February 2006
What exactly drives the stock market? In all honesty, this is a huge question. Yet no matter how big a question it is, if you are invested in stocks, it's worth asking. If you had posed this question to your friends at a Super Bowl party, you would have been rightfully sent home before halftime. But in the unfortunate event that your friends are anything like me they would have actually tried to answer it!
Most people would throw out a series of plausible drivers of the market, from strong corporate profits, momentum and human emotion to job growth and low interest rates. All these things matter in combination, but one thing is certain. The US economy basically hinges on consumer spending.
The fact that consumer spending is the primary driver of our economy is common sense really. About 70% of our gross domestic product - that is, the total value of all economic activity in our country - comes in the form of people buying things and services. The other 30% is basically evenly split between spending done by businesses and the spending done by our government. From this perspective, it shouldn't be surprising that the consumer is the primary engine of our economy.
Rather than stating the obvious, instead we want to give you a sense of what we as portfolio managers think about when it comes to managing money. How do we see the current state of the US economy and how does it affect our investment decisions now?
At the outset, it should be clear that only looking down from on high at a portfolio of individual stocks and bonds through the filter of the perceived health of the general economy is not always a wise endeavor. Too often, the big picture of the economy blinds an investment manager's view of each individual company's attractive prospects.
But it should also be clear that any investment manager that forgets they are also a portfolio manager and simply chooses to ignore the backdrop of the broader economy when making decisions (especially with today's economy) is basically asking to look foolish in hindsight.
In the final analysis, portfolio management is about having to deal only with what's right in front of you. Today, here is what we see in front of us and how we are acting on what we see.
If you accept the notion that our economy is driven by consumer spending, then frankly it's a bit hard to be overly excited about stock market in general. There are bargain stocks out there, but we think right now you'd better love what you own and only own what you love.
One of the biggest positive surprises with our economy over the past five years has been the resiliency of the US consumer. Despite the tech bubble bursting and the consumer dealing with a stock market that fell 50% off its peak, the consumer just kept on spending.
To be fair, they were helped along by two very powerful things, namely (1) a very strong housing market driven by a policy of very, very low interest rates and (2) tax cuts given by our federal government. These two things gave the consumer strong enough legs to weather a terrorist attack, a spate of ridiculous corporate scandals and it gave them the ability to stomach the sight of their ever-deflating investment accounts.
However, to put it bluntly, we need to remember that all of that is ancient history. What really matters now is what's comes next? As we look at the health of the US economy and specifically to the people that lead the way, the consumer, there are some prudent questions to ask.
What is going keep the consumer going? Is it reasonable to assume that the growth in consumer spending will begin to slow? The double stimulus of tax cuts and low interest rates are long gone. While nothing is impossible, the government can't afford tax cuts today and the important housing market is slowing by most accounts. Interestingly, this is happening with mortgage rates near their record lows. All in all, the ability of consumers to refinance their mortgage or borrow on their home equity line of credit is diminishing.
There are those that look at this economy as something to celebrate. They have a compelling list of positives to cite. Inflation is still relatively low despite oil at almost $70 per barrel. The economy has strung together 10 straight quarters of better than 3% growth. The housing market still looks okay despite short-term interest rates being increased 14 times in past year and half. Corporate profit margins are near their historic highs and the earnings of the largest public companies are at record levels. Unemployment is now a good amount under 5% and, better yet, it's still falling. Inflation is tame especially when you don't count the rising cost of health care, food or energy! And finally, as we said, the Federal Reserve is approaching the end their rate hiking campaign. What's wrong with that?
When you put it that way, it does make you wonder why anyone would be concerned at all. Certainly, we can't argue that the economy - albeit by looking backward at it all - is in horrible shape. Quite the contrary, we acknowledge that the data is generally positive. But in the world we live in, looking back is not a smart way to avoid hitting a tree. The right time to act is when things look good on the surface and appear to be weakening underneath.
We wonder out loud about the health of the US consumer. We are seeing signs that the consumer is cutting back a bit and that is all it takes to slow economy down.
If we're right, then what will take the consumer's place to keep driving the economy forward? We argue that businesses may still continue hiring for a while until it becomes obvious to them that the consumer is pulling back. Likely, businesses may follow through on plans to increase their capacity to make products or deliver services, but if the consumer is slowing down, business executives will logically pull back too. Businesses follow their customers. It makes sense that consumer spending leads the whole game and we're concerned about the consumer.
We aren't completely alone in our concern. We have seen in recent weeks the downside of the high expectations that investors have for companies in 2006. Time and time again, from Citigroup to Johnson & Johnson, from Intel to 3M, from GE to eBay, Google and Yahoo, the market has not liked the cautious views that have been put forward about the year ahead. Their past earnings and growth looked pretty good. However, the future is all that matters. The stock market rewards steady growth and slowing growth gets punished mercilessly.
Over the coming months our eyes will be tightly focused on the health of the consumer. In the meantime, our mantra is to only own what we have true conviction in and we believe that in today's hyper-quick investment environment, it will pay off to be acting on our worry a bit before it becomes obvious.
Jason P. Tank, CFA
jason@frontstreet.com