Hutchens Investment Management: Growth vs. Stimulus

June 26, 2013 - PRLog -- The initial response to Chairman Bernanke’s statements on gradual withdrawal from quantitative easing has been negative across the investment spectrum with exceptions the US dollar and energy, sectors reflective of economic growth. The only inconsistency was the reduction in the Fed economic forecast, a change that was widely expected as it was overly optimistic and on the low side for the past three quarters. The Fed policy is based on the assumption that if the economy is on target (6.5% unemployment and inflation at or above 2.0%) growth will be at a level where a stable balance sheet and low historic interest rates are stimulus enough to maintain momentum. (Projections are for the 6.5% unemployment to be reached in late 2014 and interest rates rising to 4.0% in 2015.) We now know the Fed’s plan and the market has priced in tapering, and to some extent further tightening. The recent spike in interest rates is also a response which has happened in other exits. After months of speculation on what the Fed would do, the uncertainty has been removed, a positive for equities.

Meanwhile back at the economy, the sluggish first-half of 2013 is coming to an end. Again the housing market is surprising to the upside. The S&P/Case-Shiller home price data released today show in April the Index for 20 Metropolitan Cities rose a record 12.6% over year ago levels as all 20 cities showed price increases. Also released today, the sale of new homes in May reported by the Commerce Department reached its highest level since mid- 2008. The rapid rise in prices seems to have leveled off in June as home inventory is easing and mortgage rates rose from 3.5% to 4.0%. It is generally conceded that mortgage rates will creep up going forward. But price spikes will be mitigated by additional supply. Higher mortgages in and of itself will not derail the current housing recovery. In deference to the bubble people, the 20 city price level is back to 2004, but remains 24% below the 2006 high. As might be expected the Conference Board’s Consumer Confidence Index reached 81.4, a five-year high and well-above the estimate of 74.0. Housing no doubt plays a major role in this optimism, but more important this level corresponds to a 3% growth in consumer spending.

As earnings season approaches the concerns of flat earnings for 2Q2013 is founded in the 7:1 negative to positive pre-announcement ratio, the highest level since 1Q2009 and well-above the long-term ratio of 2.4:1. Perhaps, this is a contributor to the 7% selloff in the S&P since late May. The $113.30 for the forward 4Q earnings estimate gives a forward P/E of 14X, a reasonable number with a 7.5% earnings growth. Despite analyst pessimism, which foreshadows most earnings discussions, the most recent consensus estimate by Thomson-Reuters for 2Q2013 is a 3.5% rise over 2Q2012. For full year 2013, the estimate is 5.1%. As we move through the second-half of 2013, we expect to see a renewal of the historic relationship between interest rates and multiples. Under these more normal conditions, we anticipate lower unemployment, declining profit margins but with stronger earnings and revenues, along with reduced budget deficits, especially as a percent of GDP.

Our investment strategy remains a full position in equities. The increased volatility is indicative of market uncertainty, not of a chaotic outcome of Fed policy. The run-up since the beginning of the year for equities and the recent rise in interest rates explains the current technical correction. Longer term earnings growth should accelerate later in the year as private economy growth accelerates and the next leg of the bull market rises to new all-time highs and a return to the “Old Normal.”

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens