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Friday, May 14, 2004 10:52:13 PM
Friday May 14, 2004 Daily MarketWrap
http://www.robblack.com/rb_marketwrap.shtml
The S&P 500 Index and DJIA finished little changed, rounding out their third straight week of losses. The Nasdaq Composite Index dropped after Dell's profit forecast failed to top analyst estimates. The S&P 500 and Dow average bounced between gains and losses today as investors assessed the impact of a report showing consumer prices rose for a fifth month in April. The Federal Reserve last week pledged it would raise interest rates at a ``measured'' pace to curb inflation. The S&P 500 lost 0.78, points (-0.1%) to 1095. The DJIA added 2 points to 10,012. The Nasdaq, which gets 40 percent of its value from computer-related stocks, shed 21 points (-1.1%) to 1904. For the week, the S&P 500 slid 0.3 percent, the DJIA average lost 1 percent and the Nasdaq declined 0.7 percent. Five stocks rose for every four that fell on the New York Stock Exchange today. Some 1.3 billion shares changed hands on the Big Board, making it the slowest trading day in three weeks. Since April 2, when a government report showing a greater- than-forecast increase in jobs fueled expectations of higher interest rates this year, the S&P 500 has dropped 4 percent.
Strong Sectors: oil & gas equip, gold, tobacco, casino, homebuilding, airline, auto, REIT, hospital
Weak Sectors: chip equip, software, communication equip
Top Stories . . . Crude oil rose to an all-time high in New York as surging gasoline demand raised concern that refinery capacity and fuel supplies will be inadequate in the months ahead.
Nortel Networks, facing accounting probes by U.S. and Canadian regulators, said federal prosecutors in Texas have asked the company to turn over documents as part of a criminal investigation.
The U.S. dollar fell against the euro for a third day in four after the University of Michigan's gauge of consumer confidence fell short of economists' forecasts.
Prices paid by U.S. consumers rose 0.2 percent in April amid higher costs for travel and medical care, reinforcing expectations that the Federal Reserve will start raising interest rates.
Interest Rates . . . The WSJ reports that by now, just about any economist who is paying attention expects the Federal Reserve to start raising short-term interest rates sometime in the not too distant future on signs that economic growth is picking up and inflation is beginning to creep higher. The WSJ's latest monthly survey of private economists lays out expectations for the course of short-term interest over the next 19 months. Forty-three of the 55 economists surveyed said they expected the Fed to nudge up the benchmark federal-funds rate by June from the current 46-year low of 1%. That is a sharp shift from the previous survey a month ago, when economists on average believed the Fed would wait until September before acting. The median forecast calls for the fed-funds rate to rise to 1.25% in June and hit 1.75% by December, 2.5% a year from now and 3.5% by December 2005.
Hot IPO . . . The upcoming initial public offering for Salesforce.com has been bumped back at least a week from the IPO calendar after a report in The New York Times revealed CEO Marc Benioff no longer owns about 8.4 million of his shares in the company ahead of its stock market debut. Benioff owns about 28 million shares now, down from 36.5 million shares he purchased 1999 and 2000, according to the newspaper. The IPO document does not disclose when Benioff sold his shares or how much he got for them. Kathy Smith, fund manager with Renaissance Capital, said the $85 million IPO from the San Francisco-based business software maker has been delayed from the week of May 23 to give the company time to update its IPO prospectus about the CEO's stock sale. The stock sales would have taken place during years in which Benioff earned only $1 per year in salary. Smith said the IPO will still likely kick off, but it'll face a delay. The IPO has been widely seen as a dot-com appetizer for the big $2.7 billion IPO from Google.com, since both companies share the same lead underwriter Morgan Stanley.
Market Comment . . . While high oil prices and impending interest rate increases weigh on the outlook, the positive factors are The U.S. economy is accelerating markedly. GDP growth was 4.2% in the first quarter, with each month stronger than the previous. Thus, April and May are building on very strong March results, so the comparison of the second quarter to the first is likely to be favorable when second quarter GDP data is released on July 30. Analysts are expecting 5.2%. Expect a durable, multi-year expansion spurred by a reasonably valued dollar (neither inflationary nor deflationary), small businesses, employment growth and an acceleration in growth abroad. Analysts disagree with increases will block the expansion and that China is heading for a hard-landing.
While high oil prices and impending interest rate increases weigh on the outlook, we think the positive factors are stronger. The near-term drivers are an improvement in business sentiment, which suffered a second dip in the uncertainty leading into the April 2003 Iraq war, and indications of stronger growth in inventories, business investment and payrolls.
Inventory building has not yet made a significant contribution to overall GDP growth in the current expansion. Look for the inventory “after burners” to kick in during 2004, providing a significant boost to an already accelerating expansion.
• Demand for commercial and industrial loans has recently started growing. This typically coincides with an increase in business inventories. Growth in loans and inventories make sense given the “get-it-while-you-can” nature of today’s superlow interest rate environment.
• The inventory/sales ratio is at all-time lows, well below its longer-term structural downtrend.
• In the near-term assuming a continuation of the current pace of sales growth, even a reversion to the secular downtrend (on the graph, the solid line rises to meet the declining dotted line) would add almost 0.9% to GDP.
• Further, we’re not sure the secular downtrend in the inventory/sales ratio will persist. It was partly driven by disinflation and the unusually high real interest rates in the decades after the 1970s inflation crisis. Those factors combined with technology to create a “just-in-time” inventory culture, culminating in an outright aversion to inventory in recent years. If mild inflation and relatively low real interest rates persist in coming years, the secular downtrend might flatten, with further positive implications for GDP growth, employment and industrial production.
Corporations Ready to Invest
Corporate profit growth accelerated beginning in 2002, reaching the highest percentage of GDP since the late 1960s.
• While investment spending on plant and equipment (capital spending) began to revive in 2003, it remains below the level of aggregate cash flow, reflecting both the extent of the investment excess in the late 1990s and the subsequent bust.
• While investment spending on plant and equipment (capital spending) began to revive in 2003, it remains below the level of aggregate cash flow, reflecting both the extent of the investment excess in the late 1990s and the subsequent bust.
• CEOs have become significantly more optimistic, which should reduce their risk aversion and lead to increased jobs, inventory and business investment.
With balance-sheet restructuring mostly completed, profits strong and CEOs more confident, we think pent-up investment demand will contribute to the economy’s acceleration in 2004. Don’t agree with the concern that excess capacity will place a low limit on investment growth.
• The Institute of Supply Management reports capacity utilization in its semiannual survey of its members. The ISM measure is generally larger than the Fed’s measure (which we think includes a substantial amount of uneconomic capacity) and moves with it. However, recent observations on the ISM series show a divergence, with the ISM measure rising much faster than the Fed’s.
• One explanation is that private-sector executives are “moth-balling” uneconomic capacity much faster than the Fed assumes, suggesting that business investment will grow faster than expectations in coming quarters.
Consumer Resilience
Consumption growth has accelerated despite relatively low consumer confidence and continuing concerns about the international situation.
• Retail sales were down 0.5% in April from March. However, the March-April total was 2.2% (13.9% annualized) above the January-February total. If the April sales level simply holds, second quarter retail sales will be 1.3% (4.6% annualized) above the first quarter.
Eco Speak . . . Consumer sentiment held steady in early May, researchers at the University of Michigan said Friday. The consumer sentiment index remained at 94.2, the same level as reported in late April. Economists had expected sentiment to improve in May. The consensus forecast of Wall Street economists was for sentiment to rise to 95.9. The current conditions index rose to 107.2 in May from 105.0 in April. The expectations index fell to 85.8 in May from 87.3 in the previous month.
Output of the nation's factories, mines and utilities rose at a faster-than-expected rate of 0.8 percent in April. Capacity utilization rose to 76.9 percent from 76.5 percent, the highest level in nearly three years. Economists had been expecting industrial production to rise 0.4 percent and capacity utilization to increase to 76.7 percent. Manufacturing output rose 0.7 percent in April after a scant 0.1 percent rise in March. Output at the nation's utilities rose 1.5 percent in April after falling 2.3 percent in March.
record surge in U.S. business sales helped the inventory-to-sales ratio set a new record low in March. Business inventories rose 0.7 percent in March, the seventh consecutive increase. Inventories rose to a record $1.2 trillion, while sales at U.S. businesses increased a record 2.9 percent to a record $928.7 billion. The inventory-to-sales ratio fell to a record low 1.30 in March from the previous record of 1.33 in February. Economists had been expecting inventories to rise 0.4 percent in March.
Fund Flow . . . Funds investing primarily in U.S. stocks had outflows of $700 million during the week ending May 12, estimates Trim Tabs director of research Carl Wittnebert, after taking in $600 million in new money the prior week. "With recent developments in the equity and bond markets, it is no surprise that investors are liquidating some holdings," Wittnebert said. "What surprises me is that they aren't liquidating more." Meanwhile, international stock funds had inflows of $100 million, adding to the prior week's inflows of $400 million. Bond funds suffered outflows of $3.6 billion, on top of the $1.1 billion in outflows the week before.
Financials . . . Barron's Online highlights leading Wall Street securities firms, suggesting they have low valuations and could potentially trade higher. According to the article, investors seem more focused on bad news, such as rising interest rates and geopolitical risk. So far this year, the S&P's Investment Bank index has slipped 7%. But, according to the article, this recent decline may be overdone. Rising interest rates could signal a full-fledged economic rebound, which should keep equity markets strong and prompt even more IPOs and M&A activity. Plus, the surprisingly cheap valuations make Wall Street powerhouses such as Merrill Lynch and Morgan Stanley look more compelling. The sell-off in these stocks "is an interesting thing, since [the investment banking] business is getting better and better," says Dave Macey, senior vice president and portfolio manager with Boston Company Asset Management. MER's P/E ratio is in line with its growth rate and below its 5-year median P/E of 15.3x projected earnings. It also fetches only 1.8x book value, well below its median 2.2x book over the last 5-years. While MWD's P/E slightly exceeds its growth rate, the stock looks like a value by other measures. It's 16% off its 52-week high and is trading below its median P/E of 15.3x forward earnings for the last 5-years. At 2.2x book value, it's significantly below its median 3x book over the last 5-years.
Real Estate . . . Bank of America says real estate stocks, which are down 18% since April 1 are approaching attractive valuation levels. On April 6, the firm wrote, "Even Down 8.9% Real Estate Stocks Aren't Cheap". Six weeks later, valuations have declined further, major funds outflows have not materialized, and much of the expected rate increase is behind us. Real estate stocks are no longer expensive. The average real estate stock is now trading at 11.4x 12-month forward funds from operations. Although this is still an 11% premium to the historical average of 10.3x, it is down from the April 2004 peak of 14.1x and the 1997 peak of 12.9x. The big move in rates is likely behind us as the yield on the 10-year Treasury has risen to 4.86% from 3.89% on April 1. The firm continues to like malls - including Simon Property and General Growth - because of strong growth and reasonable valuations and sees opportunity in office names like Equity Offices and CarrAmerica, industrial names like Prologis, Cattelus Development, and St Joe.
Oil & Gas . . . Morgan Stanley raised its 2004 oil price forecast to $33 per barrel from $28, citing higher marginal production costs, unusually tight refined markets and expectations of continued OPEC cohesion. June crude futures were last trading up 24 cents at $41.32. As a result, analyst Douglas Terreson raised his earnings and stock price targets on several oil companies, including Exxon Mobil, ChevronTexaco, ConocoPhillips and Marathon Oil.
Paper . . . Deutsche Bank upgrades Weyerhaeuser, Pope & Talbot, Glatfelter, Wausau-Mosinee to Buy from Hold, and upgrades RKT to Buy from Sell and upgrades Caraustar to Hold from Sell. Firm notes that the decline in paper stocks over the last 3 weeks has been dramatic, but says that over the past 6-8 weeks the cyclical recovery in pulp & paper has strengthened markedly; also, domestic demand has accelerated in several key businesses (containerboard & uncoated white paper especially), trade numbers are showing signs of improvement, and demand in many other parts of the world appears to have improved.
Food & Beverage . . . The WSJ reports that the cola warriors are shaking up the orange-juice aisle in a bid to win back calorie-counting consumers. Tropicana Products, a unit of PepsiCo, said it plans to expand its line of Light 'n Healthy reduced-calorie orange juice, while eliminating more sugar and calories from a product line that it says has become a hit with health-conscious consumers. Meanwhile, Coca-Cola's Minute Maid unit said it would begin selling later this month an orange juice with less than half the calories and sugar of regular juice. Both beverage giants are trying to reverse an industrywide slide in orange-juice sales, fueled by consumers who are drinking less of the breakfast staple because of concerns over calories and carbohydrates.
