Other than a mild dip in spring 2010, the stock market has enjoyed a near two-year uptrend. While much of the world still is trying to clear the dust and debris from the collapse in 2008, equities have disengaged themselves from the rest of the economy and are approaching pre-recession highs (see "Back from the brink").
A disconnect largely has been created where earnings and equities are continuing to rise while the U.S. economy continues to battle unemployment and sluggish growth. The January non-farm payroll report, released on Feb. 4, showed that the country only created 36,000 new jobs though the unemployment rate dropped to 9% from 9.4%, which has been attributed to faulty seasonal adjustments. "While the markets are up and earnings are up, it’s not necessarily all driven by positive, good, healthy economic growth. A lot of it is just temporary money sloshing around," says Chris Mayer, managing editor at Agora Financial.
It is tough to distinguish real growth from the effects of government stimulus and the Fed’s quantitative easing. "The economy is not growing very fast. I mean 3.2% GDP on $14 trillion stimulus is pretty pathetic," says Keith Springer, president of Springer Financial Advisors. "It was enough to prevent another catastrophe on the downside, but the economy has to find equilibrium [and produce real demand]."
Springer says the equilibrium is forming as corporate earnings are rising not as a result of an increase in demand, but because of scaling in production to meet current demand. Jobs, though, are still the heart of the matter.
"[Companies] got rid of all the fat they possibly could in the recession. Into recovery, we haven’t had an increase in hiring," says Paul Larson, equities strategist at Morningstar. "So, they are working their existing [employees] just that much harder when you look at the number of hours worked and productivity numbers."
Larson says stocks as a whole are slightly overvalued. "Our median stock is approximately 6% overvalued," adding that there is more value in large-cap stock as small-caps outperformed them over the last 18 months.
Because of the massive layoffs throughout the crisis, companies are leaner than ever and pushing their workers to do more with less. "You’ve got a skeleton crew, the employers whipping their guys [to do more] and now demand is starting to creep back in," says Jeffrey Friedman, senior market strategist at Lind-Waldock.
The result is companies that are producing enough to meet demand with a very productive workforce and access to cheap money. "Companies have laid off people and what they are doing is producing the amount of goods necessary to meet demand. We’re not seeing demand increase. A company that makes a product is only making what they know they can sell and [are] hoarding cash," Springer says.
He doesn’t see this as a positive as companies are not re-investing that cash.
While this scenario explains, in part, why equities have been so strong since the March 2009 low, it won’t support further strength without more tangible economic growth.
A lot hinges on consumer demand. Most analysts say that is beginning to return, except for housing. One factor for demand is consumer confidence; if consumers have no confidence in the economy or the safety of their jobs, then demand will diminish.
In January, the Consumer Confidence Index (CCI) rose to 60.6 from the December reading of 53.3. While an increase, the January reading is still far from the 90 that signals a healthy consumer mindset (see "Good, but not great").
This is particularly evident in the housing market. "The housing market is the bedrock of the economy. Unfortunately, values are still at a level where people can’t get out. [Both] the foreclosure rate and the purchasing rate per income still are lagging," Friedman says.
The result is consumers with enough confidence to buy small-ticket items, but not enough to help the housing market despite low rates. "People have enough confidence to go buy a new car. A $20,000 car is not a $300,000 house, though," Friedman says.
He says equities are overbought but adds, "I don’t want to fight the tape." He expects a correction, but sees the S&P 500 reaching 1371 before it happens. "If we close beneath 1300, all bets are off; we’re probably going to go down to 1260. Once we start to break, we’re going to break hard."
He also expects the Nasdaq to outperform the S&P. "The Nasdaq has bigger swingers. It is a mover and a shaker. Traders tend to gravitate to the tech world," he says.
Springer says housing is in a depression, not a recession, and sees four or five more years of it before the sector recovers.
Consequently, an uneasy equilibrium has developed where companies are matching demand but are unwilling to expand, and consumers have enough confidence to continue buying small-ticket items but not enough to commit to very large purchases.
Fed fiddling
Federal Reserve Chairman Ben Bernanke has said on multiple occasions the Fed is commited to its dual mandate to combat both inflation and unemployment. While Bernanke may say inflation still is not an issue, commodity prices of items consumers use tell a different story.
While housing continues to fall, commodities such as cotton, coffee and sugar have soared. Even lumber is near multi-year highs despite the housing woes.
Inflation is beginning to affect companies’ earnings. "Companies are split into two groups. The first are those that can raise prices and are enjoying high or expanding margins. Then you have companies that are really feeling the squeeze," Mayer says.
