Market Outlook Letter
March 22, 2013
Investment Commentary & Outlook
The stock market typically becomes more selective as it moves higher, and we believe this trend will continue considering the analyst community only expects the S&P 500 to post 1.5% annual earnings growth when first quarter earnings are announced between mid-April through late May. While the stock market may be characterized by decelerating sales and earnings, our average Small-to-Mid Growth Portfolio stock is currently characterized by 34% average annual sales growth and 360% average annual earnings growth, while our average Large Cap Growth Portfolio stock is characterized by 11% average annual sales growth and 168% average annual earnings growth.
In the meantime, yield hungry investors continue to bid up high dividend stocks like those in our Power Dividend Portfolio, which had a strong 2012 returning 24.12% (pure gross) and 22.17% (net) versus 16.42% for the Russell 3000 Index. Moreover, as inflation heats up, bond yields could rise, effectively causing the “bond bubble” to burst. Ironically, fear of the bond bubble bursting could cause investors’ asset inflows into high dividend yielding stocks to accelerate, since investors might start fleeing bonds.
We are now in the first quarter earnings pre-announcement season, and the S&P 500 has had its earnings estimates cut by 3.6% in the past month, while the Russell 1000 Growth and Value indices have seen their earnings estimates cut by 8.4% and 7.1%, respectively. So while the analyst community is slashing earnings estimates, our average Fundamental ‘A’ Portfolio stock has had its earnings revised up 11.21% in the past month. Typically, positive analyst earnings revisions precede future earnings surprises, so we are excited about the upcoming first quarter earnings announcement season.
Despite these earnings woes, The Wall Street Journal recently reported that companies in the S&P 500 are expected to pay out at least $300 billion in dividends in 2013, which is higher than 2012’s record $282 billion dividend payout, which included many special year-end dividends. The Wall Street Journal also reported that in February, Corporate America announced plans to buy back $117.8 billion in outstanding stock, which is the highest monthly buyback amount announced since records began in 1985. Clearly, the Fed’s 0% interest rate policy remains a “flashing light” for Corporate America to issue bonds and aggressively buyback their outstanding stock. Due to the Fed’s 0% interest rate policy, plus record stock buybacks and dividend payouts, investor confidence is soaring.
Thanks largely to relentless stock buybacks and rising dividends, the stock market’s day-to-day volatility has declined considerably and the VIX index that measure volatility continues breaking into new low territory. So far this year, any market pullback is quickly met with a new wave of buying pressure. As investors continue to decrease their “cash on the sidelines,” we suspect that inflows into market may persist for the next several months. Historically, however, the stock market typically gets a bit “bumpy” after the pension funding season winds down in April.
Interestingly, as the foregoing chart illustrates, May 2012 was a down month with almost daily price erosion. However, for our Large Cap Growth Portfolio, May 2012 was our best month relative to the overall stock market, since many of our Large Cap Growth stocks were announcing better-than-expected earnings and gapping higher. This “flight to quality” may very well be repeated in the upcoming months. One of concerns of the overall stock market is that many low quality stocks have been rallying, especially on strong days when there is obvious short covering.
Despite the great foundation underneath the stock market from rising dividends, increasing stock buybacks, and persistent inflows, we believe the market will narrow as it climbs higher. We expect that our fundamentally strong growth stocks will stand to benefit most when the going gets tough, just like our Large Cap Growth Portfolio did in May 2012 in the wake of better-than-expected first quarter earnings results.
FOCUS ON THE FED
The stock market is addicted to the Fed’s 0% interest rate policy – Quantitative Easing to “infinity” and Operation Twist to “eternity,” so investors can be wondering how long the low rates will last. According to the Fed, rates will remain low until the unemployment rate falls to 6.5%. Currently, the unemployment rate is 7.7%, and the February payroll report posted the biggest monthly job gain since last November. Furthermore, new claims for unemployment are at the lowest level in five years. Overall, the job market appears to be on the road to recovery, so speculation is rising about how long the Fed will keep its seemingly eternal money pump on.
Investors gained insight to the Fed’s thinking from the latest Federal Open Market Committee (FOMC) minutes. These minutes revealed the infighting within the Fed between the doves and hawks as “several” FOMC members were growing increasingly “uneasy” that the costs and risks of the $85 billion per month in quantitative easing was becoming less effective and may have negative repercussions. The minutes also identified a new idea backed by a “number” of Fed officials: that the Fed should tap the monetary brake a bit. Other ideas were also floated. The impression from the FOMC minutes was best summarized by Millan Mulraine, senior economist at TD Securities, who said, “The minutes … show a committee that is far less unified than any other time in the past few years.”
Wall Street immediately reacted negatively after the release of the FOMC minutes because it feared the Fed would scale down its $85 billion per month in quantitative easing and that the 10-year Treasury bond might rise to 3% or more, based on research recently published by Goldman Sachs. Much of the stock market’s recent strength is from investors seeking higher yields, corporate stock buybacks, plus money the Fed is pumping into the bond and mortgage-back market that is spilling into the stock market. So if the Fed “taps the brakes,” the stock market should also slow down.
The day after the stock market reacted negatively to the FOMC minutes, FOMC members started damage control and tried to calm spooked financial markets. For example, San Francisco Fed President John Williams said the Fed’s quantitative easing is providing a “much needed boost” to the economy and will be needed well into the second half of the year. Williams added that “We need powerful and continuing monetary accommodation,” and stated that “Unemployment is far too high and inflation is too low.” In a clear contrast, St. Louis Fed President James Bullard said the U.S. economy is on the mend and that Fed may consider raising interest rates by 2014 and boldly predicted that the unemployment rate will fall below 6.5% by June 2014. However, Bullard also admitted his unemployment forecast is more optimistic than his other Fed colleagues. Bullard also implied that the Fed should consider adjusting its asset purchases by $10 or $15 billion per month based on the FOMC’s interpretation of economic data. In the end, Bullard concluded that the Fed’s quantitative easing will continue for “a while” and gave the impression he was in a minority on the FOMC. Finally, an outspoken hawk, Dallas Fed President Richard Fisher said the Fed would not go “cold turkey” in halting its asset purchases.
Longer-term, one increasingly obvious negative repercussion of the Fed’s money pump is the possibility of runaway commodity inflation and the eventual decay of the U.S. dollar. In fact, we would argue that a weak U.S. dollar was largely responsible for gasoline prices going up one cents per day in the first two months of this year, since crude oil prices rise as the U.S. dollar falls. In other words, the Fed’s excessive monetary pumping is clearly sowing the seeds of inflation.
As further evidence that inflation is brewing, the Labor Department recently announced that the Producer Price Index (PPI) rose 0.7% in February. Excluding food and energy, the core PPI rose 0.2%, since energy prices rose 3%, with wholesale gasoline prices rising a whopping 7.2%. The PPI component for intermediate goods rose 1.3% in February, so it appears businesses are passing on higher energy costs.
The Labor Department also recently announced that the Consumer Price Index (CPI) rose 0.7% in February, which was slightly above economists’ consensus estimate of 0.6%. Excluding food and energy, the core CPI rose a more modest 0.2%, due largely to energy prices rising 5.4% due largely to a 9.1% rise in the price of gasoline. Core inflation in the past year is running 2% based on the CPI and 1.3% based on the Fed’s preferred Personal Consumption Expenditure (PCE) index. Despite that the PCE is still low, the Fed’s goal of keeping inflation under 2% is becoming more difficult. Since it is becoming increasingly evident that CPI inflation is rising at the fastest pace in three years, the Fed may need to tap the brakes on its money pump sooner than later, especially as the unemployment rate nears its stated target of 6.5%.
In the meantime, the U.S. dollar rose in recent weeks after Moody’s downgraded Britain from a cherished AAA rating to an Aa1 rating. Another factor bolstering the U.S. dollar is that a comedian, Beppe Grillo, won the recent Italian election in an anti-austerity protest vote. Since Beppe Grillo only won 26% of the overall vote and cannot put together a ruling coalition with former Prime Minister Silvio Berlusconi, who received 25% of the vote, another Italian election is expected resulting in voters’ success at deferring austerity cuts via political chaos.
