Equity markets: Building expectations

Earnings season is now in full swing with just over half of the companies having reported and much of the news very positive. We have no real fundamental reason for the markets not to continue their advance. The best reason offered for the past six- week decline may well have been that it is summer and everyone is focused else where. Nonetheless, corporate profits have been robust, price earnings ratios are the best they have been in four years, and the leading indicators of the major economies are very positive and on a growth trend moving forward. Why then are equity markets, especially the US markets at or near their lows for the year? Does this constitute a buying opportunity? We think so.

Concerns over second half earnings not being able to match this half, fear of rising interest rates and postulation of slowing consumer spending seem to have the markets stalled. But at this point, such concerns are only speculation, unsubstantiated with data or logic. And of course, the global geopolitical scene remains ever present. In our opinion segment this week, we focus to the fundamentals and some historical perspective. At centre, is a chart of the Dow Jones Industrial Average, the USA’s main equity index, for the past five  years in candle stick format. The thin vertical lines show the full range of trading values for each month with the wider sections showing open and close values for the month. Red are down months and open candles up months. The solid black line is the FTSE 100 index out of the UK as a comparison bench mark.

The middle chart shows the DOW index average price/earnings ratio and below it, the volume of shares traded per month. We can see the current fall in index value was not supported by the market as shown by the reduction in shares traded (volume). And the fall in P/E ratio is as expected given the strong earnings growth delivered by the corporations which was unmatched by investor pricing in the markets. When looking forward, investors should consider on the economic front, that things are good and getting better. For example, in the USA, GDP is getting stronger with expected growth of 6.5% in 2004, breaking US$11 trillion. The cost of money is very low (Fed Funds rate of 1.25%), inflation is in hand and there is better international trade balance. The major currencies seem to have found some balance as well. The economics are good and that has people worried. Why?

On the corporate front, the second-quarter has so far produced earnings growth of 24 percent versus a year ago. That’s the fourth quarter in a row of year-over-year earnings growth of at least 20 percent. The current focus of concern by the media/market guru’s have brought into question consumer spending, the cornerstone that never wavered over the past four years and which almost single handily drove us into economic recovery. Those guru’s feel that, although people were comfortable spending money over the past four years, in a time when many saw their net worth fall substantially, and where things were much more uncertain in fundamental economics, personal income and corporate profitability, that they are now going to stop spending because interest rates are going to rise. Consider two arguments. As we have discussed before, with the short term cost of money at extremely low rates (e.g. 1.25% in the US), and the world’s major economies very liquid with good money supply, how much could you reasonably expect consumer spending to slow if your consumer loan went from 4% to 5% or your savings account interest went from 0.5% to 1.5%. We concur with Alan Greenspan who says consumer spending will continue.

For a second argument, after spending four years to get the world’s economies moving forward through difficult times, why would you expect GDP growth to simply stop ? It would take many many quarters to shift the direction of an economy, whether it be growing or shrinking. Greenspan who says GDP growth will be steady and positive, and we agree.  Remember, on historical average, economic growth cycles average three times longer than contraction cycles.  It seems unreasonable that three years of shrinking should only produce 18 months of growth cycle.

United States:
Federal Reserve Chairman Alan Greenspan, in his two-day meeting with the US Senate Banking Committee, spoke of the likelihood that the short slump in US consumer spending would prove short-lived.  Many investors interpreted these comments as indicative that interest rate rises were unlikely to be postponed until 2005. US equities rose and US government bonds fell as investors reacted to these comments. That said, June did not see the expected slump in housing forecasters predicted due to rising interest rates. June was the best figure for 10 months.

United Kingdom: The annual rate of expansion rose by 3.7%, the strongest pace since the third quarter of 2000. According to the figures retail sales grew by 1.1% in June compared with 0.7% in May, boosted by the Euro 2004 football tournament. Mortgage lending rose sharply in June, according to a report from the British Bankers’ Association. Lending rose by ?6.5bn, up from ?5.1bn in May, and was higher than the recent monthly average of ?5.7bn.

Continental Europe:
French consumer spending surged in June at the fastest pace in almost eight years. Spending on manufactured goods rose by 4.2% from May as government-regulated seasonal discounts lifted sales of home appliances and clothing. Investor confidence in Germany rose for the second month in July as exports surged.

Looking Ahead:
The world’s major economies are very healthy. Corporations are lean, mean and producing great returns to shareholders. The world is growing and improving. We expect that since consumer spending did not miss a beat recently when things were a lot worse, it is unlikely it will miss a beat now when things are so much better. The high liquidity in the systems will continue to support consumer spending and will need to be controlled only to the level to prevent inflation from becoming an issue. Corporate profits therefore, should not miss a beat either. With only 100 days to the US Presidential election, the time is now to take your positions and lets hope the terrorist threat does not materialise.

www.investments-intl.com or email darcy@investments-intl.com