Economic Growth A Larger Influence Than Inflation For Future Stock Performance

We have written a number of articles on the impact of inflation on future bond and stock returns. Our recent article from earlier this month, Inflation And Its Influence On Investment Classes, pointed to the fact that stocks are a good hedge against higher inflation rates versus bonds. At very high levels of inflation though, commodities are the better performing asset class.

The more significant factor, however, is the growth of the economy as measured by GDP. As the below chart shows, the S&P 500 Index continues to move higher in spite of the fact the year over year change in inflation (blue line) is muted. The equity market performs at its worst when GDP (green bar) is contracting and the economy has entered a recessionary period. Earlier in April, the month over month change in the consumer price index was reported at minus .2%. This negative CPI report had some strategist indicating the weaker equity returns for the week of 4/15 was partially due to a deflationary scare.

From The Blog of HORAN Capital Advisors

For investors then, paying attention to economic variables that might indicate a recession is forthcoming is of greater importance than inflation in and of itself. Some of the variables to watch are: jobless claims, durable goods orders, retail sales, existing home sales, consumer confidence and the interest rate spread. We touched on these data points in an article a few years back, Economic Indicators That May Signal A Bottom In The Economy, when we were looking for an economic upturn.

Sector Rotation May Be Underway

One aspect of the strong performance for the S&P 500 Index so far this year has been the outperformance of the defensive market sectors. As the below chart details, the top performing sectors this year are health care (20.5%), utilities (18.8%), consumer staples (17.8%) and telecommunications (15.3%). A notable characteristic of the defensive sectors is their higher dividend yields. With the near zero interest rate environment being perpetuated by the Federal Reserve, investors seem to be allocating some of their investment dollars to these higher yielding stocks and sectors.

From The Blog of HORAN Capital Advisors

Last week though saw a shift in which sectors were contributing to the market moving higher. As the below chart shows, the previously mentioned sectors that contributed to the positive market move on YTD basis were the worst performing sectors last week. Telecommunications, consumer staples, health care and utilities all were the worst performers. The more cyclically sensitive sectors performed the best: financials, materials, technology and industrials.

From The Blog of HORAN Capital Advisors

A characteristic of the defensive sectors at this point in time is they are trading at higher P/E multiples relative to the S&P 500 Index. The utilities, staples and health care sectors are each trading at multiples of near twenty times earnings or higher.

From The Blog of HORAN Capital Advisors

For investors, keep in mind that stocks/sectors will trade on future earnings growth prospects. Factset's earnings summary report released on Friday does show the sectors with the best anticipated earnings growth in 2014 are the more cyclically exposed sectors and not the defensive sectors that have worked so well for investors this year.

From The Blog of HORAN Capital Advisors

Better Investing Members Favored Stocks

Better Investing Magazine publishes the most active stocks reported by its membership. The list is based on an informal sampling of Better Investing members. Below is the list of most active stocks as of April 23, 2013.

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Contrarian Cover

If one is a bull at the moment, Barron's cover for this week's magazine is not one you wanted to see. These types of headlines tend to serve as contrarian market indicators. Admittedly, this market's rise since November has been littered with mixed signals.

From The Blog of HORAN Capital Advisors

Investor Letter: Focusing On Variables We Can Control

Our firm's First Quarter 2013 Investor Letter provides a review of Q1 with thoughts on the outlook ahead. One factor we touch on in the Investor Letter is the fact the defensive sectors of the market have been contributing the most to the market's advance this year.  One factor we believe is contributing to this strength is investors search for yield in dividend paying stocks. Also included in the letter is a discussion on intra-year market declines. A near-term equity market pullback would not be surprising. However, a protracted U.S. or global economic recession seems unlikely barring an unforeseen shock, like an outbreak of war precipitated by North Korea.

From The Blog of HORAN Capital Advisors

We believe there are variables we can control, such as risk mitigation and the avoidance of euphoric markets, but there are things we cannot control, such as the Fed and North Korea. Our clients ask us to focus on the things we can control and the things that matter most to them. If we execute on that basis, we’ve formed a valued partnership.

The complete Letter can be accessed directly from our website at this link: 1st Quarter 2013 Investor Letter.

Equity Put/Call Ratio At Level Last Seen In November

The equity put/call ratio is above .80 once again and is at a level last seen in early November of last year. We noted the elevated ratio in November last year when it equaled .82 and the S&P 500 Index was trading at 1,379. Since that November 9th report, the S&P 500 Index is up 12.5%. Could the current ratio of .85 be suggesting excessive market bearishness again? As we noted then, the market does have a history of reversing at P/C ratios above .80.

"The equity P/C ratio tends to measure the sentiment of the individual investor by dividing put volume by call volume. At the extremes, this particular measure is a contrarian one; hence, P/C ratios above 1.0 signal overly bearish sentiment from the individual investor. This indicator's average over the last 5-years is approximately .7, indicating the individual investor has been generally mostly bullish and more active on the call volume side"

From The Blog of HORAN Capital Advisors

Cost Cutting Is Driving Earnings Beats In Q1

With about 20% of companies in the S&P 500 Index reporting earnings, 70% have reported earnings exceeding analyst expectations. This is above the long term average beat rate of 63%. However, only 44% have reported revenue above analyst expectations, which is below the long term average of 62%. This suggests the EPS beat rate is being driven by cost cutting versus higher demand. As the below chart shows, 58% of the reporting companies that beat their EPS estimate also missed on revenue.

From The Blog of HORAN Capital Advisors

Source: Thomson Reuters

The growth rate of earnings on a year over year (YOY) basis for Q1 2013 is a low 2.1% in spite of the fact analyst had cut earnings estimates going into the first quarter. 

Lastly, the number of negative pre-announcements remains high. Thomson Reuters reports there have been 112 negative EPS pre-announcements versus 26 positive ones. This results in a negative to positive ratio of 4.3 for the S&P 500 Index companies. Thomson notes, this would be the highest N/P ratio since Q3 of 2001.

One factor that seems to be driving revenue growth weakness for the larger companies that comprise the S&P 500 Index appears to be weakness in business outside the U.S. The Bespoke Investment Group prepared a chart showing sector performance versus percentage of revenue in the U.S. Those sectors that have companies that generate a smaller percentage of their revenue in the U.S. have been the weaker performers.

From The Blog of HORAN Capital Advisors

Source: Bespoke Investment Group

A part of this is related to issues in the euro zone as well as a slow down in the emerging market economies. The other factor is the strength of the U.S. Dollar, as we wrote about earlier this week in an article titled, Stronger U.S. Dollar Attracting Investment Flows To U.S. Assets.

For investors the economies around the world continue to adjust to higher debt levels and artificial stimulus by central banks. The resulting economic growth rates are ones that are slower or slowing resulting in a separation of the winners and losers at the company level.

Expect An Equity Market Correction

We are wrapping up our quarterly Investor Letter and one item we discuss in the Letter is the magnitude of intra-year market corrections. As the below chart shows, since 1980 the market has experienced an intra-year correction averaging 14.7%. In spite of these corrections, the market has generated positive returns in 25 of the 33 years that are shown.

From The Blog of HORAN Capital Advisors

Source: JP Morgan's Guide to the Markets

Stronger U.S. Dollar Attracting Investment Flows To U.S. Assets

The impact of central banks around the globe instituting quantitative easing (QE) programs has resulted in a race to the bottom for country currencies. Japan is the latest country to announce and implement an expanded QE program. Earlier this year the Bank of Japan (BoJ) announced  that it would spend an additional $155 billion on stimulus projects a month on top of a of the current stimulus of $410 billion. The impact on the Yen has been to weaken it. For Japanese investors, they can buy U.S. Dollar denominated investments and as the Yen weakens relative to the U.S. Dollar, get enhanced returns when converting the Dollars back to Yen.

One attractive area for foreign investors has been the corporate bond market. As the below chart of the iShares Total Core Bond ETF (AGG) shows, since November 1, 2012, the AGG has returned a negative 1%. The return of AGG in Yen though translates into a return of over 21%.

From The Blog of HORAN Capital Advisors

For a U.S. investor who invests in the Nikkei, the strong Dollar/weak Yen can work in reverse. Although the Nikkei is up almost 50% since November of last year, when converting those returns back to Dollars, the Nikkei index is up 21% in U.S. Dollar terms.

From The Blog of HORAN Capital Advisors

Two added cautions for U.S investors in this race to the bottom with respect to currencies is the fact the U.S. is turning out to have the stronger currency. The stronger Dollar is attracting foreign in flows, but what happens when the Dollar begins to weaken? Will foreign investors sell U.S. assets? Secondly, the stronger Dollar will put downward pressure on multinational company earnings that are generated overseas. Certainly companies can hedge their currency exposure; however, this is not an easy game to play.

Bulls Turn Into Bears

Today's release of the American Association of Individual Investors sentiment reading saw an enormous drop in bullish sentiment by individual investors. Bullish investor sentiment dropped 16.2 percentage points and saw the bull/bear spread reported at -35.2%. This is the most negative spread since it was reported at -36.1% on July 8, 2010. The bullish sentiment was last at this level on March 5, 2009, near the market low reached at the height of the financial market crisis. The sentiment reading is only one data point; however, investors should keep in mind this contrarian indicator is most accurate at its extreme. Today's reading qualifies as an extreme, almost two standard deviations below its average reading of 38.9%.

From The Blog of HORAN Capital Advisors

Additionally, fund flow data would indicate this has been a stealth rally that has left many equity investors behind. The blue bars in the below chart is the rolling one year sum of equity mutual fund flows. Not shown below, however, fund flows have turned positive for the first two months of the year.

From The Blog of HORAN Capital Advisors

Updated 12:08pm 4/11/2013:

AAII's response to survey results:

"...A total of 145 AAII members took the survey this week. This is down from the three-month average of 330 responses. A weekly “reminder” email normally sent to a sample of our members was unintentionally not sent this week. Previous drops in the number of respondents on a given week have not resulted in the magnitude of change recorded in this week’s survey, however. Furthermore, 145 is not an abnormally low number of responses for the survey...."

Dow Dogs Are Outperforming This Year

An investment strategy some investors follow at the beginning of each year is investing in the Dogs of the Dow. As noted in prior posts, the Dow Dog strategy consists of selecting the ten stocks that have the highest dividend yield from the stocks in the Dow Jones Industrial Index (DJIA) after the close of business on the last trading day of the year. Once the ten stocks are determined, an investor would invest an equal dollar amount in each of the ten stocks and hold them for the entire year. The strategy has generated mixed results over the years.

For the Dow Dog investor this year though, the dogs are outperforming the Dow Index as well as the S&P 500 Index (10.5% return YTD) as noted in the below table. As of the market's close today, the Dow Dogs have returned 15.9% versus the Dow Industrial Index return of 11.5%.

From The Blog of HORAN Capital Advisors

Source: Dogs of the Dow

Higher Tax Rates Not Sequestration More Justifiable Reason For Weak Jobs Report

The weak jobs report was cited as a reason investors sold stocks on Friday. More importantly though is answering the question why the jobs report was so weak. Expectations for the employment report were for payrolls to increase in excess of 190,000 and the employment report from BLS reported only 88,000 jobs were created in March.

As soon as the number was reported, nearly all commentators cited sequestration as the primary cause of the weak report; however, only 7,000 government jobs were lost last month. One area that experienced particularly concerning weakness was in the retail segment which saw a loss of 24,100 jobs. Weakness in retail is a concern as consumers account for nearly 70% of economic growth.

From The Blog of HORAN Capital Advisors

In addition to sequestration, Congress and the White House managed to hammer out a deal at the end of last year that averted going over the so-called fiscal cliff. A part of this agreement included tax increases, thus taking money out of the private sector. As the below chart shows, revenue taken in by the government now exceeds the revenue level preceding the financial crisis. These figures represent data through year end and given the higher tax rates, I expect Q1 2013 revenues will continue to increase.

From The Blog of HORAN Capital Advisors

Also, in spite of these higher federal revenues, the growth of the federal debt seemingly grows unabated.

From The Blog of HORAN Capital Advisors

In our estimation, sequestration has had a limited impact on the March employment report. What appears to be having a larger influence is the higher rate of taxation approved by Washington at year end last year. Continuing to take money out of the private sector is not a recipe for a stronger economy and stronger job growth especially when the funds are not used to balance the federal budget.

Inflation And Its Influence On Investment Classes

One aspect influencing the economy and the markets is the Federal Reserve's stimulative monetary policy via its Quantitative Easing (QE) programs. A concern for market participants is the impact on inflation resulting from the QE programs. Current CPI data shows little inflationary impact; however, is there a point in the future where inflation takes hold? If so, how should investors position their investment portfolios. First though, below are several charts confirming the Fed's influence on some economic/monetary variables.

• Significant growth in the monetary base continues unabatted:

From The Blog of HORAN Capital Advisors

• The money supply seems to be "trapped" in banks and is showing up as excess reserves:

From The Blog of HORAN Capital Advisors

• Typically, the excess reserves held by banks would be deployed into the economy by growth in Commercial & Industrial loans. This loan growth has occurred...:

From The Blog of HORAN Capital Advisors

• ...But not at a pace that has increased the velocity of money; hence, this money supply growth has not resulted in inflationary pressure:

From The Blog of HORAN Capital Advisors

Our firm has  published a number of posts on inflation and its inpact on investment returns over the years. As long ago as January 2009, we wrote a post, Money Supply Causing Concern With Future Inflation, that looked at the Quantity Theory of Money and velocity's impact on inflation. So inflation was an investor concern in 2009 and has been misplaced, yet this post is going to discuss inflation concerns again in 2013. The point is this slow pace of economic growth, developed economy deleveraging and the high debt to GDP level in many countries may actually be restraining inflation pressures. However, investors should be aware of strategies that can be implemented that might provide a hedge against inflation as it relates to the return generated by one's investment portfolio.

