Yesterday Once More
by Brian Pretti CFA, Contrary Investor. January 22, 2010
As you know, the mainstream financial media has been literally falling all over themselves quoting equity market performance since the March lows of last year. And of course the numbers are virtually magical. Once in a lifetime. Every investors dream, right? Of course this occurred after an every investors nightmare prior few years. The point is that although 2009 was indeed a year of extremes in terms of the early year plunge and then record setting rally, performance of the S&P and the Dow did not even measure up to the initial rally year of 2003 in the prior economic/equity cycle. But one thing is true though, 2003 and 2009 looked very similar in terms of the rhythm of human decision-making. Although no one knows what lies ahead, I always like to look back at historical patterns of human decision making for potential clues as to what might lie ahead. Especially when so few expect such an outcome. Let’s have a little visual look that you may already know all too well. It’s a look at the 2003 equity market experience as compared with 2009 using the SPX as a proxy for equities in aggregate. We’ve tacked on 2004 experience for compare/contrast purposes. The numbers are current through Wednesday of this week.
Directional rhythm in the 2003 and 2009 markets was extremely similar. Not too hard to understand in that on a very simplistic basis, both markets had reached prior period extreme lows and were acting to attempt to discount an economic recovery to come. As is the sworn solemn duty of equities, they lead. They anticipate. But to be honest, it was not just the rhythm of the markets that looked similar, but equity sector performance as well. In the early cyclical bull year of 2003, it was tech, materials and consumer discretionary that led the way out of the starting gates. Exactly the same deal in 2009. The buy high beta mantra at the beginnings of the cyclical bull was a page right out of the institutional playbook.
Additionally, if there is one other truism in investing, it’s that human behavior and decision making repeat. They rhyme in rhythmic patterns throughout market history. As Jesse Livermore suggested to us long before we were born, “human decision making never changes, only the wallets do". So it just might have been that a different set of wallets were doing the driving in 2009, but the decision making behavior looks like a dead ringer for what played out in 2003. And although this may seem a bit Twilight Zone-ish, the S&P last year closed 3 points higher than it’s 2003 close. The Dow was 24 points higher. In other words equities closed 2009 almost exactly where they stood at YE 2003. The rhythmic decision-making was so similar, it virtually cries out for analytical comparison.
In the clarity of hindsight the market was absolutely doing it’s job in 2003. Price anticipation in equities indeed was rewarded by much better macro economic numbers as the year came to an end. Equities correctly anticipated and realized definitive private sector led economic improvement in 2003. That’s a big differentiation point relative to where we now stand. For now, the US government is largely the key provocateur in US economic expansion, but you will be treated to a huge 4Q GDP number based on an in process inventory rebuild of the moment (so be prepared). Very quickly let’s look at some macro economic stats that existed at year end 2003 relative to the same numbers we now see as 2009 has bid us its final farewell (some of these are still as of November end at this point). Have a look as the divergences are more than apparent.
|Economic Stat||YE 2009||YE 2003|
|Final Sales To Domestic Purchasers: Yr/Yr||(3.5)%||6.0%|
|Non-Defense Non-Aircraft Capital Goods New Orders||(10.2)%||10.2%|
|Industrial Production Yr/Yr||(5.1)%||2.1%|
|Average Weeks Of Unemployment||28.5||19.8|
|Continuing Unemployment Claims||509,000||373,000|
|Credit Market Debt As % Of GDP||369%||298%|
|Household Debt As % Of GDP||96%||83%|
|Disposable Personal Income: Yr/Yr||1.4%||5.9%|
|Banks Loans And Leases Outstanding: Yr/Yr||(6.5)%||5.8%|
The first three stats in the table above relate directly to the US private sector. And relative to 2003 year end, the world could not be more different as we move into 2010 when it comes to the economic strength and character we see in private sector stats, or lack thereof to be more correct. Polar opposites may indeed be the more proper characterization. On a very near term basis, the market is already telling us a very important watch point for investors as a whole and asset classes specifically over the next few months as we enter the new year will be employment. Just look what happened in terms of investor behavior and resulting asset price adjustments post the “surprise” 11,000 loss in jobs for November. Gold immediately began its current correction that day, interest rates began their current northern journey, and the US dollar arose from the dead five seconds after the employment news hit the tape. But the very few macro employment stats in the table above tell us real improvement in the labor markets toward anything even approaching the strength we saw in late 2003 seems a good bit away at this point. Finally, as per the balance sheet stats, if you will, the deleveraging cycle of the moment has a huge amount of territory still to cross just to return to late 2003 levels, let alone travel further in terms of reconciliation. So the 2003 equity market was indeed discounting meaningfully improved economic character of the private sector. The discounting of that improvement in 2009 still remains to be proven correct after prices have now already moved. The markets in 2003 were discounting better residential real estate conditions as housing starts were four times higher than we see today. The 2009 market was still guessing at a housing cycle bottom, which remains uncertain at best as we move into the new year. Labor market conditions in late 2003 already witnessed positive monthly job growth. As of now we are still waiting for the blessed event, but due to seasonal strength in the Birth/Death model that really occurs in the first half of each year coupled with the temp census workers that will be hired in the months ahead, we will be surprised at nothing as we move forward.
