Two recent headlines:
"FedEx cuts outlook, citing global growth concerns."
"Dollar General Boosts Outlook."
As we have noted countless times in this space, the genius of Mr. Charles Dickens (pictured above) has given us the perfect way to describe this most imperfect economy. A year ago the concern focused on the anemic recovery here in the United States, a recovery so meager that the unemployment rate was (and still is) stuck at levels once associated with a full-blown recession. Stagnant wage growth seemed to be eroding the once-vast middle, pushing prosperity, in true "Tale of Two Cities" fashion, to the very high end and the very low end. Hello, Coach and Tiffany, Dollar Tree and TJ Maxx; goodbye J.C. Penney. Then, as the European crisis and the slowdown in China took center stage, the high-end luxury retailers had their trip to the woodshed. After all, their growth supposedly depends on international expansion. As 2011 came to a close, worries about the U.S. economy seemed to abate, and stocks staged an impressive rally in the first quarter of 2012. The gathering clouds of a perfect economic storm have waxed and waned in the consciousness of investors, as the world economy seems more and more imperiled, and as it appears more and more unlikely that our elected officials here at home will do anything to avert the so-called "fiscal cliff" of drastic spending cuts and tax increases due to arrive on the first day of 2013. And yet, the stock market has mustered another rally this summer. How can the market do so well even as nothing seems to be halting the pace of our march to the economic precipice?
Part of that answer involves the anticipated monetary easing from our Federal Reserve. The Fed's easy-money policy is designed to stimulate economic growth--and, of course, the jobs that improved growth might bring.The problem is that historically low interest rates do not guarantee that the cheap money will be applied to productive investments that spur economic growth. In other words, the Fed, through lower interest rates, creates conditions favorable to economic expansion, but that doesn't mean that the expansion will necessarily occur. If you would like to buy a house and are enticed by rock-bottom mortgage rates, you are still unlikely to take that step if you think you might lose your job within six months. Or, it is like if your car won't start because the battery is dead and you need a new one, but the mechanic shows up and puts a new set of tires on your vehicle without replacing the battery. A new set of tires, like lower interest rates, is probably good, but the car still won't start. Investors still hold out hope that this latest round of monetary stimulus might finally do something to kick the economy into a higher gear. Skepticism is warranted, however, because the Fed's prior easing moves thus far have not translated into enough growth to meaningfully improve the employment picture.
Stock prices are a function of two factors: the anticipated future earnings of corporations and the interest rate used to arrive at a present value of those earnings. If this latest round of monetary stimulus does lead to more growth, then that will likely mean higher earnings for many companies. So, one reason the stock market responds favorably to such stimulus is the prospect that the economy may indeed improve at least somewhat, making it likely that companies will do more business and earn more profits. Even without a significant improvement in profits, however, the Fed's easing works its magic on the stock market by making each dollar of earnings worth more. Think of it this way: How much would you be willing to pay today for the promise of $100 in seven years? Well, you would begin by figuring out how much you would have to put into an interest-bearing savings vehicle so that, with compound interest, you would end up with $100 at the end of seven years. At an interest rate of 10%, that comes to about $50 (this is known as the seven-year rule, where at 10% interest, compounded, you double your money in seven years). So, here that $100 in seven years has a present value of $50, at 10%--and you wouldn't pay any more than $50 for that $100 seven years hence. Now suppose that instead of 10%, the interest rate in question is just 1%. The future payment of $100 is now worth much more than $50; likewise, you would have to start out with much more than $50 if you wanted to have $100 at the end of seven years. With stocks, every dollar of future earnings is worth more as interest rates decline, and this is what is reflected in a stock's price-to-earnings multiple (P/E ratio, or the value placed on each dollar of earnings). As interest rates fall, higher P/E multiples typically result, and that is how we can get higher stock prices without a big improvement in earnings.
