By: Tim Callan
We are off to a great start in 2012 with the S&P up over 10% in the first quarter giving back only about 2.5% during the month of April. The S&P is up 108% (120% if you include dividends) since it bottomed in March 2009.
During this period, many investors have remained on the sidelines fearing volatility. Currently, $9.9 trillion of investor funds sits in savings accounts, money market funds, certificates of deposits etc., earning near zero return. To put that in perspective, total mortgage debt outstanding in America is $9.8 trillion. We are now within 10% of the market highs set in 2007, and many investors fear that the current rally is over. A pull back after such a significant gain would be normal. However, fundamentals suggest the market still has room to grow long term. Large U.S. companies have never been more profitable than they are now, and they have never hoarded so much cash either. The forward price to earnings multiple is 13 times, which represents a 17% discount to the valuation at the peak of 2007 and a 50% discount to the valuation at the peak of 2000.
As companies continue to hoard cash, they experience increased pressure from investors to return it to the shareholders through either share buybacks or increasing dividends. For the S&P 500, buybacks are up from $50 billion in 2009 to $120 billion in 2011 and dividends have increased from $80 billion in 2010 to over $140 billion in 2011. We expect 2012 to set a new record for dividends and buybacks with growth of over 20%.
Economic Growth and Employment
The economy continues to grow, albeit slowly. The fourth quarter gross domestic product increased 3% on an annualized basis and we expect between 2.5% – 3% growth for 2012. We continue to see job growth around 200,000 jobs per month, (excluding March which came in at 120,000 jobs) and we stand at an 8.2% unemployment rate. At the current rate of job growth, we likely won?t see full employment until 2016.
Unemployment varies drastically by education level. The unemployment rate for those without a high school degree is 13%, while those with college degrees have an unemployment rate of 4.2%. Many individuals start college and for various reasons, mainly financial, never finish. There?s not a big difference between those with high school diplomas and some college experience versus those with high school degrees and no college experience, 7.3% versus 8.3% respectively. As a result, it?s more important than ever that parents plan for continuing education for their children.
The 4th quarter of 2011 saw significant fears of another global recession stemming from the European debt crisis. However, those fears have subsided. The ECB injected over $2 trillion into the banking system in the 4th quarter preventing another Lehman style disaster in the region. As a result, we expect the European recession to be milder that we previously thought for the major economies of France and Germany. However, risks still remain especially in the peripheral countries of Greece, Italy, Spain and Portugal as they fight to keep their borrowing costs under control.
Other risks are still in play. A tremendous amount of political pressure exists to cut the mounting U.S. deficits by a large amount in a short period of time. If nothing is done by the end of the year, $500 billion in austerity measures will take effect in 2013 which, if legislation doesn?t change, would push the economy into recession. For example, the Bush tax cuts are set to expire at the end of this year causing tax increases across the board. In addition, part of the debt ceiling limit increase agreement reached in July 2011 creates $1.2 trillion in spending cuts over 10 years starting in 2013. The best way to reduce the deficit is gradually rather than immediately. Congress will likely come to an agreement to change this after the presidential election.
The other risks we see pertain to oil prices. Oil is now trading at $104 per barrel up from $45 after the crash in 2008. Oil currently represents a 3.2% drag to our GDP growth. For every 30% increase in oil, it reduces our GDP growth by 1%. We do see risks with Iran, which provides about 4.9% of the worlds oil supply. The U.S. is increasing sanctions on Iran effectively cutting the supply of the market and putting upward pressure on prices. The world economy can withstand a 4.9% cut and continue to grow. However, Iran has threatened to shut down the Strait of Hormuz where 18% of the world?s oil travels. They don?t have the military capabilities to do this for a long period of time but they can certainly cause havoc in the oil markets if they attempt to do so.
Despite the current market rally and risks, we continue to think that riskier assets, i.e. stocks, will outperform risk-free assets, i.e. treasury bonds and we continue to position our portfolios to reflect this.