Lazard Asset Management recently published two white papers on asset returns and inflation. A link to both papers is provided at the end of this post. Two important factors are cited that determine the type of investments that do well in various inflationary environments: the rate of GDP growth and the level of inflation.

From The Blog of HORAN Capital Advisors

At the outset of the part 2 paper, Lazard notes, over the "long run" equities are a good hedge against inflation. However, this long run may be thirty years or more and if an investor is older than say 70, the thirty year time period may be irrelevant unfortunately.

From The Blog of HORAN Capital Advisors

So as the above chart shows, equities do provide a good hedge against inflation versus bonds. At high rates of inflation though, real equity returns historically are negative. Lazard notes critical determinants of the best types of investments to hedge inflation are,

"Both the inflation rate and the type of inflation regime are critical to evaluate the degree of inflation protection provided by any asset class. Therefore, it is important to understand the drivers of a given inflationary period. In a regime where inflation is being driven by companies passing on costs to consumers via price increases, alongside a booming economy with strong growth rates, stocks (and also commodities) can offer good inflation protection. This may be explained in part because stocks and commodities both act as real asset investments as they typically benefit from a strong economy and because company profits may rise with inflation as illustrated in Exhibit 2.

Nonetheless, an equity-driven inflation hedge is quite limited if inflation is a result of erroneous monetary policy, commodity shortages, protectionism, extreme volatility in economic data, or inflated wage contracts, alongside a phase of weak growth and deeply embedded structural problems. Stocks tend to generate weak growth under these circumstances, particularly in times of low growth and high inflation."

Finally, the white paper demonstrates that tactically allocating one's investments, even at the equity sector level (and individual stock level) can enhance a portfolio's real return. Exhibt 5 of the Part 2 paper provides industry and style factors investors can consider based on inflation views. Lazard concludes,

"It turns out that portfolios with high inflation betas generally offer better inflation protection compared to portfolios that have been constructed based on the relationship of each stock to a conventional capitalization-weighted index. Not surprisingly, many of the stocks with high inflation betas are concentrated largely in the gold, commodities, raw materials, and technology sectors, but the manufacturers of essential consumer goods, pharmaceutical stocks, and selected industrial stocks also come under consideration for such portfolios... An additional observation regarding inflation betas is that a long-short portfolio (long high inflation beta and short low inflation beta) improves the hedging capability of a portfolio (see Bernard 1982).

...inflation protection is usually only one of several investment goals. It is likely that a focus on inflation protection may introduce opportunity costs or generate additional risks, as it entails heavy concentration in specific sectors or factors and may forgo diversification benefits. Therefore, it is conceivable that in a singular pursuit of inflation protection, an investor may neglect other investment goals, as well as the earnings potential of other stocks, and be subject to valuation implications (stocks that offer inflation protection may become expensive in specific phases when everyone wants to buy inflation protection). In our view, inflation protection is part of a broader goal in a portfolio and, thus, an important task of strategic asset allocation in connection with a comprehensive assessment of investment objectives.

Based on our analysis, a straightforward answer cannot be given for assets that will protect against inflation in every economic environment and in every investment horizon. The recent revival of the inflationary debate has sparked interest in seeking optimal inflation hedges. However, searching for assets that protect against inflation proves to be a complex enterprise, as a myriad of factors affect the inflation-protecting capabilities of financial assets."

Source:

Equity Investments as a Hedge against Inflation, Part 1
Lazard Asset Management
By: Werner Krämer, Managing Director, Economic Analyst
http://www.lazardnet.com/lam/global/pdfs/Literature/EquityInvestmentsAsAHedgeAgainst_LazardResearch.pdf

Equity Investments as a Hedge against Inflation, Part 2
Lazard Asset Management
By: Werner Krämer, Managing Director, Economic Analyst
http://www.lazardnet.com/lam/global/pdfs/Literature/Part2-EquityInvestmentsAsAHedgeAgainst_LazardResearch.pdf

Defensive Equity Sectors Outperforming Year To Date

At HORAN Capital Advisors, we do believe the market ultimately trades on fundamentals. One difficult part with today's market is the Fed's seemly unlimited intervention with its ongoing Quantitative Easing (QE) programs. This QE activity is anything but a fundamental factor. Global central banks have also jumped on the QE bandwagon with Japan being the latest to announce their QE program. For investors then, it is advantageous to look at short term technical factors in order to provide additional insight into the market's potential future direction. A couple of technical measures are raising warning flags about a potential near term pull back.