Tobacco . . . UBS upgraded Altria to "neutral" vs. "reduce" and reiterated a price target of $51, highlighting the positive prospects for a spinoff of the company's majority stake in Kraft over continued tobacco litigation. "UBS has always argued that US tobacco litigation is unpredictable," UBS said in a note to clients. "The events of 12th May (The Florida Supreme Court's decision to overturn the Engle judgement) prove this once again." UBS said the spinoff of Altria's Kraft stake is the main investment case for the stock and the valuation now appears "far more reasonable," he said.
Retail . . . Wal-Mart reported 1st quarter 2004 EPS from continuing operations of $0.50 vs. $0.41, a penny above estimates and consensus of $0.49 and at the higher end of the $0.48-$0.50 plan. Higher other income as well as a higher level of share repurchase than we were estimating drove the penny upside in the quarter. GAAP EPS was $0.50 vs. $0.42, as 1st quarter 2003 included $0.01 from the McLane business which sold in May 2003. Total U.S. retail comps for 1st quarter 2004 came in at 6.4% for the quarter, composed of 5.9% comps at the Wal-Mart stores division and 8.8% comps at Sam’s Club. Wal-Mart provided 2nd quarter 2004 EPS guidance of $0.60 to $0.62 and raised its full year 2004 EPS guidance to $2.35-$2.39 from $2.34 to $2.38. 2nd quarter 2004 comps are planned in the 4%-6% range for the total corporation vs. a 3.2% comparison. Analysts are bumping up our 2nd quarter 2004 estimate to $0.61 from $0.60 and full year 2004 estimate goes to $2.38 from $2.36. Analysts are also raising 2005 EPS estimate to $2.72 from $2.70. Comp comparisons are 2.1% in May, 2.7% in June and 4.6% in July. Analysts are estimating 2nd quarter 2004 U.S. comps of 5.0%, comprised of a 5.0% increase at the Wal-Mart stores division vs. a 3.1% comparison and 5.0% comps at Sam’s Club vs. a 3.6% comparison. May comps are planned up 4%-6% vs. a 2.1% comparison, and comps are trending in line with plan month-to-date.
High energy prices are pressuring WMT both on the expense side, with utilities costs now expected to run 5% above the original plan for the balance of 2004, and sales line, with gasoline prices negatively hurting consumers by an average of $7 a week. However, an improving jobs picture and real incomes should help mitigate high energy prices. Wal-Mart has not yet seen a pick up in spending by lower income households as indicated by the mid-month paycheck cycle which remains pronounced. Revised comp estimate for
2004 is 4.7% (vs. prior 4.5%), and are not expecting Wal-Mart to gain any leverage on expenses this year due to higher healthcare, workers’ compensation and utility costs. However, expecting gross margin expansion due to better management of apparel inventory and benefits from global sourcing. Note that gross margin comparisons ease in 2nd half 2004, particularly in 3rd quarter vs. gross margin declines a year ago.
Media . . . SunTrust Robinson Humphrey upgrades Roxio to Neutral from Reduce based on their assumption of a stabilizing and profitable software biz, as well as their belief that Napster is in the early stages of what could be tremendous growth.
The Washington Post reports that Yahoo officials said that the market for Internet searches will grow from $3 billion to $11 billion over the next 5 years, as computer users increasingly look for more local and product information online. Even as Internet searches continue to grow in popularity around the world, Yahoo executives said the big money to be made in the near term is by linking computer users with more retailers, restaurants, dry cleaners and other businesses located nearby. Already, 20% to 25% of online queries have some local component, and Yahoo is planning to introduce greater capabilities for company's to advertise locally in the coming months. "We think now is the right time to go after the local market," said Ted Meisel, president of Overture, Yahoo's search engine subsidiary.
Outsourcing . . . Jefferies on Indian IT consulting: The upset victory by the Liberal Congress Party has generated speculation that the new government could be more protectionist. With the rupee down the last few weeks, and no need for foreign investment in order to grow. the firm says Indian IT companies are less vulnerable to potential changes in economic policy. Jefferies says that while the new government could be less pro-business, India-based IT services firms are intact and potentially improving... Major Indian IT names: Infosys, Satyam, Wipro.
Network Equipment . . . Buckingham says that channel checks indicate that Avaya is displacing Cisco and beat competition from Nortel for high reliability VoIP implementations at 3 major brokerage firms, with greenfield builds for corporate headquarters. Firm believes that CSCO continues to win the low-end VoIP business for remote sites deployments, with AV supplying the backup.
Cisco authorizes up to $5 billion in additional repurchases of its common stock. Cisco's board had previously authorized up to $20 billion in stock repurchases. There is no fixed termination date for the repurchase program.
Boxmakers . . . CIBC downgrades DELL to Sector Perform from Outperform. While execution remains solid within a challenging backdrop, firm believes that factors outside DELL's control are putting structural -- and perhaps secular -- pressure on margins, which marked a 4th consecutive quarterly decline. Firm says intensified pricing from large competitors and rising component costs combine for a squeeze which they do not see abating, as their perspective in semi and FPD markets points to more shortages through 2H04; firm also notes that the stock trades at a 52% premium to the S&P 500.
Analysts are somewhat disappointed with DELL's $100 million revenue upside to $11.54 billion, which was offset by a challenging component environment that drove gross margins lower than expected. Gross margin came in at 18.1% versus 18.3% expectations, resulting in no EPS upside which most market participants had been betting on. Also, Dell server revs reported an increase of 26% to $1.3 billion, which missed analyst expectations, and storage revs increased 18% y/y to about $412 million, which missed the 25-35% year/yaer growth expectations. UBS notes that the storage miss could be attributed to a mix shift, as Dell shifted its focus to selling more co-branded Dell/EMC mid-range CLARiiON systems rather than reselling some high-end EMC branded Symmetrix systems and selling its own direct attached storage offerings. Regarding EPS guidance for 2nd quarter, the company had another disappointment in store, as despite guiding higher than consensus on revenue ($11.7 bln) and enjoying a lower than anticipated tax rate of 27% (versus 28%), the co only managed to guide in-line with the Street estimate of $0.29. Merrill Lynch notes that this suggests gross margin won't rebound. On a more positive side, JP Morgan notes that Dell's results provided strong evidence that PC demand remains healthy, though the component pricing environment remains difficult. Firm believes it is now clear that corporate PC demand is accelerating. At 24x their calendar 2005 EPS estimate, Dell trades at the low-end of its historical multiple range.
