The following commentary is from Jeff Westmont, who is the founder of Westwoods Investment Capital, a hedge fund focused primarily on consumer companies. He was formerly a Managing Director in investment banking for a bulge bracket investment bank where he focused on consumer companies.
While many analysts and investors continue to expect a substantial pullback in the stock market, there are a number of indicators that suggest the current levels are at, or near, fair value. Although the economy is still facing many headwinds, the following points provide support for current market levels and offer the tantalizing possibility of continued gains:
- Third- and fourth-quarter earnings should largely beat expectations, which means the current 2009 S&P 500 earnings multiple will appear more reasonable. True, many companies will achieve these results largely by cost cutting, but what is critically important is that companies have demonstrated the ability to operate profitably at lower revenue levels. This puts an earnings floor under the stock market even if revenues don't pick up materially (as long as revenues continue to stabilize). If revenues do begin to rise, there will be a substantial flow through to earnings.
- Through the morning of October 13, 30 S&P 500 companies had reported third-quarter earnings. While more than 70% of these companies reported revenue declines, nearly 60% actually reported higher operating EPS than last year. In fact, of the approximately 65 companies that have reported in the past three weeks, more than 80% have met or beaten expectations and more than half of these companies reported the same or higher EPS than the prior year.
- Coming out of an economic downturn, what is important is sequential revenue improvement. Retail sales over the last few months have demonstrated a slow, steady improvement -- as has the performance of many industrial and technology companies.
- Consumer debt levels have come down from peak 2007 levels and net worth is once again rising. In fact, the household debt service ratio has returned to 2001 levels and has risen from 12% of disposable personal income in 1990 to 13.1% today. Equally important, despite the large rise in mortgage debt over the last seven years, consumer net worth, while down 20% from the peak in 2007, is still 30% higher than in 2002 (an increase of $12.5 trillion).
- Consumers have significantly benefited from lower interest rates, commodity and food prices, thereby boosting real disposable income. For instance, lower oil prices are currently saving the U.S. (which consumes approximately 20 million barrels a day) approximately $140 billion annually (assuming an average price of $92 barrel last year). This effective rise in real consumer disposable income helps offset the income decline impact of higher unemployment.
- In the current environment, the focus on retailers' same-store sales to judge the health of the consumer is somewhat misplaced. First, companies have reduced their sourcing costs and, combined with lower raw material and shipping costs, this means that price points have come down. This aforementioned impact can be seen in the higher gross margins of retailers such as Bed Bath & Beyond (BBBY) - Get Bed Bath & Beyond Inc. ReportBBBY and Family Dollar Stores (FDO) despite sluggish sales. Second, most retailers blew out inventory for nearly three quarters, which drove top line at the expense of margins. Now, retailers have much lower inventory and sales are less frequent and more 'planned'. Not only does this reduce same-store sales, but it also impacts consumer spending: After becoming conditioned to massive clearance sales, consumers are now faced with purchasing more 'full price' products, which they need time to become accustomed to.
- Housing affordability is near a multi-decade high and inventories are now below 2006 levels (although still higher than prior years). Equally important, since buying a house is the largest investment most consumers ever make, potential homebuyers may now be more inclined to purchase as they don't feel like they're 'catching a falling knife'. While the "shadow inventory" or lack of continued government support could send the market once more into a tailspin, the lower interest rates and inventory and improved affordability and confidence suggest the worst is over.
- Nearly 50% of the revenue of the S&P 500 companies is international. Since the rest of the world will probably grow faster than the U.S., these companies should prosper. They will also benefit from the almost inevitably weaker U.S. dollar.
- Historically, unemployment peaks 12-14 months after the stock market bottoms.
- The inventory rebuild cycle has yet to occur and only $200 billion of the stimulus money has been allocated (some of which hasn't been spent).
- There will be some 'catch up' consumer spending, particularly in capital goods. For instance, the U.S. needs to purchase 14 million new cars annually to replace 'junked' ones and to keep up with the addition of new drivers. The annual sales rate will not stay around 10 million indefinitely.
- Finally, while the market has come very far, very fast, the S&P 500 index is still approximately 32% below its peak despite the huge rally. This decline is still worse than every post-WWII bear market except 1973 (48% decline) and 2001 (49%) and fairly comparable to the 1987 and 1968 bear markets. More importantly, the 2009 estimated S&P earnings provide a quantitative floor under the market. The decline from the October 2007 highs is a more relevant comparison than focusing on the rise from the panic March lows, which at a 58% decline from the peak, was the worst bear market since the Great Depression.
This is not to suggest that the U.S. economy and stock market have clear sailing ahead. The massive government borrowing requirements and the
's need to unwind its balance sheet (the Fed must find buyers for well over $1 trillion of government securities) could potentially lead to substantially higher real interest rates and derail a nascent economic recovery. In fact, there is a real risk that the massive government borrowings, leveraged consumer and rising health care costs will impair the U.S. economy over the medium to long term. The U.S. government must get its fiscal situation under control or risk the distinct possibility of an even larger financial crisis.
Looking forward, there is no doubt that high unemployment, the credit-constrained and over-leveraged consumer, excess spare production capacity, rising interest rates and higher taxes will result in a sluggish recovery. Just as it took time to get into our current situation, so too will it take time to get out. IN the near term, we may see a trading pullback, particularly since the economic data is unlikely to be uniformly positive, implied volatility is low and earnings expectations are higher. But this market rally has been built on more than the absence of a potential 'doomsday' event, but also on improving real fundamentals. Yet many still question this recovery and market rally (and retail investors are not rushing in), which from a contrarian viewpoint is a strong positive for additional gains. Finally, the consumer, while battered, is stronger than many pundits believe and the economy has prospered historically despite tax increases and much higher interest rates (such as in the 1990s)
Absent any significant deterioration in the U.S. treasury market or employment situation, the stock market appears to have support from both a valuation perspective as well as the improving macroeconomic trends. Further market gains are not only dependent on near-term corporate earnings and revenue growth, but also an improvement in the labor market, continued stabilization in housing, renewed government fiscal discipline and consumer ability and willingness to spend again, even if judiciously. Finally, perhaps the most important variable will be the ability of the government bond market to absorb both the massive new supply as well as the Fed's secondary securities sales. Clearly there are more challenges ahead than at any time since the Great Depression, yet the U.S. economy has somehow always managed to eventually return to growth and prosperity.
We remain cautiously optimistic that the economy and the stock market will continue to gradually improve.
At the time of publication, Westmont owned BBBY.
Jeff Westmont, who is the founder of Westwoods Investment Capital, a hedge fund focused primarily on consumer companies. He was formerly a Managing Director in investment banking for a bulge bracket investment bank where he focused on consumer companies.