You get the picture. Very similar market behavior and rhythm when looking at 2003 and 2009, but very dissimilar economic circumstances. Very dissimilar. A few more quick compare and contrast comments. In 2003, S&P earnings growth was up 18.7% over depressed 2002 numbers. In 2009 the growth rate year over year in SPX earnings is currently estimated at 10.2%, yet equities bolted higher last year without anywhere near the earnings growth vindication that was already seen by late 2003. From the Twilight Zone department one more time, S&P earnings in 2003 came in at $54.69. For 2009, the current expectation when all is said and done is $54.15. In one sense 2003 and 2009 are look-alikes - same earnings and same equity price levels (S&P and Dow) as the years ended. Again, in the clarity of hindsight, investors were staring at a 23.7% realized increase in 2004 S&P earnings as they stood at the precipice of that new year. A very big number by any stretch of the imagination. Today the consensus is expecting a 37% increase in 2010 S&P earnings. Whether that comes true or not will be a big issue for investors as we move throughout the current year. But despite the huge increase in actual earnings for 2004 on the back of already big 2003 growth numbers, you can see in the chart that after the big run in equities during 2003, stock prices took a breather and traded in a range for a good 11 months in 2004. In fact, one could have gone to cash on January first of 2004 and then come back and been fully invested in the middle of November of that year, and caught the entire year’s performance. Certainly this is not what the consensus is expecting as we move into 2010. Far from it.
One more time from the personal interpretation department, the markets in 2004 began a necessary transition or maturing. The trading range environment over the first 10-11 months of 2004 allowed economic and corporate earnings reality to “catch up” to what the financial markets had already discounted in 2003. As of year-end 2009, the reality of the US economy is that it has not yet caught up to what the markets have implicitly discounted. Secondly, over the last three to four months, upward analyst earnings revisions have been coming hot and heavy. In fact, we have really not seen this rush of upward earnings revisions anywhere over the last five years. That’s a good thing for equities, but a key question looking into the new year is how much of this good news is already in prices? Earnings estimates for 2010 are well known at this point. That news should already be well discounted. Now corporate earnings need to deliver that reality. So it seems to make some intuitive sense that current equity markets enter at least some type of digestion period ahead to allow the reality of economic and corporate earnings improvement to catch up to what the markets have already discounted, or perhaps over discounted in current prices. To be honest, a period of digestion or sideways movement would actually be very healthy. A direct example of this thinking is the materials sector. In 2009, sector earnings actually declined by close to 17% relative to 2008 (as per current YE estimates), yet materials equity sector performance last year was a gain of over 45%. Looking ahead and discounting much better 2010 earnings? Without question. Current estimates are for a 72% gain in 2010 materials sector earnings. That has clearly gotten into price. Now the reality needs to materialize. We would expect equities in the sector to pause to catch their breath and allow initial earnings results as the year begins to prove the estimates have gone in the right direction and magnitude of potential gain is realistic.
In summary and unlike 2003, equities have moved out ahead of economic improvement in the current cycle well beyond what was true at year end 2003. Not surprising. The normal lead-time may be prices moving 6-8 months in front of true private sector economic improvement. In 2009, stock prices certainly moved, but 6-8 months later the macro economy has yet to prove itself despite equity price anticipation. The private sector has very much yet to prove it can sustain economic growth. The delivery of expected corporate earnings in 2010 appears a must to support prices since there has been little to no vindication on the macro economic front. We already know earnings growth estimates for 2010 are very lofty. Yes, there has been significant operating leverage created in the corporate community via cost cutting over the past few years. But earnings must come through now to allow current prices to hold and move higher as the consensus expects in the year ahead. That’s the bottom line.
As we continue our little journey through 4Q earnings reporting season, my suggestion to you is that the numbers are really the least of our concerns. At this juncture in the equity cycle, it’s how stock prices (and implicitly investors) reaction to those earnings and broader financial/economic/geopolitical news in general. After pouring over reams of 2010 Street forecasts, I see that virtually no one expects a trading range environment along the lines of the 2004 experience to develop. Just read Barron's last week. Even most of the roundtable was on the same page. Although no one knows what lies ahead, I think there is one thing I do know. When “everyone” expects something to happen, expect the unexpected. Keep an open mind. The only constant in financial markets is the repetition in human decision-making.
© 2010 Brian Pretti