After a robust first quarter, the market started April by taking a bit of a breather. There are several reasons for this, as we will explore, but we are not surprised the market had its best first quarter since 1998.
According to data from Bloomberg, earnings from S&P 500 companies grew 15% in 2011, and yet the index including dividends advanced only 2%. The index started 2010 with a P/E ratio of 15.4, roughly the long-run historical average. Since earnings grew strongly and the market hardly moved, the P/E ratio dropped to 13.0 by the end of 2011. External factors such as the debt crisis in Europe and political squabbles in Washington trumped the solid earnings news, to the point where we felt the market could be a “coiled spring” waiting to advance.
As news from Europe quieted down and Washington found short-term peace, the market was able to focus on solid earnings and slightly stronger economic data in the U.S. However, even with the market’s strong first quarter advance of 12.6%, the P/E ratio based on 2011 earnings increased to only 14.6, quite near the historical average. Valuation looks even more reasonable if earnings from companies comprising the S&P 500 index grow 9% during 2012, as market analysts expect. This level of earnings growth would drive the multiple down to 13.4 by year-end.
So what explains the softer showing in early April? Largely, the market seems to be reacting to slower employment growth, renewed rumblings out of Europe, and higher prices, in particular for gasoline. The latter is snuffing out hopes that the Federal Reserve will provide further monetary support that will continue to hold down interest rates and support stock prices.
March saw employers add only 120,000 new jobs in the U.S., far slower than the 200,000-plus per month job growth recorded in the previous three months. The unemployment rate dipped to 8.2% from 8.3% in February, the lowest rate in three years. However, the decline in the unemployment rate was due mostly to people abandoning their efforts to find new jobs. In the beginning of a robust expansion, the unemployment rate normally increases as job seekers enter the market to take advantage of expanded job opportunities. This hasn’t happened, in fact the labor force participation rate dipped to 63.8% in March, about 2% lower than when the recession began.
There was somewhat better news on wage growth. March saw average hourly earnings advance 2.1% year-over-year. However, this is less than the 2.7% increase in the March Consumer Price Index, led by a 9% surge in gasoline prices. Despite sluggish wage growth in January and February, consumers were in a buying mood, as spending advanced 0.4% and 0.8%, respectively. The personal savings rate for both months declined and now stands at 3.7% in February. In the face of higher consumer prices and sluggish wage growth, it seems unlikely to us that consumers can continue to spend at this pace.
The combination of slower employment growth and higher prices puts the Federal Reserve in a bind. Investors are hoping the Fed will provide additional monetary support, perhaps another round of treasury bond-buying called QE III (the third cycle of “quantitative easing”). However, the Fed realizes that QE III would not be a good idea if it further stokes inflation. Higher inflation would increase long-term interest rates, exactly the reverse of what the Fed wants. Some investors who were betting on Fed action appear to be reversing these trades now.
While the foregoing could argue for a weaker stock market, we continue to believe the investing environment isn’t much different than it has been over the past couple of years. The recent patch of soft economic data may be a more accurate reflection of the economy’s growth prospects coming off an unseasonably warm winter that supported non-winter activities such as construction and car buying. Growth continues consistently, albeit more slowly than most of us would like. Other economic indicators such as manufacturing and producer prices, continue to head in the right direction.
While employment growth is sluggish, companies have done an excellent job maximizing results from their existing workforce. A Wall Street Journal analysis of annual reports from S&P 500 companies calculated that revenue per employee averaged $378,000 in 2007. In 2011, this number had jumped to $420,000. These higher productivity levels have helped drive earnings growth. While the easy gains may be gone, firms will continue to focus on higher productivity going forward.
As we so often recommend, it doesn’t make sense to us to try to time the market, especially in a growing economy coupled with a reasonably valued market.