With a temporally stronger U.S. dollar, which helps reduce commodity inflation near-term, the Fed is still clear to continue its seemingly endless money pump. This was made clear by Fed Chairman Ben Bernanke who recently went before Congress to defend the Fed’s unprecedented quantitative easing. Bernanke openly admitted that he and his colleagues on the FOMC are debating whether or not to curtail its $85 billion per month in quantitative easing amidst concerns that the Fed’s $3.1 trillion balance sheet (up from approximately $800 billion in 2008) may encourage excessive risk-taking by investors and complicate the Fed’s eventual exit from its relentless quantitative easing. However, the most fascinating comment from Chairman Bernanke was when he said the Fed’s policies “are increasing demand globally and helping not only our businesses but the businesses in other countries that export to us.”
In other words, Bernanke feels the Fed’s responsibility is to not only right America’s economic ship, but to also save the world economy. The other interesting exchange was when Senator Bob Corker of Tennessee called the Fed Chairman a “dove” and Bernanke responded by saying, “Well maybe in some respects I am, but on the other hand my inflation record is the best of any Federal Reserve chairman in the postwar period … at least one of the best, about 2% average inflation.” The bottom line is that Chairman Bernanke essentially admitted he was a proud “dove” that was saving the world and left the impression that the Fed would likely continue its quantitative easing for up to 3 years.
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With the perception that the Fed pump might be perpetual, the stock market rose after Chairman Bernanke’s testimony before the Senate Banking Committee. Bernanke said, “In the current economic environment, the benefits of asset purchases are clear.” Translated from Fedspeak, the Fed Chairman is saying the Fed cannot turn off the money pump without causing interest rates to soar. As far as the stock market rallying due to the low interest rate environment the Fed created, Bernanke said Fed policy was not fostering a bubble in the stock market, “I don’t see much evidence of an equity bubble.” Bernanke added that “Earnings are very high, and equity holders are risk-averse in their behavior,” but tried to assure Congress the Fed was on the lookout for excessive risk-taking. In the end, Bernanke’s comments ignited an impressive stock market rally.
Adding fuel to the stock market’s fire was also Fed Vice Chairman Janet Yellen who stated in a speech at a San Francisco Fed research conference, “At present, I view the balance of risks as still calling for a highly accommodative monetary policy to support a stronger recovery and more rapid growth in employment.” Interestingly, Yellen essentially admitted there is some inflation risk to the Fed’s aggressive quantitative easing but said, “at this stage, I do not see any that would cause me to advocate a curtailment of our purchase program.” Since Yellen is viewed as a potential replacement for Fed Chairman Ben Bernanke when his term expires in 2014, her dovish stance on the benefits of relentless quantitative easing further helped spark the stock market and propel the Dow Industrials to new highs.
Yellen’s most controversial statement was that “A premature removal of accommodation could, by slowing the economy, perversely serve to extend the period of low long-term rates.” Translated from Fedspeak, Yellen admitted she plans to keep quantitative easing in full force, so the stock market naturally celebrated the Fed’s intervention. In an attempt to thwart criticism that the Fed may be creating a stock market bubble, Yellen defended it by saying, “At this stage, there are some signs that investors are reaching for yield, but I do not now see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability.” It appears the Fed’s money pump is going to be on for at least the next couple years.
While we are talking about the Fed, we must add that the recently released Beige Book survey indicated that the federal government is getting in the way of a sustainable economic recovery. The survey cited that retail sales had slowed in many districts through late February and cited muddled fiscal policy and higher gasoline prices as the culprit behind slowing retail sales. Interestingly, the Fed reported that employers in several districts also cited “unknown effects” of the Affordable Care Act as reasons for planned layoffs and a reluctance to hire more staff. Despite these distractions, 10 of the Fed’s 12 districts reported gradual economic growth through late February, while the Boston and Chicago districts reported slower economic activity. Overall, it is clear the Fed will use this latest Beige Book survey to continue to justify its aggressive money pump at its March FOMC meeting. So the seeming eternal Fed money pump will remain on, and the stock market is the primary beneficiary.
