We were honored to receive an invitation to speak at a local business association’s monthly meeting. The following is an excerpt from the Q&A that followed our prepared remarks:
WHAT’S DRIVING THE MARKET? CHEAP STOCKS OR CHEAP MONEY?
Cheap money. Financing is plentiful from the likes of banks, hedge funds, Petrodollars and the Chinese. There’s also the Yen carry trade.
We’ve even seen The Fed increase the monetary base in contrast to its rate hikes.
CAN YOU EXPLAIN HOW CHEAP MONEY DRIVES THE MARKET? AND WHAT EXACTLY IS THE YEN CARRY TRADE?
I’ll take the last part of your question first. The carry trade refers to borrowing Yen at artificially low rates close to 0% which is then swapped for higher yielding currencies. A hedge is used to mitigate currency risk allowing the borrower to profit from the difference between the yield on the higher currency and the low borrowing cost of the Yen.
How does cheap money drive the market? Well, public companies use it to repurchase shares. Private equity uses it to lever the balance sheet. This increased demand for stocks coupled with the resulting decreased supply drives up prices.
SO IF CHEAP MONEY IS DRIVING THE MARKET, DOES THAT MEAN STOCKS AREN’T CHEAP?
I wouldn’t say they’re expensive. I think it’s more accurate to say stocks have grown into their multiples. Aggregate earnings of S&P 500 companies have more than doubled yet the index has lagged small caps, commodities, emerging markets and so on.
Look at companies like GE and Home Depot. Earnings are up over the past few years. Way up. Yet we don’t see PE’s of 50+ like we did during the good ol’ days. I believe GE is trading at about 18 times earnings and Home Depot at about 14 times earnings – very respectable levels for high quality companies given that the S&P as a whole is in the mid-to-high teens.
WOULD A PULLBACK BE A BUYING OPPORTUNITY?
I think so. I don’t mean to imply we’re sitting on the sidelines right now. Many of our clients are committing new capital. And, yes, trying to time the market is a fool’s game. Having said that, fundamentals remain in place for a continuing positive market. A pullback should be viewed as a short-term bump.
WHAT ARE THESE FUNDAMENTALS YOU REFERRED TO?
We’ve already talked about cheap financing. We have corporate profits coming in stronger than expected. Consumers continue to spend. Inventories are at relatively low levels. The Fed remains on hold and there’s always the prospect of a rate cut. Problems in subprime and autos seem contained. Geopolitical issues remain tame – at least for now.
WOULD A CHANGE IN ANY OF THESE SEND US INTO RECESSION?
It’s unlikely. Our economy is much too diverse. I think the impact would be more psychological. Think back to the late February sell off.
SO WHAT WOULD SEND US INTO RECESSION?
The usual culprits I suppose. I had a brief chat during the break with someone commenting about rising long rates. I’m not sure that’s a problem. The 10-year has moved up 20 basis points from 4.6% to 4.8%. That’s still pretty good. I think we could go up another 100 basis points without seeing much of an impact.
HOW CAN RISING RATES NOT HURT THE ECONOMY?
It’s not that rates rise but why. If rates rise because of inflation then, sure, it’s not a good thing. If rates rise because the economy is strong then we’re just fine. The economy will continue to do well if we can grow faster than inflation.
I’VE READ WHERE PEOPLE ARE LOOKING FOR THE FED TO CUT RATES? WHAT’S YOUR TAKE?
I’m not much for reading tea leaves. Plus I believe the bond market does a nice job of hinting at the future of rates. Having said that, my guess – and I stress that term – is that we’ll see a cut late this year.
Core inflation remains above Bernanke’s target but not by much and, in his terminology, it’s likely to moderate over the coming months. GDP growth remains strong – even stronger than expected – but this expansion has gone on for quite some time. With no inflation on the horizon, there’s no reason we can’t have a small cut to boost growth.
HAVE WE SEEN ANY MEANINGFUL ECONOMIC IMPACT FROM LAST FALL’S ELECTIONS? WHAT’S THE LIKELY OUTCOME OF NEXT YEAR’S PRESIDENTIAL ELECTION AND WHO ARE YOU VOTING FOR?
No real meaningful impact. Just a lot of rhetoric and grandstanding.
Look at the recent increase in the minimum wage. Markets set wages – not the government.
Next year’s election will be interesting. I don’t buy into the idea that a Democratic White House is a forgone conclusion. I think their win in Congress last November was less of a vote of displeasure with Republicans as it was of their policies. People wanted a policy change and didn’t care who gave it to them – or at least promised it.
This is where the Democrats have failed to capitalize. They promised change but have in hindsight delivered rhetoric and, to be blunt, nothing but complaint. They’ve still yet to give us their solution to our problems.
I think both parties are in real trouble. The Republicans have the Bush stigma and the Democrats still haven’t shown any pro-growth solutions. My guess is today’s frontrunners be it Obama or Clinton or Edwards or Giuliani or McCain are in real trouble. Two outsiders who I don’t think have a shot but might be nice alternatives are Fred Thompson and Bill Richardson. Richardson is particularly intriguing as he just might be the pro-growth Democrat we haven’t seen in a while.
JFK might be the last tax cutting Democrat from the past 50 years.
How am I voting? I’m not sure. I typically vote Libertarian although I suspect this time will be different. I haven’t given things much thought on a personal level. My guess?…I’ll step into the voting booth, vote my wallet and pull the Republican lever. I’ll have to rely on the good sense of our citizenry to fight the social conservatives and our eroding civil liberties. But that’s one man’s opinion and one vote.
We’ll see how I feel next November.
WHAT ARE YOUR THOUGHTS ON THE RECENT IMMIGRATION BILL?
I haven’t read much about it. I understand there will be an expansion of the H-1B visa program. That’s a good thing. These are the visas issued to highly-skilled workers. Keeping research and development here should offset some of the off-shoring of high-paying jobs.
HAVE WE SEEN THE END OF CHEAP GASOLINE?
I suppose it depends what you consider cheap gasoline. I do think gas prices are headed down though. The issue isn’t the price of oil. Oil prices and wholesale gas prices decoupled some time ago. The issue is on the refining side. Too many refineries are offline due to maintenance or the switch to reformulated summer fuels. The idea that there’s gouging is ridiculous. The crack spread – essentially the margin earned by refiners on their finished product – is at record highs. They’d produce as much as possible at these levels. There is nothing nefarious going on. There’s no artificial supply limitation to manipulate price.
ARE THEY EVER GOING TO FIX THE AMT?
I’d say 50/50 is too pie in the sky. It really depends upon who the “they” is that controls Congress and the White House next year. The AMT fix is going to cost Treasury billions. Offsetting this by letting Bush’s tax cuts expire will undoubtedly hurt the economy. I’m guessing we’ll see either no action or annual patches until the time is right for real reform of the tax code.
More intriguing of a tax topic is the corporate rate. We’re at 35% which is higher than many places in the world. Even France has a lower rate! We’re seeing more companies domiciled in places like Ireland. An out of hand SarbOx hasn’t helped either. These topics aren’t on the front burner but I hope we’ll see them debated in the near future.