Semiconductors . . . Bernstein gives an update on their conversation with INTC CEO Craig Barrett; in response to the most frequently asked question since the Q1 call on April 13, Barrett said that he was comfortable with inventories at Intel and in the channel, and said that an inventory write-down was the "farthest thing from my mind" since it was due to better than expected yields, not worse than expected demand. Firm says he was very disdainful of this question, and their conclusion is that he thinks there is zero chance of a microprocessor inventory write-off. Regarding the cancellation of its next-generation "Tejas" and "Jayhawk" processors due to head dissipation, firm believes that the cancellations and difficulty Intel is having with power dissipation at 90nm make it likely that AMD will have a harder time with its R&D budget, which is one fifth as large as Intel's. Maintains Outperform rating.
Software . . . B. Riley downgrades Activision and THQI to Neutral from Buy based on valuation. In addition, firm sees difficulties ahead for the video game software publishers: with the Xbox 2 and PS3 likely to be released in 2005 and 2006. Respectively, firm expects software sales industry-wide to be down in 2005; and unlike the last console transition. The firm expects the software publishers to continue to create front-line games for the PS2 and Xbox even as the PS3 and Xbox 2 are rolled out, which should result in a slower ramp of next generation console sales than occurred in the last video game cycle.
Lesson on Which is Better . . . Stocks or Bonds?
What Is the Mean?
Forecasting seems to often assume that it is just a matter of time until history repeats itself. On average, the future will be average. The mean is the mean. Even statistical techniques that isolate dependent variables from independent variables presume a regression to the mean. But what is the relevant sample to determine what is average, what is the mean?
Ten-year U.S. Treasury issues are yielding 4.5%, about 65 bps below what they yielded, on average, over the past 75 years, and 260 bps below the average yield post-1982. (Why 1982? It’s not a totally arbitrary starting point — that year marked the beginning of a great bull market in financial assets, for both bonds and stocks.)
The “earnings yield” of the S&P 500 (i.e., the inverse of the P/E ratio and, supposedly, a popular metric at the Federal Reserve) is 4.6%. This compares with an average earnings yield of 7.5% over the past three-quarters of a century, and 5.7% average post-1982.
It’s a Real World
Yet we believe it would be foolish to argue that these “nominal” numbers will regress to their means. Why? Because it’s a “real” world. Bonds are bought for their real yields, i.e., after taking inflation into account. The same holds true for equities. Indeed, the same is true for any and all investments. In real terms, Treasury yields do not look compelling: The real 10-year bond yield
is 2.5% today versus a long-term average of 2.0% and 3.9%, on average, post-1982. Likewise, there is no compelling case for equities either: The real earnings yield is 2.6% today versus an average of 4.3% long term and 2.5%, on average, post-1982.
In contrast to today, in recent years it was only rarely the case that the stock market earnings yield was above the U.S. Treasury yield. The fact that this has not been the case recently does not mean that equities are less risky than Treasuries. Rather, the key issue is that equities offer the
potential for a growing stream of income (i.e., earnings and dividends), whereas bonds offer a static — and relatively puny — stream (i.e., coupons).
A Relative Case for Stocks Versus Bonds
Comparing stocks and bonds, the current 10 bp equity earnings yield gap makes a relative case for stocks, given that the current equity earnings yield gap is 225 bps above the post-1982 average. However, versus the long term (i.e., 1925 forward), the current equity earnings yield gap is still 145 bps below average. So which period is relevant? Which mean will the markets regress to?
The period beginning in 1925 includes the depression and World War II, times of great uncertainty. That could well account for the materially higher equity earnings yield gap over the long term (i.e., from 1925 on) than in the post-1982 period. Indeed, it was not until 1968 that the earnings yield first fell below the government bond yield, although only for a five-year period. It really was not until the 1980s that the earnings yields remained below the bond market yield.
Why has the spread moved lower? As Citigroup economist Steven Wieting has noted, the “Great Moderation” (as Fed Governor Ben S. Bernanke has dubbed it) seems to provide a possible explanation. According to this theory, as economic volatility has declined (as evidenced by the declining standard deviation of GDP growth), the inherent risk of equities has declined and, therefore, so has the equity earnings yield gap.
Also note that, until the second half of the 20th century, stock market dividend yields were actually higher than bond yields. This was not because stocks were riskier back then, but rather because a larger portion of the total return from equities came from dividends. Indeed, it was not until 1959 that the stock market dividend yield fell below bond yields. The dividend payout ratio prior to 1959 was, on average, over 62%; after 1959, the average payout was under 50%.
The Absolute Case for Equities Requires Low Inflation
Based on the post-1982 averages, in order to make any absolute case for equities today (rather than simply a relative case versus bonds), one has to assume that the key post-1982 variable of low inflation remains in place. Declining inflation has largely been attributed to above-trend productivity gains. Indeed, nonfarm productivity rose 9.5% during the third quarter of last year and averaged 4.5% overall during 2002–03 — its best two-year performance since the survey began in 1947, and the first time it exceeded 4.0% for two years in a row. These outsized productivity gains have, in turn, suppressed resource utilization and inhibited job growth.
To be sure, fourth quarter productivity declined to 2.6%, which may have contributed to the surprisingly strong addition of 308,000 to March nonfarm payrolls, as well as to upward revisions to the prior two labor reports. Moreover, bellwether economic indicators such as the core CPI and the GDP price deflator have risen, and the personal consumption deflator — a measure of inflation tied to consumer spending favored by the Fed — rose at its fastest pace since the third
quarter of 2000.
Despite renewed inflation fears fueled by these reports, Fed Chairman Alan Greenspan and other members of the FOMC have been quick to state that concerns about broad-based inflationary pressures are unwarranted given the still considerable slack in the economy. Expect new efficiencies fostered by technology and the growing integration of a global workforce to help sustain relatively high productivity gains longer than in past economic cycles.
Of course, reinflation, or fears thereof, could take a toll on both the stock and bond markets. Or would it? Clearly any reinflation would be a negative for bonds. But could a little inflation actually be good for stocks?
In theory, the lower the inflation rate, the lower the rate at which future growth is discounted; therefore, the lower the required earnings yield and the higher the P/E ratio. (The P/E ratio is the inverse of the earnings yield.) But, in fact, the equity market has historically had a “sweet spot —” i.e., where earnings yield is lowest and P/E is highest — when inflation has been between 2% and 4%. Understandably, high inflation has been a negative, but so has low inflation/deflation. Why? Possibly because deflation, and fears of deflation when inflation fell to very low levels, threatened the future growth of profits.
So does that mean that reinflation from today’s low levels to the 2%–4% “sweet spot” would drive stocks higher? Not necessarily — not if stocks are already valued to reflect that higher inflation level. Indeed, current earnings yields (and therefore P/E ratios) seem to be already at levels commensurate with inflation rates that are higher than those currently prevailing.