• Have we seen the end of the 5th wave pattern in terms of the Elliott Wave parlance?

From The Blog of HORAN Capital Advisors

Source: The Kirk Report

• The defensive sectors, consumer staples and healthcare, have been outperforming the non-defensive sectors, materials, technology and industrials.

From The Blog of HORAN Capital Advisors

• The small cap stock Russell 2000 Index has been underperforming the large cap S&P 500 Index since mid March. This can also be a sign of a risk off mood of investors.

From The Blog of HORAN Capital Advisors

• The transport index has been underperforming the broader market since mid march and this could be signaling economic weakness ahead. Additionally, there have been some transport company warnings recently, FedEx (FDX) being one.

From The Blog of HORAN Capital Advisors

The U.S. market has had a strong advance so far this year and the consensus seems to believe the market is due for a correction. One factor that is almost a certainty in investing is the market does a good job at proving the consensus wrong. As Charles Kirk of the The Kirk Report noted in his after market strategy report this evening, he is focusing on the technical aspects of the market set up,

"While central bankers around the world did their best to restore confidence, concerns over both the economy and upcoming earnings kept the upside limited and big bets on hold at least until the jobs report tomorrow morning. From a technical perspective, we did not see much progress today another than to not be very impressed by the bounce given the significant weakness we have seen this week. Today’s upside once again came on below average volume with mixed leadership and was mostly driven by programs in a thin tape attempting to defend and keep the market from moving lower.

Tomorrow morning will be a busy one due to the jobs report and other econ data. The bears will need to step up their game tomorrow and put some pressure on or the bulls will do what they do best and attempt another reversal back to potentially test if not break through the all time intraday highs at S&P 1576."

Buybacks And Dividends A Mixed Picture In Fourth Quarter

Standard and Poor's reports preliminary buyback activity for the fourth quarter of 2012 fell 4.4%. On a year over year basis, buybacks are up 13.2%; however, for the year 2012 buybacks declined 1.5%. On the other hand, dividends in Q4 increased nearly 15% compared to the third quarter and were higher by 21% on a year over year basis. Howard Silverblatt, Senior Index Analyst for S&P Dow Jones Indices noted in the press release,

"For 2013, S&P Dow Jones Indices anticipates that companies will continue to protect their earnings by buying back the number of shares necessary to prevent earnings dilution – something not difficult to do given record levels of cash on hand."

From The Blog of HORAN Capital Advisors

Source: S&P Dow Jones Indices

Monday Market Blues

I just returned from a well rested week's vacation. It is always good to step away from the market from time to time in order to refocus one's perspective. A tough part of taking the week off is giving up the view of the sunset I had each day. The fishing off the dock was good, but shrimp bait was in tight supply as the water temperature was on the cold side. Some of my younger relatives were not too fond of baiting the hooks with live shrimp and they found hot dogs, chicken and bread worked just as well at catching the fish.

From The Blog of HORAN Capital Advisors

The market results for the first Monday of the quarter continued the typical pattern of generating negative results for investors. As the below chart shows, the average return of the Dow has been negative for Monday's so far in 2013. Could this be a precursor of return expectations for the second quarter?

From The Blog of HORAN Capital Advisors

Source: The Kirk Report and Bespoke Investment Group

Conversely, today The Wall Street Journal reported on a comment from Rob Leiphart of Birinyi Associates that noted the total return for years in which the S&P 500 Index had first quarter returns greater than 10%, the balance of the year on average generated positive returns.The S&P 500 Index was up 10% in the first quarter and the Dow was higher by 11.25%.

"Birinyi Associates points out there have been 12 other years dating back to 1929 in which the S&P 500 rose by at least 10% in the first quarter. In 11 of the those 12 instances, the S&P 500 finished those years in positive territory, with 1930 being the lone outlier. However, much of those full-year gains were front-loaded in the first three months of the year. After accounting for the gain in the first quarter, the market is still up, but only 1.39% on average, from the end of the first quarter through the end of the year,” Leiphart said in an email, while noting the index was positive from the second quarter through the fourth quarter of those years 10 out of 12 times. The S&P 500 has averaged a 16% full-year gain in those 12 instances."

From The Blog of HORAN Capital Advisors

Source: The Wall Street Journal

One important factor in the market's future direction will likely hinge on upcoming first quarter earnings reports.