Commentary from Hutchens Investment Management

CONCORD, N.H. - June 4, 2014 - PRLog -- Over the past few months the discussion on stock market direction has gone from a broad consensus of about “8%-10% increase in the S&P 500” to a likelihood of a broad-based correction as witnessed in the selloff of overpriced small cap momentum stocks.  The most recent preoccupation has been the surprise decline in long-term interest rates.  Whether the market corrects short term is academic, since it will not affect the long-term performance of equities.  Of more importance is the outlook for consumer spending and further economic growth.  Fixed income is favored by institutions as inflows into bonds have dominated.  For the four weeks ended May 28, net inflows into bonds by mutual funds were $5.9 billion, while the funds sold net, $5.6 billion in domestic stocks.  This same trend is apparent for ETF’s.  Purchases of bonds by ETF’s were $9.8 billion and net sales of equities $3.4 billion.  So much for the “great rotation.”  However, stocks continue to rise and last week the S&P 500 reached a new record high, creating a fork in the road.

Housing

For consumer spending the problems border on becoming structural rather than cyclical.  The housing slowdown continues as prices of new and existing homes rise and the first time homebuyer fades into the rental market.  With all of the structural problems confronting the home purchaser, there exists a philosophical difference compared to the historical approach to homeownership.  The 2006 housing bubble and the subsequent housing depression brings into question the long-term economic viability of owning a home rather than renting.  The latest housing data do not show improvement and while it may be premature to discount a turnaround, the problems that surfaced in mid-2003 still exist and in some instances have worsened.  Among these are:

• Mortgage qualifications restrict potential buyers, most notably the down payment.

• Higher prices and lower inventory are causing a shift in the supply/demand curve.  With the withdrawal of investment cash purchasers the traditional buyers have not transitioned to fill the void.

• The inventory of low-priced distressed homes (foreclosed or sold at a loss) has been dramatically reduced.  From 2009 through 2011 these cheaper houses accounted for 1/3 of sales.  Today, the National Association of Realtors (NAR) estimates this number will be 11% in 2014.

• Large developers have ready access to capital, while small builders experience difficulty in securing loans.  Additionally, even builders with funds find the pool of experienced skilled workers inadequate.  Many former home construction workers have moved on and are reluctant to return.

• According to the NAR, prices of newly constructed homes are expensive when compared to existing homes.  The comparable new home cost is about 38% higher than an existing home.

These constraints currently limit the upside in this vitally important sector.  The Fed has expressed its concerns for housing which may be reflected in its interest policy.

Retail Sales

Historically, the retail sector has been able to correctly adjust focus to consumer preferences.  Today, the shift is away from enclosed malls to online and lifestyle centers. A select handful of department stores have accelerated this move to online sales.  Most notable are Macy’s and Nordstrom where online sales accounted for 12% and 13%, respectively, of total sales in 2013.  Accompanying this shift away from “bricks and mortar” will be store closings, dictated by slowing mall traffic.  This trend will accelerate as leases are not renewed in areas of store concentration and low quality malls.  According to Morgan Stanley, online was 12% of retail sales in 2013.  This is well-above the comparable number of 7.5% published by the US Census Bureau.

Anyone looking at Amazon.com can spot hundreds of storefront distributors and small businesses offering items such as electronics and small appliances, I would bet fly under the Census Bureau’s sampling radar.  There are thousands of independent retailers online whose sales will never be included in the data.   As tighter margins force competition away from the stores onto the Internet, the battle for market share will initially result in lower-than-expected earnings for many consumer discretionary companies.  This battle for survival will be won by the online fittest, but consumers will be the ultimate beneficiary of this paradigm shift.

Earnings and Stock Prices

The recent declines in the 10-year Treasury yield and the new highs for the S&P 500 has dominated media attention.  As more money managers and strategists weigh in, we thought we should give our two cents.  Short covering, speculation on ECB easing, and the slower US economy beginning after the 2Q bounce are cited as causes.  We believe it is a confluence of all of these, but more importantly should the economy slow, it would negatively affect current stock valuations.

As many investors agree, stocks discount future earnings. This correlation is apparent during the bull market following the market bottom in March 2009.  Assuming that stock prices lead future four quarter earnings the Index data in the Table lag earnings by one calendar year.  As can be seen in the Table there is a direct relationship between stock prices and earnings given this calendar year lag.  The resultant P/E ratios, based on these assumptions, remained in a tight range between 13X and 13.3X for the earnings years 2010-2013.  For  2014 the estimated earnings growth is 10%, but stocks in 2013 have already indicated a much higher earnings growth rate.  In fact, a multiple expansion brings the estimated P/E ratio to 15.7X, still a reasonable valuation.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens