Look Back Before Looking Forward - Commentary from Hutchens Investment Management

CONCORD, N.H. - Dec. 3, 2013 - PRLog -- A review of 2013 will set the background for our “Outlook for 2014” in a subsequent issue of the Compass. With the major stock indices showing outsized gains for 2013 through November, it is important to note what precipitated this appreciation in an economy with high unemployment, slowing corporate earnings, and a weakened middle class. Many attribute this rising equity market to the latest dose of QE. We do not disagree that the Federal Reserve policy of $85 billion monthly purchases of MBS’s and Treasury securities has played a role. However, we view these purchases as necessary for an economy that is slowly transitioning from a deep recession to a traditional business cycle. The demand side of the equation remains below previous recovery levels thereby allowing excess funds, including those from QE, to flow into stocks, real estate, and for the first half of 2013, domestic bonds and international investments.

The stock market gains thus far in 2013 (S&P +24%) continue despite widespread warnings of the unknown consequences of tapering and political uncertainty. The Government shutdown and the Obamacare chaos failed to distract markets. In fact, as the problem of the healthcare law unfolded over the past eight weeks, stocks moved unrelentingly to new record highs. Housing, which had spurred growth through the summer, has flat-lined and retail spending is slowing just as we begin the all- important Holiday season. Employment increases are well-below recovery levels as entitlements replace entry level jobs and structural unemployment becomes more apparent. As yet, the much anticipated cyclical increase in capital spending has not occurred. Excess capacity is the most frequent rejoinder for the lack of Capex. However, corporations with healthy balance sheets are less likely to put hard earned capital at risk when the outlook five or more years out is clouded by increasing regulation and uncertain demand. Also, the trend to initiate or increase dividends has limited excess capital which could be earmarked for Capex.

With all the impediments to economic growth, why then have stocks had such a good year? So called smart money, the hedge funds, have as a group, woefully underperformed the stock market this year. Black Rock notes that cash levels for its investors are about 50%. A large proportion of individual investors has been absent from the market since the depth of the financial crisis in 2008-2009. In the beginning of the year the uncertainty of increased taxes and the effects of the Sequester clouded the outlook. However, both were quickly taken off the list of potential correction causes. From all the economic, fundamental, and political impediments to stocks in 2013, the easy way out is to blame the Fed for “artificial gains” and that the stock market will reverse when the Fed begins to taper. We do not subscribe to this reasoning.

The stock market in 2013 was more than an outgrowth of QE. The economy is in transition for what many have wrongly dubbed the “New Normal” to a traditional business cycle. The recession that occurred during the financial crisis was not only deep, but the damage was to our financial system, the lifeblood of the economy. Typically a recession is a cleansing of the problems that led to the downturn, however because of the breadth of the recession and Government interference, the restoration of the free market recovery has been prolonged and uneven. We believe the private economy will, in the not too distant future, once again reflect the free market principles of a historic business cycle.

As we have repeatedly shown in our reports over the past few months, clear signs of economic progress are evident during 2013. S&P earnings have risen consistently, albeit at a slower pace, since the lows in 2009 and now are estimated to be about 25% above the recessionary levels. Housing, a major component of GDP was a drag on growth for four years following the peak in 2006 and despite numerous government interventions, regained its growth status in 2011. Once again we are seeing the term “bubble” used when describing the 2012-2013 housing recovery. Since July, housing sales have slowed as inventory constraints resulted in higher prices. Single family housing starts have risen to a 600,000 annual level today up, from the 400,000 recessionary lows in early 2010. It would take a tripling of single family housing starts to return to the 1.8 million level of 2006. Employment, constrained by structural and educational limitations, has averaged 194,000 over the past 12 months ending October 2013, below normal recovery levels but improving. All in all, the “Old Normal” business cycle is returning.

Our investment strategy remains long-term positive on equities, but we do see potential for a correction in the not too distant future. The confluence of weakening consumer spending, uninspiring 3Q2013 earnings, and the reappearance of Governmental dysfunction during the budget process creates a situation that dictates caution. The underlying strength of the US economy and its potential growth, buoyed by solid financials of corporations, will not be denied longer term.

Authors:

David Minor

Rebecca Goyette

Editor:

William Hutchens