The global economy did not stop dead in its tracks after Brexit as many pundits had predicted. Earnings reported so far for the second quarter and the outlook for the rest of the year appear surprisingly strong. No surprise to us.
Low interest rates In combination with higher earnings has resulted with a stock market continuing its upward path to new highs. It does not hurt that the flow of funds from abroad keeps our yield curve flatter than it ordinarily would be at this point in the economic cycle. The dollar, too, has been a beneficiary of the flow of funds from abroad and a strengthening U.S economy.
I have heard what all the naysayers continue to say about the market. Many who predicted a difficult/down year for months are now calling for a summer correction of 6+%, including my former partner Byron Wien. I don't think that they realize how strong underlining S & P earnings currently are and that earnings growth will accelerate over the next few quarters as volume improves resulting in positive operating leverage. It does not hurt that energy and material companies' earnings comparisons get easier sequentially too. Better days are ahead and the market is a predictor of the future, isn't it?
Corporations have done an excellent job managing profitability in a difficult global economic environment and the best is yet to come. I suggest that you listen to or read the Nucor, Honeywell and General Electric conference calls to get a glimpse of what I am discussing here. Managements look for acceleration in orders, shipments and profitability for the remainder of the year and for 2017. Balance sheets are strong and each company is generating huge free cash flow. GE reiterated that it will achieve its earnings target of $2.00 per share in 2018 from approximately $1.50 per share this year which is up over 10% on an operating basis from 2015. Not too shabby. Nucor is a gem in the steel industry and Honeywell is just a well-managed growth industrial company. We own all three stocks.
While the stock market continued to advance to new highs, the bond market backed up further and yields are now above the pre-Brexit levels. The 10-year bond still hovers around 1.55%, which is remarkably low due in good part to huge inflows from abroad where rates remain negative in many countries. It is clear that the ECB and BOJ will maintain its overly aggressive easing policies so don't expect the longer end of our bond market yield to lift as you may assume. The question on the table is what the Fed may do as our economy accelerates in the second half of the year as we anticipate. Common sense would dictate that they maintain rates at these levels keeping their feet off the brakes, as the global economy needs our economy to be strong offsetting weakness elsewhere.
Let me repeat that the Federal Funds rates would NOT be this low in normal times but this is anything but normal. We live in a VUCA environment and the Fed should not alter policy until the global economy is on better footing. Risks to the downside and deflationary fears remain present so why take the risk.
Bottom line is our stock market remains statistically undervalued as the market multiple should be higher than most think reflecting low rates, low inflation and less financial risk in the system, and we are on the verge of an earnings resurgence that most do not predict.
Stop looking at historic multiples at past tops, as these are not normal times. When has our 10-year bond yielded 1.54% with an economy expanding by 2+% and inflation running around 1.8%? Not in my lifetime. Here again, the experts are looking through the rear view mirror. The Fed has finally awoken that low inflation may not be transitory so why don't the "market experts" recognize that change everywhere and the past is not the prologue for the future. It is a whole new ballgame. Unless you adapt your thinking, you will continue to underperform as you have for four years.
Could there be a correction? Of course, and for a multitude of reasons, but the wind is now behind your back. As I mentioned last week, most investors have record cash levels and are under invested. Expect repeated calls for a correction as the market marches higher and also expect analysts to lower their ratings after sharp up moves in stocks. All are trying to trade the market, which is difficult at best. How many rich traders do you know? Even we hedged a small portion of our portfolio as we mentioned last week as strong performance took us up over 98% net long.
Bottom line, it is not over yet so don't trade out of your investments. Hold the line!
We are investors, not traders, and recognize that the broader trends in place dictate higher stock prices, higher bond yields and a strong dollar. We continue to outperform for all the right reasons.
Summary of Key Events of the Last week
1. The U.S economy continued strong and the majority of companies reporting second quarter profits beat forecasts
2. The ECB maintained its current policy taking a wait and see policy regarding Brexit but stands ready to act more if needed. The Bank of England did not alter policy too but remains ready to act if needed as well.
3. The BOJ commented that both additional monetary and fiscal stimulus may be needed but disavowed, "helicopter money."
4. The Group of 20 convened in China and said once again that there needs to be more coordinated actions amongst all nations, more fiscal stimulus and regulatory reform and no competitive devaluations. Sounds like a broken record to me.
5. The Republican Convention formally anointed Donald Trump as their Presidential Candidate along with Michael Pence of Indiana as his running mate
6. Hilary Clinton announced that Tim Caine of Virginia will be her running mate.
Let's wrap this up.
I believe that "incremental domestic growth and "incremental" profitability will improve in the second half of the year leading to stronger stock markets and a rising slope in the yield curve. Both the BOJ and ECB will maintain overly aggressive easing strategies, which will keep the short end of the yield curve low and also put a lid on our longer-term interest rates due to huge flow of funds into the U.S. from abroad. I continue to believe that energy supply/demand will move into balance in the second half of the year and oil prices are range bound between $40 and $50 dollars per barrel. M & A will stay at record levels, as both the buyer and the seller are winners. It does not hurt that corporate balance sheets are strong, companies are generating huge free cash flow and terms to finance deals are incredible as buyers for the debt are everywhere searching for some yield.
But remember that this is a market of stocks and not all are equal. I prefer to only buy market leaders with strong management, sound growth strategies, great balance sheets and dividend yields around 3% or better. Finally I continue to shift toward a more cyclical bent in the portfolio maintaining excess liquidity all the time to be prepared to take advantage of unexpected events.
It is imperative that you gather all the data, take a deep pause and reflect, consider mindset changes, control risk and maintain excess liquidity, do independent research on each investment idea and..
William A. Ehrman is managing partner at Paix et Prosperite LLC.