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The S&P 500 Index and DJIA finished little changed, rounding out their third straight week of losses. The Nasdaq Composite Index dropped after Dell's profit forecast failed to top analyst estimates. The S&P 500 and Dow average bounced between gains and losses today as investors assessed the impact of a report showing consumer prices rose for a fifth month in April. The Federal Reserve last week pledged it would raise interest rates at a ``measured'' pace to curb inflation. The S&P 500 lost 0.78, points (-0.1%) to 1095. The DJIA added 2 points to 10,012. The Nasdaq, which gets 40 percent of its value from computer-related stocks, shed 21 points (-1.1%) to 1904. For the week, the S&P 500 slid 0.3 percent, the DJIA average lost 1 percent and the Nasdaq declined 0.7 percent. Five stocks rose for every four that fell on the New York Stock Exchange today. Some 1.3 billion shares changed hands on the Big Board, making it the slowest trading day in three weeks. Since April 2, when a government report showing a greater- than-forecast increase in jobs fueled expectations of higher interest rates this year, the S&P 500 has dropped 4 percent.
Strong Sectors: oil & gas equip, gold, tobacco, casino, homebuilding, airline, auto, REIT, hospital
Weak Sectors: chip equip, software, communication equip
Top Stories . . . Crude oil rose to an all-time high in New York as surging gasoline demand raised concern that refinery capacity and fuel supplies will be inadequate in the months ahead.
Nortel Networks, facing accounting probes by U.S. and Canadian regulators, said federal prosecutors in Texas have asked the company to turn over documents as part of a criminal investigation.
The U.S. dollar fell against the euro for a third day in four after the University of Michigan's gauge of consumer confidence fell short of economists' forecasts.
Prices paid by U.S. consumers rose 0.2 percent in April amid higher costs for travel and medical care, reinforcing expectations that the Federal Reserve will start raising interest rates.
Interest Rates . . . The WSJ reports that by now, just about any economist who is paying attention expects the Federal Reserve to start raising short-term interest rates sometime in the not too distant future on signs that economic growth is picking up and inflation is beginning to creep higher. The WSJ's latest monthly survey of private economists lays out expectations for the course of short-term interest over the next 19 months. Forty-three of the 55 economists surveyed said they expected the Fed to nudge up the benchmark federal-funds rate by June from the current 46-year low of 1%. That is a sharp shift from the previous survey a month ago, when economists on average believed the Fed would wait until September before acting. The median forecast calls for the fed-funds rate to rise to 1.25% in June and hit 1.75% by December, 2.5% a year from now and 3.5% by December 2005.
Hot IPO . . . The upcoming initial public offering for Salesforce.com has been bumped back at least a week from the IPO calendar after a report in The New York Times revealed CEO Marc Benioff no longer owns about 8.4 million of his shares in the company ahead of its stock market debut. Benioff owns about 28 million shares now, down from 36.5 million shares he purchased 1999 and 2000, according to the newspaper. The IPO document does not disclose when Benioff sold his shares or how much he got for them. Kathy Smith, fund manager with Renaissance Capital, said the $85 million IPO from the San Francisco-based business software maker has been delayed from the week of May 23 to give the company time to update its IPO prospectus about the CEO's stock sale. The stock sales would have taken place during years in which Benioff earned only $1 per year in salary. Smith said the IPO will still likely kick off, but it'll face a delay. The IPO has been widely seen as a dot-com appetizer for the big $2.7 billion IPO from Google.com, since both companies share the same lead underwriter Morgan Stanley.
Market Comment . . . While high oil prices and impending interest rate increases weigh on the outlook, the positive factors are The U.S. economy is accelerating markedly. GDP growth was 4.2% in the first quarter, with each month stronger than the previous. Thus, April and May are building on very strong March results, so the comparison of the second quarter to the first is likely to be favorable when second quarter GDP data is released on July 30. Analysts are expecting 5.2%. Expect a durable, multi-year expansion spurred by a reasonably valued dollar (neither inflationary nor deflationary), small businesses, employment growth and an acceleration in growth abroad. Analysts disagree with increases will block the expansion and that China is heading for a hard-landing.
While high oil prices and impending interest rate increases weigh on the outlook, we think the positive factors are stronger. The near-term drivers are an improvement in business sentiment, which suffered a second dip in the uncertainty leading into the April 2003 Iraq war, and indications of stronger growth in inventories, business investment and payrolls.
Inventory building has not yet made a significant contribution to overall GDP growth in the current expansion. Look for the inventory “after burners” to kick in during 2004, providing a significant boost to an already accelerating expansion.
• Demand for commercial and industrial loans has recently started growing. This typically coincides with an increase in business inventories. Growth in loans and inventories make sense given the “get-it-while-you-can” nature of today’s superlow interest rate environment.
• The inventory/sales ratio is at all-time lows, well below its longer-term structural downtrend.
• In the near-term assuming a continuation of the current pace of sales growth, even a reversion to the secular downtrend (on the graph, the solid line rises to meet the declining dotted line) would add almost 0.9% to GDP.
• Further, we’re not sure the secular downtrend in the inventory/sales ratio will persist. It was partly driven by disinflation and the unusually high real interest rates in the decades after the 1970s inflation crisis. Those factors combined with technology to create a “just-in-time” inventory culture, culminating in an outright aversion to inventory in recent years. If mild inflation and relatively low real interest rates persist in coming years, the secular downtrend might flatten, with further positive implications for GDP growth, employment and industrial production.
Corporations Ready to Invest
Corporate profit growth accelerated beginning in 2002, reaching the highest percentage of GDP since the late 1960s.
• While investment spending on plant and equipment (capital spending) began to revive in 2003, it remains below the level of aggregate cash flow, reflecting both the extent of the investment excess in the late 1990s and the subsequent bust.
• While investment spending on plant and equipment (capital spending) began to revive in 2003, it remains below the level of aggregate cash flow, reflecting both the extent of the investment excess in the late 1990s and the subsequent bust.
• CEOs have become significantly more optimistic, which should reduce their risk aversion and lead to increased jobs, inventory and business investment.
With balance-sheet restructuring mostly completed, profits strong and CEOs more confident, we think pent-up investment demand will contribute to the economy’s acceleration in 2004. Don’t agree with the concern that excess capacity will place a low limit on investment growth.
• The Institute of Supply Management reports capacity utilization in its semiannual survey of its members. The ISM measure is generally larger than the Fed’s measure (which we think includes a substantial amount of uneconomic capacity) and moves with it. However, recent observations on the ISM series show a divergence, with the ISM measure rising much faster than the Fed’s.
