“If I gave you time to change my mind, I'd find a way just to leave the past behind.” Tim Hardin, Reason to Believe
“These are my principles. If you don't like them…well, I have others.” Groucho Marx
In my opinion, the first quotation is a perfect description of what has been happening to investors in the last three months. (We’ll get to Groucho in a minute.) I think it is a big deal. I think it is a sea change. I think it is a tectonic shift. It doesn’t happen very often. It seldom happens on cue. But when it does happen, most of us are surprised by both its magnitude and duration.
Nothing about the equity market’s movements in the last four years makes any sense unless you realize that there has been an ominous consensus embedded in almost all of our psyches: “Sooner or later, we will have to pay for the excesses of the last 25 years. Sooner or later, we will have less wealth and see less growth because of past debts incurred and past promises made.” I do not think it is true. On the contrary, I think that the gradual effacement of this dread can provide the impetus for an extended period of rising equity prices. That process may have started with the new year.
Since 2008, the Federal Reserve (Fed) has kept risk-free returns near zero to encourage economic growth and push money towards riskier assets such as stocks. So far, the results of these actions are mixed. Given the fragility and uncertainty of growth, I suspect that the Fed will continue to push until a solid economic recovery is well and obviously under way.
Economic growth has been slow and stuttering. However, because of cost cutting, low interest rates, and technologically induced efficiencies, corporate earnings and cash flows have been very strong. Given widespread uncertainty and pessimism, little has been spent on expansion and hiring. Some has been paid out in dividends (yet payout ratios are historically low), and some has been stockpiled for a rainy day. A lot has been used to repurchase shares. By reducing the outstanding shares, the last action tends to increase earnings per share and gives the impression of greater growth. As with Fed accommodation, I see little chance that this practice will end soon. A better U.S. economy should augment, not reduce, corporate cash flows. While the perception of better economic growth may increase corporate investment, lingering uncertainty and cynicism may restrain this. Beside, large corporations do not seem to need capital, and expansions can be funded with existing cash. The money should be there for more net buybacks.
The change should come from individuals and institutions. Since 2008, individuals have embraced risk-free and return-free investments and, in general, have been net sellers of equities. They have been a long time going and, I suspect, they will be a long time coming back. I think they started the return journey in January. The institutions have bought stock because some of them had to. They also invested heavily in equity-market-neutral alternative vehicles that came with pretty stiff fees. That may have worked in 2011 when stocks were flat, but it has become harder to justify greater costs and less liquidity when common stocks rise and keep on rising.
The point of this exercise is simple. When you look at the buyers and sellers of stocks and the factors that motivate them, I think you will see that the pressures should produce more buyers and fewer sellers. Because, in the end, buyers must equal sellers, it would appear that something will have to give. My guess is that it will be higher stock prices over the next few years.
As to Groucho: While I believe the power of money is still in the process of pushing stocks higher, I am neither dogmatic nor rigid. I wouldn’t be surprised if earnings are a little turbulent in the first-quarter reports. There may have been some hangover from the fiscal cliff in January. Also, weak European economies might combine with a strong dollar to give us a few additional shortfalls. I don’t think it will be much, but I wouldn’t be surprised if things got a little bumpy in the earnings preannouncement period of the next two weeks. I am still a buyer, but maybe I get to buy at a little lower price.