History indicates that equities tend not only to be more volatile in inflationary times but these also have been some of their best years (see "Inflation and the S&P"). The longest period of extended equity growth occurred after the inflation tiger was tamed in the early 1980s. It is hard to say what effect, if any, changes in Consumer Price Index (CPI) reporting to produce a lower CPI (but not necessarily less inflation) are having on the markets. (For an alternative look at CPI, go to www.shadowstats.com.)
If companies are able to continue posting good earnings even with inflation at work, the Fed may need to revisit its "extended period" for exceptionally low rates. "The Fed really is in a hard spot. On the one hand, they are providing all this extra money, pumping up the liquidity and really causing inflation," Mayer says. "On the other hand, they want to keep interest rates low, because consumers are still pretty leveraged and the government has to roll over quite a bit of debt every week."
The question really becomes at what point should the Fed risk a shaky recovery by raising rates? "QE2 put the deflationary spiral fears to bed and tipped the inflation needle back toward higher inflation," Larson says. "The bigger concern now is inflation and is the Fed going to be able to raise rates to fend off inflation at the same time that we have an economy that is still recovering?"
The Fed soon may have to address inflation. "The Fed is not putting money into the system because things are good right now. They continue to keep interest rates low because they know things are terrible," Springer says.
Proceed with caution
Analysts stressed the need for investors to perform their own due diligence as they research companies. "If you’re buying stocks, you are buying individual businesses and it pays to watch those individual businesses," Larson says.
Mayer agrees. "I’d be very conscious about investing in a business that can survive in what I envision will be a very inflationary environment where costs are rising," he says. "Pay attention to the business in particular as to whether it can raise prices or re-price in a market where we’re going to have rising costs."
Springer says investors should continue to watch earning and earning expectations. Additionally, sentiment can be a factor, something he says the individual investor cannot judge on his own. "When he feels good, it’s usually the worst time to buy," he says.
While all the analysts we spoke with expected the stock market to make further gains, they were nonetheless divided on the long-term trend of the market, whether it is a bull or bear.
Mayer calls it a bull. "We’ve been in a bull market since the March ’09 bottom. The earnings story tells a lot. Companies clearly are better off now than they were in ’08. The rest is the action of the market itself; it has pretty much doubled since then," he says.
Friedman agreed with much of that assessment and added that he expects to see 10%-15% gains in the stock indexes by the end of 2011. Good stock pickers should be able to do even better, he says.
Springer disagrees and says we just are experiencing an up-leg in a secular bear market. While he expects the markets to make gains of up to 20% in the first half of the year, he expects the market to turn from there. "We’re having a bull market right now which could last six months to a year longer. This is still a bear market, though, that started in 1999 and will probably go until about 2017. Every bear has its up-legs," he says.
Larson is somewhere in the middle. "The markets are roughly fairly valued at this point. I am neither a raging bull nor bearish at this time. I would call it even money at either outcome," he says.
Jeff Greenblatt, editor of the Fibonacci Forecaster, provides clearer guidance. "We’ve been watching resistance in the SPX at 1325 for weeks. This is the long-term bear market’s most important test. It’s an excellent gauge as to whether we can confirm the March 2009 bottom as a generational low. If the SPX pierces this level it is no longer in bear market territory."
Two sectors our analysts expect to do well this year are healthcare and technology. Healthcare was hampered last year by the healthcare reform legislation. "These stocks sold off early because of all the fear, uncertainty and doubt," Larson says. "The current uncertainty surrounding the healthcare bill isn’t as much of a factor because we’re still going to see a higher proportion of the public with health insurance going forward."
Within the sector, Larson likes Pfizer (PFE), which he owns. He says it isn’t cheap because of the reform, but because the patent on Lipitor is set to expire soon. Springer named Healthcare Properties (HCP) because of its 7% yield and he projected it would have 20% growth.
Springer also picked the technology sector. "Companies use technology to down-size workers. If you can buy a piece of equipment that does the work of two to four people, you’re going to do it even if it’s a high cost upfront," he says. To that end he says Google (GOOG) is a perfect modernizing tool for businesses. Springer also mentioned Apple (AAPL), "Because people always want their toys."
Friedman agreed that technology would continue to do well. "There seems to be a love affair with electronics and the American consumer. Looking through that view explains why the Nasdaq has been leading the way," he says.
We keep hearing the economy is turning a corner, but a lot of questions still exist. "We’re probably OK for 2011, but I worry longer-term," Mayer says. "If we start to see a dip in unemployment and if we finally see the housing market recover, then we have a chance of the recovery sticking around."
Another question investors may ponder is if equities can perform so well in a sick economy, does that mean they will perform even better when we see growth, or is that future growth already priced in?
