May 26, 2004The surprising 2003 rally in low quality stocks led many market pundits to deduce that investors had gone ‘crazy’ or returned to their irrational, bubble year ways. However, given the results of the past two months, we are happy to report that the rational investor has made a triumphant return and now appears to be dictating the course for stocks.
The initial catalyst for this return appeared on April 2nd, when investors were surprised by an employment report showing that more than 300,000 new jobs were created in March and over 500,000 new jobs were created in the first quarter of 2004. On April 14th investors were surprised again by a report stating that core inflation (a.k.a. Core CPI) had accelerated at a much greater than expected annualized rate of 3.0% over the prior 3 months. Why is this data important? Because it is confirmation that the economy is growing rapidly and that inflation is back. More importantly, this is exactly the type of data that will likely spur the Federal Reserve to finally raise the historically low Fed Funds rate.
Following the receipt of additional data that further confirmed the likelihood of a Fed rate hike, investors reacted by selling stocks and bonds. In fact, the S&P 500 has fallen nearly 3% since the end of March while the yield on the 10-year Treasury note (the bellwether for long term interest rates) jumped by more than 1.0%, resulting in a significant decline in the bond’s value. Why did investors react this way? Simply put, they responded rationally to economic data. Higher interest rates typically result in slower economic growth and slower corporate earnings growth in the future. Key factors driving economic and earnings growth over the past 12 months have been historically low interest rates and significant amounts of liquidity (i.e. cash) available to consumers and corporations. Higher interest rates and a reduced level of liquidity will likely result in slower consumer spending as well as a decline in the growth of corporate earnings. The stock market rally of 2003 was fueled by strong economic and earnings growth, but now investors are correctly “pricing in” a reduced level of growth over the next 12 months as higher interest rates take their toll.
It may sound like heresy to state that a sell-off in the stock market is actually a healthy development, but the recent decline in both stocks and bonds is just what the doctor ordered. Asset valuations cannot go straight up forever, and a short-term decline in the midst of a long-term rally gives company fundamentals a chance to catch up to stock prices and provides investors with an opportunity to buy better values. If there is no price decline, a “bubble” may be created followed by the inevitable, and painful, popping of the bubble. Consider the stock market bubble of the late 1990’s. Both economic and earnings growth peaked in mid-1999, about the same time that the Federal Reserve began raising short term interest rates in an attempt to cool off an overheating economy. However, investors ignored the Fed rate hikes and continued to drive stock prices higher. Valuations in the “new economy” stock market subsequently reached extreme levels in relationship to earnings growth and the market did not begin its sell off until 9 months later in March of 2000. The ensuing correction was much more severe than it would have been had investors recognized the economic and earnings growth peak in mid-1999 and begun to value stocks more rationally.
Today, the stock market is healthier than it was just two months ago. The forward P/E (price to earnings) ratio of the S&P 500 has declined from 19x to 17x over this time period. This decline is indicative of a correction spurred by a much needed reduction in investor risk appetite, and there is now a good deal of caution being displayed by investors as opposed to the euphoria witnessed during much of the previous 12 months. This caution is warranted because, as the chart below shows, there has been a tremendous increase in growth rates and we have likely seen the peak of the current economic and earnings growth cycle. Real GDP has grown at an average of almost 5% over the past 4 quarters, while corporate earnings have risen at a rate greater than 20% year over year for the past 3 quarters. These growth rates rival those seen at the peak of the 1990’s bubble and are clearly unsustainable, particularly in the face of higher interest rates. So, how do investors make money in stocks over the next few years?
We believe higher interest rates and higher inflation will be key factors in driving stock prices over the next several years. As a result, we are continuing to employ an investment strategy that includes a focus on “hard” assets, including energy stocks, other commodity-oriented stocks, and real estate investment trusts (REITs). When inflation increases, dollar-denominated assets like stocks and bonds suffer because their real values decline. However, hard assets generally benefit from higher interest rates and inflation. Therefore securities tied to hard assets perform better in an inflationary environment. For that reason, we own the stocks of companies leveraged to oil & gas prices, commodity prices, and real estate values.
We continue to believe energy represents an excellent long-term investment opportunity even without the added impact of higher inflation. The petroleum and natural gas industries are currently experiencing a structural supply/demand imbalance that is not likely to be repaired any time soon. In fact, oil prices have climbed above $40/bbl recently. There is insufficient supply available on the market to meet the world’s surging demand and this disparity is only being exacerbated by rapidly growing economies like India and China (now the world’s second largest consumer of oil). Yes, there is a geopolitical risk premium in the oil market today, but even without this premium oil would likely be trading in the $33 - $35/bbl range. Furthermore, energy companies are reluctant to commit significant resources to finding and developing new reserves because the costs associated with this activity have risen dramatically and they are generally skeptical that current oil and gas prices are sustainable over the long term. In addition, there are fewer and fewer productive properties left in the world. In fact, some experts believe that global oil production will peak in 2010. To support this, they state that worldwide oil discoveries peaked in 1964 and assert that 70% of today’s oil supply is produced from oil fields discovered before 1970. Wall Street analysts do not buy this argument, and, as the chart below shows, are currently assuming oil prices in the second half of 2004 in the high $20’s/bbl and natural gas prices of only $4/mcf (vs. actual prices of $40/bbl and $6.50/mcf) when valuing the stocks of energy companies. As a result, unless oil & gas prices suffer a severe and abrupt decline over the next few months, productive energy companies will generate much higher than expected earnings and cash flow over the near term. Burlington Resources (BR), which will grow production volumes by 9% in 2004, and ConocoPhillips (COP), which is the largest refiner of crude oil in the world, are two companies that we believe will exceed these conservative expectations.
The growth of foreign economies such as China and India should also lead to continued strong demand for commodities such as aluminum, steel, coal, lumber, and paper products. The Chinese government has recently begun making efforts to cool the rapid economic growth in that country and commodity prices have declined in response to these efforts. However, as China and India continue to modernize, there will be strong demand for the commodities needed to build the infrastructure and fuel the economies that support the 2.5 billion people who inhabit these two nations. We believe Alcoa (AA), the leading producer of aluminum in the world, as well as International Paper (IP) and Rayonier (RYN), both leveraged to wood and paper production, will benefit from this demand.
As we have often stated, stock prices will move with economic and earnings growth. However, even in periods of slower growth there are opportunities to invest profitably. Although some may pine for the go-go years of 1999 or even 2003, we are pleased with the current state of the market and believe it represents an excellent opportunity to acquire reasonably-valued investments that can perform well in an environment characterized by higher interest rates, higher inflation and lower investor risk appetite. At Westwood, we happily welcome a new era of rational exuberance.
Click here if you would like a printable version of this article.
This information is provided for clients and prospective clients of Westwood Management and Westwood Trust, hereinafter "Westwood" and their employees. It is not an offer or solicitation to sell securities. The information provided here is copyrighted by Westwood and may not be used without its permission.