• One explanation is that private-sector executives are “moth-balling” uneconomic capacity much faster than the Fed assumes, suggesting that business investment will grow faster than expectations in coming quarters.
Consumer Resilience
Consumption growth has accelerated despite relatively low consumer confidence and continuing concerns about the international situation.
• Retail sales were down 0.5% in April from March. However, the March-April total was 2.2% (13.9% annualized) above the January-February total. If the April sales level simply holds, second quarter retail sales will be 1.3% (4.6% annualized) above the first quarter.
Eco Speak . . . Consumer sentiment held steady in early May, researchers at the University of Michigan said Friday. The consumer sentiment index remained at 94.2, the same level as reported in late April. Economists had expected sentiment to improve in May. The consensus forecast of Wall Street economists was for sentiment to rise to 95.9. The current conditions index rose to 107.2 in May from 105.0 in April. The expectations index fell to 85.8 in May from 87.3 in the previous month.
Output of the nation's factories, mines and utilities rose at a faster-than-expected rate of 0.8 percent in April. Capacity utilization rose to 76.9 percent from 76.5 percent, the highest level in nearly three years. Economists had been expecting industrial production to rise 0.4 percent and capacity utilization to increase to 76.7 percent. Manufacturing output rose 0.7 percent in April after a scant 0.1 percent rise in March. Output at the nation's utilities rose 1.5 percent in April after falling 2.3 percent in March.
record surge in U.S. business sales helped the inventory-to-sales ratio set a new record low in March. Business inventories rose 0.7 percent in March, the seventh consecutive increase. Inventories rose to a record $1.2 trillion, while sales at U.S. businesses increased a record 2.9 percent to a record $928.7 billion. The inventory-to-sales ratio fell to a record low 1.30 in March from the previous record of 1.33 in February. Economists had been expecting inventories to rise 0.4 percent in March.
Fund Flow . . . Funds investing primarily in U.S. stocks had outflows of $700 million during the week ending May 12, estimates Trim Tabs director of research Carl Wittnebert, after taking in $600 million in new money the prior week. "With recent developments in the equity and bond markets, it is no surprise that investors are liquidating some holdings," Wittnebert said. "What surprises me is that they aren't liquidating more." Meanwhile, international stock funds had inflows of $100 million, adding to the prior week's inflows of $400 million. Bond funds suffered outflows of $3.6 billion, on top of the $1.1 billion in outflows the week before.
Financials . . . Barron's Online highlights leading Wall Street securities firms, suggesting they have low valuations and could potentially trade higher. According to the article, investors seem more focused on bad news, such as rising interest rates and geopolitical risk. So far this year, the S&P's Investment Bank index has slipped 7%. But, according to the article, this recent decline may be overdone. Rising interest rates could signal a full-fledged economic rebound, which should keep equity markets strong and prompt even more IPOs and M&A activity. Plus, the surprisingly cheap valuations make Wall Street powerhouses such as Merrill Lynch and Morgan Stanley look more compelling. The sell-off in these stocks "is an interesting thing, since [the investment banking] business is getting better and better," says Dave Macey, senior vice president and portfolio manager with Boston Company Asset Management. MER's P/E ratio is in line with its growth rate and below its 5-year median P/E of 15.3x projected earnings. It also fetches only 1.8x book value, well below its median 2.2x book over the last 5-years. While MWD's P/E slightly exceeds its growth rate, the stock looks like a value by other measures. It's 16% off its 52-week high and is trading below its median P/E of 15.3x forward earnings for the last 5-years. At 2.2x book value, it's significantly below its median 3x book over the last 5-years.
Real Estate . . . Bank of America says real estate stocks, which are down 18% since April 1 are approaching attractive valuation levels. On April 6, the firm wrote, "Even Down 8.9% Real Estate Stocks Aren't Cheap". Six weeks later, valuations have declined further, major funds outflows have not materialized, and much of the expected rate increase is behind us. Real estate stocks are no longer expensive. The average real estate stock is now trading at 11.4x 12-month forward funds from operations. Although this is still an 11% premium to the historical average of 10.3x, it is down from the April 2004 peak of 14.1x and the 1997 peak of 12.9x. The big move in rates is likely behind us as the yield on the 10-year Treasury has risen to 4.86% from 3.89% on April 1. The firm continues to like malls - including Simon Property and General Growth - because of strong growth and reasonable valuations and sees opportunity in office names like Equity Offices and CarrAmerica, industrial names like Prologis, Cattelus Development, and St Joe.
Oil & Gas . . . Morgan Stanley raised its 2004 oil price forecast to $33 per barrel from $28, citing higher marginal production costs, unusually tight refined markets and expectations of continued OPEC cohesion. June crude futures were last trading up 24 cents at $41.32. As a result, analyst Douglas Terreson raised his earnings and stock price targets on several oil companies, including Exxon Mobil, ChevronTexaco, ConocoPhillips and Marathon Oil.
Paper . . . Deutsche Bank upgrades Weyerhaeuser, Pope & Talbot, Glatfelter, Wausau-Mosinee to Buy from Hold, and upgrades RKT to Buy from Sell and upgrades Caraustar to Hold from Sell. Firm notes that the decline in paper stocks over the last 3 weeks has been dramatic, but says that over the past 6-8 weeks the cyclical recovery in pulp & paper has strengthened markedly; also, domestic demand has accelerated in several key businesses (containerboard & uncoated white paper especially), trade numbers are showing signs of improvement, and demand in many other parts of the world appears to have improved.
Food & Beverage . . . The WSJ reports that the cola warriors are shaking up the orange-juice aisle in a bid to win back calorie-counting consumers. Tropicana Products, a unit of PepsiCo, said it plans to expand its line of Light 'n Healthy reduced-calorie orange juice, while eliminating more sugar and calories from a product line that it says has become a hit with health-conscious consumers. Meanwhile, Coca-Cola's Minute Maid unit said it would begin selling later this month an orange juice with less than half the calories and sugar of regular juice. Both beverage giants are trying to reverse an industrywide slide in orange-juice sales, fueled by consumers who are drinking less of the breakfast staple because of concerns over calories and carbohydrates.
Tobacco . . . UBS upgraded Altria to "neutral" vs. "reduce" and reiterated a price target of $51, highlighting the positive prospects for a spinoff of the company's majority stake in Kraft over continued tobacco litigation. "UBS has always argued that US tobacco litigation is unpredictable," UBS said in a note to clients. "The events of 12th May (The Florida Supreme Court's decision to overturn the Engle judgement) prove this once again." UBS said the spinoff of Altria's Kraft stake is the main investment case for the stock and the valuation now appears "far more reasonable," he said.
