Tuesday, April 24, 2007

The resilient U.S. equity market

Why is the U.S. equity market so strong and so resilient? Sure, corporate earnings continue to impress, below last year's pace but ahead of this year's expectations. And unemployment levels remain low in a moderately growing economy. P/E's are not at unreasonable levels if the party continues, and the U.S. remains as the great entrepreneurial haven in the world. So that's the answer. Everything's just fine.

That's, of course, not the full story. The U.S. as an economy has significant structural problems that are clear to everyone. First, while trade imbalances and budget deficits are not inherently a problem at reasonable levels, the U.S. positions are no longer reasonable and the market is taking it out on the dollar. That's a big macro deal. On the more immediate front the consumer in the aggregate seems to have the potential to run into a wall. There are many reasons for this but the simple explanation is that the paycheck to paycheck lifestyle that many Americans live is supported by credit, and this may not end well.

The stock market should be doing ok, no doubt about it. The question, however, is why is it doing so extraordinarily well. Here are a few stabs at an answer:
---Where is another attractive market? Bonds don't look like a bargain and the general bias is that medium and longer term rates must eventually climb and prices fall to support the budget deficit's funding by foreign buyers of U.S. securities. And if bonds by any chance rally, the stock market will as well. Cash is not bad with yields in money market funds at 5% but after tax the investor basically keeps even with inflation, no pain no gain. Real estate is an area where it looks today like the money has already been made and the upside today is for the serious risk taker to chase. The stock market has momentum and, practically speaking, it works. What is the alternative?
---The U.S. dollar has fallen roughly 33% against the Euro and the Pound over the last three years, a fact that would seem to augur against support for the U.S. equity market. There are at least three reasons why that is not necessarily the case. First with the multinational U.S. corporates' global exposure, overseas earnings translate into more dollars which translate into more EPS. Secondly, the investing world is global and a primary theme of global investing, and investing in general, is asset allocation. So if a fund has a U.S. equity market allocation of, for example, 30% and the value of their holding goes below that level due to the dollar decline, they buy more U.S. equities to keep at that 30%. Third, to those global investors who are discretionary and do old fashioned stock picking, today the price for a U.S. business can look cheap, just like Manhattan restaurants, hotels and shops are bargains to many foreign tourists. If they weren't in this market already, it's time to shop.
---The U.S. equity market is strong not necessarily because businesses are strong, but because the financial management of businesses is superb. A focus on reducing costs, inventory management, and returning capital to shareholders through stock buybacks and dividends(taxed at 15%) keeps underpinning earnings per share. Whether this is at the expense of reinvesting in the business(in research and development, in employee training and loyalty, in capital investments) is a longer term question, but financial management creates the results today.
---The amount of money chasing returns in the world today is huge, and private equity is always there, it seems, as either a windfall or a backstop. It can pay up for a performing company and bail out an underperforming one. There is the saying that the market in the short term is a voting machine but in the long term it's a scale. The voting machine is humming and the demand is underpinned by market liquidity. What the scale says, value or not, has yet to be determined.
---Since the market looks ahead and discounts future events, the fact that there are only 19 months left in the presidency of George W. Bush is likely another positive, without question from a global perspective but also one could guess in the financial centers of New York and Boston.

What is the outcome of all of this? If the music stops, who doesn't get a chair? The only thing for certain is that participation is mandatory. So what stocks look good for tomorrow.


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