article 05-18-2015

On the Road to Normal

While conflicting signs of economic strength are, for the time being, stalling a rise in rates, Portfolio Manager Charlie Dreifus continues to believe that active stock picking remains an attractive approach in the current environment.

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Had one heeded the advice of prognosticators since 2010 about interest rates heading higher, one would be much poorer. Obviously interest rates will rise, and that is a good thing. It indicates that the U.S. economy is getting off life support, is healing, and is on the road to normalcy.

This is ironic because the same people often want it both ways—those who think it is terrible that the Fed ballooned its balance sheet and kept rates so low as to fuel bubbles are the same ones who are now warning us about the ill effects that rising rates will have. Give me a break! Remember—the measure of whether any QE (quantitative easing) program has worked can be taken only when bond yields rise.

I am not writing to tell you the market is inexpensive because that is not the case. However, the bears that show us graphs of valuation to GDP or sales are missing one important fact, namely that corporate profitability is way up—so it is different this time.

No doubt the bear response would be to concede this point before claiming that profitability cannot, and will not, remain at current levels. We beg to differ and will explain why. For now, I will simply suggest that robust profitability is perhaps what keeps Fed Vice Chairman Stan Fischer relatively quiet despite his focus on financial stability risks.

While major market indexes are at or near record highs, there is a difference—multiples within these indexes for the most part are not as extended or extreme as past peaks. With the exceptions of biotech and social media, this is true, and those two areas are not as widely owned or touted as the fashionable industries of old.

Sluggish economic growth, expected weak earnings, a rising dollar, and the fear of higher interest rates have all kept equities range-bound since November. Of course, earnings were not as bad as companies had guided many to believe. On the whole, company guidance has been very downbeat of late—even before the awful winter weather and West Coast port issues.

This has become more common as companies have gamed expectations so that they can beat them. Of course, another way companies can meet or exceed expected EPS is through stock buybacks. February saw the highest dollar value of share buyback authorizations ever.

The resilience of equities still encounters resistance from skeptical investors—neither institutional nor retail investors seem to be particularly optimistic, which would be unusual for a market top, as some are calling the location of the current cycle.

When rates rise, history suggests that stock pickers should outperform passive funds. When there is less correlation between sectors, as well as within sectors, active management has tended to outperform passive.

I would point to the following as signs that we are not at a market top: a blow off top, heavy flows into equities, IPO activity, rising real rates, a shift towards defensive names, and materially widening credit spreads. An even more revealing indicator that stocks are not in bubble territory is the price of Sotheby's shares, which has historically shared peaks with bubbles in general.

I would make one additional point: as of the end of March 2015, according to Strategas Research Partners, the next twelve month P/E's of the 50 largest companies in the S&P 500 Index is 16.5x compared to 27.0x in March of 2000. While certainly volatile, it is nonetheless noteworthy that earnings for companies in the S&P 500 tend to advance 6-7% over long periods of time.

The fact that the U.S. economy is not obviously accelerating into "lift off" mode raises questions about its underlying vigor and at what level is the "neutral interest rate." In its recent meeting statement the Fed acknowledged this by saying that recent tepid growth was "in part" due to transitory factors. This reveals some ambivalence as to the extent to which the economy will pick up speed.

The Fed's view seems to be that there is enough uncertainty as to how recent signs of softness will affect the overall pace of growth such that a rate hike needs to be delayed for now, at least until a clearer and stronger picture emerges. The bottom line? The Fed is still on a path towards normalization.

The market has been range-bound largely as a result of conflicting economic signals. Signs of strength are followed by evidence of weakness, and both result in a very close focus on the Fed's actions on interest rates. And while investors probably want to see better economic news before taking on more risk in equities, they also are worried that stronger economic news will raise rates.

Could it be, then, that we are in an odd state in which bad economic news is really good stock market news? Regardless of where we see ourselves in the currently confusing picture, "de-equitization" continues as buybacks keep significantly outpacing IPO activity.

The strength of the U.S. dollar is keeping downward pressure on U.S. inflation and interest rates, which makes rising dividends an even more powerful potential lift for equity prices.

According to Andrew Garthwaite of Credit Suisse, cash on hand at corporate and private equity firms, adjusted for the use of leverage, amounts to some $4.3 trillion, or 10% of global market cap. As a result, we are likely to see much more transactional activity.

Better growth (coupled with stimulus) abroad is helping investors become more comfortable moving into U.S. stocks that are more closely tied to global growth despite continued foreign exchange headwinds year over year. In fact, we may have experienced an inflection point towards the end of April when the global growth outlook improved, inflation signals strengthened, and bond yields rose.

For 2015 and 2016 combined, I believe it is likely that S&P 500 earnings growth will not be far below its historical annual average of 6%. Earnings estimates proved to be too low for the first quarter.

When rates rise, history suggests that stock pickers should outperform passive funds. When there is less correlation between sectors, as well as within sectors, active management has tended to outperform passive.

Another sign of the possible resurgence of stock picking is the fact that the equal weight S&P 500—that is, the "average stock"—is outperforming the index so far in 2015. We can also see this in the Value Line Arithmetic Index (an equal weighted index), which is also outperforming the S&P 500 this year.

Problems worth worrying about remain. They include Greece derailing the eurozone, a Russian banking crisis enveloping Europe, a hard landing in China, ever-present geopolitical tensions, and the consequences of income inequality.

Securing the notion of the attractiveness of the U.S. vis-à-vis the rest of the world was the fact that in 2014 the U.S. was the top petroleum and natural gas producer in the world.

Important Disclosure Information

Charlie Dreifus is a Portfolio Manager and Principal of Royce & Associates, LLC, investment adviser to The Royce funds. Mr. Dreifus's thoughts and opinions expressed in this piece are solely his own and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The Value Line Arithmetic Composite Index is an equally weighted price index of all stocks covered in The Value Line Investment Survey. Arithmetic refers to the averaging technique used to compute the average. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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