Retail . . . Wal-Mart reported 1st quarter 2004 EPS from continuing operations of $0.50 vs. $0.41, a penny above estimates and consensus of $0.49 and at the higher end of the $0.48-$0.50 plan. Higher other income as well as a higher level of share repurchase than we were estimating drove the penny upside in the quarter. GAAP EPS was $0.50 vs. $0.42, as 1st quarter 2003 included $0.01 from the McLane business which sold in May 2003. Total U.S. retail comps for 1st quarter 2004 came in at 6.4% for the quarter, composed of 5.9% comps at the Wal-Mart stores division and 8.8% comps at Sam’s Club. Wal-Mart provided 2nd quarter 2004 EPS guidance of $0.60 to $0.62 and raised its full year 2004 EPS guidance to $2.35-$2.39 from $2.34 to $2.38. 2nd quarter 2004 comps are planned in the 4%-6% range for the total corporation vs. a 3.2% comparison. Analysts are bumping up our 2nd quarter 2004 estimate to $0.61 from $0.60 and full year 2004 estimate goes to $2.38 from $2.36. Analysts are also raising 2005 EPS estimate to $2.72 from $2.70. Comp comparisons are 2.1% in May, 2.7% in June and 4.6% in July. Analysts are estimating 2nd quarter 2004 U.S. comps of 5.0%, comprised of a 5.0% increase at the Wal-Mart stores division vs. a 3.1% comparison and 5.0% comps at Sam’s Club vs. a 3.6% comparison. May comps are planned up 4%-6% vs. a 2.1% comparison, and comps are trending in line with plan month-to-date.
High energy prices are pressuring WMT both on the expense side, with utilities costs now expected to run 5% above the original plan for the balance of 2004, and sales line, with gasoline prices negatively hurting consumers by an average of $7 a week. However, an improving jobs picture and real incomes should help mitigate high energy prices. Wal-Mart has not yet seen a pick up in spending by lower income households as indicated by the mid-month paycheck cycle which remains pronounced. Revised comp estimate for
2004 is 4.7% (vs. prior 4.5%), and are not expecting Wal-Mart to gain any leverage on expenses this year due to higher healthcare, workers’ compensation and utility costs. However, expecting gross margin expansion due to better management of apparel inventory and benefits from global sourcing. Note that gross margin comparisons ease in 2nd half 2004, particularly in 3rd quarter vs. gross margin declines a year ago.
Media . . . SunTrust Robinson Humphrey upgrades Roxio to Neutral from Reduce based on their assumption of a stabilizing and profitable software biz, as well as their belief that Napster is in the early stages of what could be tremendous growth.
The Washington Post reports that Yahoo officials said that the market for Internet searches will grow from $3 billion to $11 billion over the next 5 years, as computer users increasingly look for more local and product information online. Even as Internet searches continue to grow in popularity around the world, Yahoo executives said the big money to be made in the near term is by linking computer users with more retailers, restaurants, dry cleaners and other businesses located nearby. Already, 20% to 25% of online queries have some local component, and Yahoo is planning to introduce greater capabilities for company's to advertise locally in the coming months. "We think now is the right time to go after the local market," said Ted Meisel, president of Overture, Yahoo's search engine subsidiary.
Outsourcing . . . Jefferies on Indian IT consulting: The upset victory by the Liberal Congress Party has generated speculation that the new government could be more protectionist. With the rupee down the last few weeks, and no need for foreign investment in order to grow. the firm says Indian IT companies are less vulnerable to potential changes in economic policy. Jefferies says that while the new government could be less pro-business, India-based IT services firms are intact and potentially improving... Major Indian IT names: Infosys, Satyam, Wipro.
Network Equipment . . . Buckingham says that channel checks indicate that Avaya is displacing Cisco and beat competition from Nortel for high reliability VoIP implementations at 3 major brokerage firms, with greenfield builds for corporate headquarters. Firm believes that CSCO continues to win the low-end VoIP business for remote sites deployments, with AV supplying the backup.
Cisco authorizes up to $5 billion in additional repurchases of its common stock. Cisco's board had previously authorized up to $20 billion in stock repurchases. There is no fixed termination date for the repurchase program.
Boxmakers . . . CIBC downgrades DELL to Sector Perform from Outperform. While execution remains solid within a challenging backdrop, firm believes that factors outside DELL's control are putting structural -- and perhaps secular -- pressure on margins, which marked a 4th consecutive quarterly decline. Firm says intensified pricing from large competitors and rising component costs combine for a squeeze which they do not see abating, as their perspective in semi and FPD markets points to more shortages through 2H04; firm also notes that the stock trades at a 52% premium to the S&P 500.
Analysts are somewhat disappointed with DELL's $100 million revenue upside to $11.54 billion, which was offset by a challenging component environment that drove gross margins lower than expected. Gross margin came in at 18.1% versus 18.3% expectations, resulting in no EPS upside which most market participants had been betting on. Also, Dell server revs reported an increase of 26% to $1.3 billion, which missed analyst expectations, and storage revs increased 18% y/y to about $412 million, which missed the 25-35% year/yaer growth expectations. UBS notes that the storage miss could be attributed to a mix shift, as Dell shifted its focus to selling more co-branded Dell/EMC mid-range CLARiiON systems rather than reselling some high-end EMC branded Symmetrix systems and selling its own direct attached storage offerings. Regarding EPS guidance for 2nd quarter, the company had another disappointment in store, as despite guiding higher than consensus on revenue ($11.7 bln) and enjoying a lower than anticipated tax rate of 27% (versus 28%), the co only managed to guide in-line with the Street estimate of $0.29. Merrill Lynch notes that this suggests gross margin won't rebound. On a more positive side, JP Morgan notes that Dell's results provided strong evidence that PC demand remains healthy, though the component pricing environment remains difficult. Firm believes it is now clear that corporate PC demand is accelerating. At 24x their calendar 2005 EPS estimate, Dell trades at the low-end of its historical multiple range.