SUMMARY
The stock market is behaving like a great party where everyone is having a wonderful time. However, like at any great party, we must identify the designated drivers and try to ensure everybody gets home safe. Like last May 2012, we expect the market will experience some sort of correction this year. We believe the most likely time for this correction is in May after the pension funding season winds down in April and the seemingly flow of funds into the stock market ebbs a bit.
In preparation for the bumpy road ahead, we have been concentrating many of our growth portfolios in fewer stocks and selling companies that have become increasingly volatile. Ironically, the vast majority of stocks we have been selling in the past couple months are still characterized by fundamentally strong sales and earnings. However, we believe to control volatility, we sometimes have to sell good stocks to buy better stocks.
The overall stock market has a good foundation thanks largely to stock buybacks and dividend payouts, plus the Fed’s seemingly eternal money pump. That is the good news. The bad news is that the first quarter earnings announcement season is expected to be tough for the S&P 500, since overall earnings are expected to rise only 1.5%. We are now in the first quarter earnings pre-announcement season, and the S&P 500 has had its earnings estimates cut by 3.6% in the past month, while the Russell 1000 Growth and Value indices have seen their earnings estimates cut by 8.4% and 7.1%, respectively.
Similar to what occurred in May 2012, we believe a flight to quality is inevitable, since too many low quality stocks have been rallying this year. We have been focusing our growth portfolios on fundamentally strong stocks that can best weather the expected bumps that typically occur when the stock market becomes increasingly selective after a strong bull market. As a result, we have been selling stocks that have become too volatile in recent months.
We should add that we anticipate that any of these “bumps” will be temporary, since the stock market’s earnings are expected to pick up in the second half of 2013. We are excited by the larger trends of the market: companies increasing dividends and aggressively buying back outstanding stock, plus the Fed pumping $85 billion per month into the financial markets is aiding stock buybacks as companies rush to issue bonds yielding less than 3%. Corporate America is now raising almost $2 trillion per year in the bond market to refinance existing debt, buy other companies, and aggressively buyback existing stock.
The Fed’s 0% interest rate policy and seemingly eternal money pump is a big “flashing light” for Corporate America to aggressively buy back its outstanding stock before the Fed turns off its money pump. This will likely happen when the unemployment rate approaches 6.5%, down from 7.7% currently. According to St. Louis Fed President Bullard, the Fed may end its quantitative easing by mid-2014, since he is optimistic the unemployment rate will hit 6.5%. However, Bullard is in the minority, and the consensus of most economists is that the unemployment rate will not reach 6.5% until mid-2015. On the other hand, there is Fed Chairman Bernanke who said the Fed would likely continue quantitative easing for up to 3 years. Whether or not the Fed will turn off its money pump in 2014 (Bullard), 2015 (consensus of economists), or 2016 (Bernanke), the bottom line is the stock market has emerged as the primary beneficiary of the Fed’s seeming eternal money pump.
We want to assure you that despite what we believe will be an increasingly bumpy stock market by May, we believe fundamentally strong growth stocks will fare especially well, as they did last May. The average dividend yield associated with our growth portfolios continues to rise and now stands at 1.61% for our flagship Large Cap Growth Portfolio. Corporate stock buybacks remain relentless, especially after Corporate America announced plans in February to buy back $117.8 billion in outstanding stock, which is the highest monthly buyback amount announced since records began in 1985. As always, our growth portfolios remain characterized by stocks with strong sales and earnings. And though we believe we are still in the early innings of a stock market rally, remember that typically the longer the rally persists, the fewer stock market leaders will emerge.
P.S. Please visit our stock rating system on over 5,000 stocks at http://www.navellier.com/StockGrader. The enhanced version of our stock rating system allows you to save portfolios, so that you can check the stock ratings on separate portfolios every week. We update our stock database every Monday following our weekend research.
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