This is how the stock market faced a situation very close to what could be called a "win/win" over the past several months, at least. If it turned out that economic growth was actually stronger than what was expected, this would presage higher earnings, and stocks would increase in value to reflect these improved profitability prospects. If economic growth was instead weaker than expected, the Federal Reserve would undertake more accommodative monetary action to lower interest rates, and this would mean that each dollar of future earnings would be worth more. Either way, the stock market goes up. (Isn't it lovely!) This relationship between interest rates and assets prices is often expressed in yet another way. When the Fed says that interest rates will be near zero for the next three years, people realize that they are not going to be getting any kind of return from their cash balances, and more money is moved into riskier assets that have the potential of generating a higher return. That is what the Fed would like to see happen, at least--more money put to work. However you look at it, the tendency is for lower interest rates to foster higher stock prices.
While lower interest rates can be good for stocks in the short term, we need to remember the "no free lunch" rule of investing--like unicorns and time travel, there is no such thing. The check that is likely to ultimately come due may very well be higher inflation down the road. Consider the mechanism through which the Fed effects its stimulus. It buys bonds, which moves bond prices higher and interest rates lower. Where does the Fed get the money to buy those bonds? Well, it just creates that money out of thin air, often referred to as "printing money," but actually just a few computer keystrokes that cause cash to appear on balance sheets where bonds once resided, with those bonds now on the Fed's balance sheet. Money is subject to the same laws of supply and demand that apply throughout the economy, so all of that liquidity being pumped into the economy can actually erode money's value, as measured by its purchasing power. When the price of gold goes up, that doesn't mean that gold is inherently worth more, but rather that the dollars used to buy gold are worth less. (If we discovered that gold had magical properties for curing cancer, that would be different, and the inherent value of gold would increase.) The slack in the economy may mitigate the inflation effects somewhat, but sooner or later some prices are likely to go up, reflecting that the value of money, the dollars in which values are denominated, has declined. Inflation tends to transfer wealth from creditors to debtors, as fixed obligations can be paid back with cheaper dollars. This is why we often hear that the Fed is "monetizing the debt."
Now, let's return to the two headlines at the top of this article. Investors pay particular attention to the comments from FedEx, because the company operates in the transportation sector, long viewed as a leading indicator for the entire economy. I used to work with a portfolio manager who liked to gaze out of his downtown Memphis office window at the barge traffic on the Mississippi River. He also would count the number of cars on freight trains passing through town, observations that he thought might give him the edge of early insight. So, the warnings from FedEx may serve as the proverbial "canary in the coal mine," a signal that economic activity is indeed slowing around the world. If the earnings prospects of companies worsen, then rising stock prices just mean that investors are paying more for each dollar of lackluster earnings--yet another form of inflation.
The upbeat outlook from Dollar General (DG, $51) reminds us that there is a difference between the market as a whole and individual stocks. Just this morning (Thursday), Ross Stores (ROST, $65) raised their third quarter earnings view to a range of $.70 to $.71 from a previous view of $.63 to $.66. The discount stores are not the only areas of strength, however, and it is our job as investors to find those companies that are doing well in spite of all the dead canaries. Along with the strength in the housing sector, we have banks looking to rid themselves of the job of servicing mortgages. That shift is giving a boost to stocks like Ocwen Financial (OCN, $36) and Altisource Portfolio Solutions (ASPS, $107), both of which are prospering by relieving banks of the mortgage-servicing task. We can also find prosperity in certain areas of retail, with Michael Kors (KORS, $53) as an example. Biotechnology is another area where growth does not depend as much on economic activity: Alexion Pharmaceuticals (ALXN, $118), Biogen Idec (BIIB, $153), and Regeneron Pharmaceuticals (REGN, $163).
The caveat, as usual, is that a really severe market decline will probably take down all stocks, at least for a time. The survivors, though, are likely to be those companies relatively immune from economic weakness, and those that are benefiting from longer-term, sustainable trends. In the drama that is our Dickensian economy, the chief villain is really uncertainty. I suspect that a positive resolution to the fiscal cliff would resolve a great deal of that uncertainty about the future by vanquishing the menacing villain. As investors, we need to pay attention to how that unfolds. Until then, we'll just have to step carefully among the dead canaries.
Life is short. Get busy.
Jim
Disclosure/Disclaimer: My family members and/or I own shares of DG, ROST, OCN, ASPS, REGN, ALXN, BIIB, and KORS. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any specific security.
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