Semiconductors . . . Bernstein gives an update on their conversation with INTC CEO Craig Barrett; in response to the most frequently asked question since the Q1 call on April 13, Barrett said that he was comfortable with inventories at Intel and in the channel, and said that an inventory write-down was the "farthest thing from my mind" since it was due to better than expected yields, not worse than expected demand. Firm says he was very disdainful of this question, and their conclusion is that he thinks there is zero chance of a microprocessor inventory write-off. Regarding the cancellation of its next-generation "Tejas" and "Jayhawk" processors due to head dissipation, firm believes that the cancellations and difficulty Intel is having with power dissipation at 90nm make it likely that AMD will have a harder time with its R&D budget, which is one fifth as large as Intel's. Maintains Outperform rating.
Software . . . B. Riley downgrades Activision and THQI to Neutral from Buy based on valuation. In addition, firm sees difficulties ahead for the video game software publishers: with the Xbox 2 and PS3 likely to be released in 2005 and 2006. Respectively, firm expects software sales industry-wide to be down in 2005; and unlike the last console transition. The firm expects the software publishers to continue to create front-line games for the PS2 and Xbox even as the PS3 and Xbox 2 are rolled out, which should result in a slower ramp of next generation console sales than occurred in the last video game cycle.
Lesson on Which is Better . . . Stocks or Bonds?
What Is the Mean?
Forecasting seems to often assume that it is just a matter of time until history repeats itself. On average, the future will be average. The mean is the mean. Even statistical techniques that isolate dependent variables from independent variables presume a regression to the mean. But what is the relevant sample to determine what is average, what is the mean?
Ten-year U.S. Treasury issues are yielding 4.5%, about 65 bps below what they yielded, on average, over the past 75 years, and 260 bps below the average yield post-1982. (Why 1982? It’s not a totally arbitrary starting point — that year marked the beginning of a great bull market in financial assets, for both bonds and stocks.)
The “earnings yield” of the S&P 500 (i.e., the inverse of the P/E ratio and, supposedly, a popular metric at the Federal Reserve) is 4.6%. This compares with an average earnings yield of 7.5% over the past three-quarters of a century, and 5.7% average post-1982.
It’s a Real World
Yet we believe it would be foolish to argue that these “nominal” numbers will regress to their means. Why? Because it’s a “real” world. Bonds are bought for their real yields, i.e., after taking inflation into account. The same holds true for equities. Indeed, the same is true for any and all investments. In real terms, Treasury yields do not look compelling: The real 10-year bond yield
is 2.5% today versus a long-term average of 2.0% and 3.9%, on average, post-1982. Likewise, there is no compelling case for equities either: The real earnings yield is 2.6% today versus an average of 4.3% long term and 2.5%, on average, post-1982.
In contrast to today, in recent years it was only rarely the case that the stock market earnings yield was above the U.S. Treasury yield. The fact that this has not been the case recently does not mean that equities are less risky than Treasuries. Rather, the key issue is that equities offer the
potential for a growing stream of income (i.e., earnings and dividends), whereas bonds offer a static — and relatively puny — stream (i.e., coupons).
A Relative Case for Stocks Versus Bonds
Comparing stocks and bonds, the current 10 bp equity earnings yield gap makes a relative case for stocks, given that the current equity earnings yield gap is 225 bps above the post-1982 average. However, versus the long term (i.e., 1925 forward), the current equity earnings yield gap is still 145 bps below average. So which period is relevant? Which mean will the markets regress to?
The period beginning in 1925 includes the depression and World War II, times of great uncertainty. That could well account for the materially higher equity earnings yield gap over the long term (i.e., from 1925 on) than in the post-1982 period. Indeed, it was not until 1968 that the earnings yield first fell below the government bond yield, although only for a five-year period. It really was not until the 1980s that the earnings yields remained below the bond market yield.
Why has the spread moved lower? As Citigroup economist Steven Wieting has noted, the “Great Moderation” (as Fed Governor Ben S. Bernanke has dubbed it) seems to provide a possible explanation. According to this theory, as economic volatility has declined (as evidenced by the declining standard deviation of GDP growth), the inherent risk of equities has declined and, therefore, so has the equity earnings yield gap.
Also note that, until the second half of the 20th century, stock market dividend yields were actually higher than bond yields. This was not because stocks were riskier back then, but rather because a larger portion of the total return from equities came from dividends. Indeed, it was not until 1959 that the stock market dividend yield fell below bond yields. The dividend payout ratio prior to 1959 was, on average, over 62%; after 1959, the average payout was under 50%.
The Absolute Case for Equities Requires Low Inflation
Based on the post-1982 averages, in order to make any absolute case for equities today (rather than simply a relative case versus bonds), one has to assume that the key post-1982 variable of low inflation remains in place. Declining inflation has largely been attributed to above-trend productivity gains. Indeed, nonfarm productivity rose 9.5% during the third quarter of last year and averaged 4.5% overall during 2002–03 — its best two-year performance since the survey began in 1947, and the first time it exceeded 4.0% for two years in a row. These outsized productivity gains have, in turn, suppressed resource utilization and inhibited job growth.
To be sure, fourth quarter productivity declined to 2.6%, which may have contributed to the surprisingly strong addition of 308,000 to March nonfarm payrolls, as well as to upward revisions to the prior two labor reports. Moreover, bellwether economic indicators such as the core CPI and the GDP price deflator have risen, and the personal consumption deflator — a measure of inflation tied to consumer spending favored by the Fed — rose at its fastest pace since the third
quarter of 2000.
Despite renewed inflation fears fueled by these reports, Fed Chairman Alan Greenspan and other members of the FOMC have been quick to state that concerns about broad-based inflationary pressures are unwarranted given the still considerable slack in the economy. Expect new efficiencies fostered by technology and the growing integration of a global workforce to help sustain relatively high productivity gains longer than in past economic cycles.
Of course, reinflation, or fears thereof, could take a toll on both the stock and bond markets. Or would it? Clearly any reinflation would be a negative for bonds. But could a little inflation actually be good for stocks?
In theory, the lower the inflation rate, the lower the rate at which future growth is discounted; therefore, the lower the required earnings yield and the higher the P/E ratio. (The P/E ratio is the inverse of the earnings yield.) But, in fact, the equity market has historically had a “sweet spot —” i.e., where earnings yield is lowest and P/E is highest — when inflation has been between 2% and 4%. Understandably, high inflation has been a negative, but so has low inflation/deflation. Why? Possibly because deflation, and fears of deflation when inflation fell to very low levels, threatened the future growth of profits.
So does that mean that reinflation from today’s low levels to the 2%–4% “sweet spot” would drive stocks higher? Not necessarily — not if stocks are already valued to reflect that higher inflation level. Indeed, current earnings yields (and therefore P/E ratios) seem to be already at levels commensurate with inflation rates that are higher than those currently prevailing.
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