an epic battle against deflation and deleveraging. Over the past twenty years, it has fought against the vast new labor pool of highly educated Eastern Europeans, the popping of the Tech, Internet, and Telecom bubbles, and even more powerful wave of cheap Chinese labor, and the popping of an even more powerful housing bubble. The Fed’s solution has been to cut short-term interest rates to zero, and via Operation Twist (buying more longer-term Treasuries) to push long-term rates as low as possible.
When such blunt instruments are deployed, there no doubt are unintended consequences. By pushing ten-year Treasury yields into the two percent range, the Fed changed the relationship between bond yields and dividends yields. Over forty percent of the stocks in the S&P 500 index have dividend yields greater than the ten-year Treasury. September’s fifty percent reading was the most since at least 1972.
Was that consequence completely unintended? Perhaps not. The Fed’s goal is to push investors into riskier assets, like stocks. But the real question from here is whether Dividend Payers are overbought or attractive.
- In the short-term, a bullish stock-market cycle is a relative headwind for Dividend Payers (emphasis on “relative”, should the stock market cycle remain bullish Dividend Payers should also make money, and more safely so relative to their higher beta stock peers).
- In the long-term, Fed policy, improving corporate balance sheets, secular trends, and demographics enhance the attractiveness of dividends.
In regards to the question, “are Dividend Payers overbought”, Dividend Payers have outperformed relative to Non-Payers during this cycle of economic expansion, but not by nearly the degree they have historically. The recession odds have come down over the last month, but we still believe that the risk of a recession is very high in 2012 if more stimulus is not injected into the economy. If the recession odds increase then the stock market would likely resume its downtrend, which would favor low-beta Dividend Payers.
The above is a cyclical (i.e. shorter-term) comment. Longer-term, it is of interest to note that after collapsing in 2009, twelve month trailing GAAP (generally accepted accounting principles) earnings for S&P 500 companies, earnings hit a record $88 per share in the third quarter (Q3) in 2011. Yet the dividend ratio is a record low 28.6%, indicating that companies have the capacity to increase dividends.
Over the last couple years, corporations have retained more of their earnings than had been typical, pushing cash levels to a record high $3.9 trillion, or a record high 14.2% of total assets, implying the potential for the supply of dividends to continue to increase. (We do not dismiss the potential competition from stock buybacks but, at the very least, the cash on hand means that aggregate dividend payouts are not set to decline.) The point is that stocks that have increased dividends have tended to outperform over the long-run, which should benefit Dividend Payers and Dividend Growers.
Another secular bonus for Dividend Payers is that as baby boomers move into their retirement years, their focus is likely to shift from capital appreciation to income. If they are not getting income from bonds (or, if they simply cannot get income from Treasury bonds in particular), then dividends are a reasonable alternative. Demographics and Fed policy should keep the demand for dividends elevated.
Bottom Line: Indicators suggest the rally could continue. We should simply stay flexible, and monitor the indicator evidence and our reward/risk entry points.
Bulls continue to have a great deal of contrary pessimism in their favor, and the market may continue to rally as long as economic conditions don’t worsen. Bears, on the other hand, have an uncertain outcome in Europe and the rising risks of recession in 2012 if additional stimulus is not forthcoming. On a trading basis, the S&P 500 is expected to approach, if not achieve, 1,300 points over the coming months.
On a fundamental basis, the U.S. experiences a recession, on average, once every six years. That means some economic expansions last two years, some ten years. By the summer of 2012 the current expansion will have trended for three years and will have exhausted stimulative fiscal and monetary policies, while maintaining a disturbingly high unemployment rate. A new recession cannot be held off forever, not even the best of scenarios and the best of times. We worry about recession in late 2012 (this is not a new concern for us; we have been expressing this concern since June 2009 when we first projected that the U.S. was coming out of recession). But as stated earlier, in the midst of the pessimism, we remain optimistic – even if only temporarily so.