The Amazing U.S. Stock Market Recovery

February 22nd, 2011 | By Nick Sargen

Among the most frequently asked questions I get from clients today is the following:

“Is now a good time to add to U.S. equities; or, is it better to pare back and wait for a pullback?”

This question invariably arises whenever the stock market has had a good run. The current situation, however, is unlike any we have experienced previously, as the U.S. stock market has doubled in value from its March 2009 low. According to Birinyi Associates, this is the fastest market climb of 100% in 75 years!

For those who have waited for a pullback, the past two years have been very frustrating to say the least: There has been only one episode (during the four months ended August 2010) in which the market experienced a sell-off of more than 10%. During that interval, the U.S. economy lost momentum; talk of deflation and a “double-dip” was rife; and market bears proclaimed an end to the bull-run. Consequently, many investors were reluctant to add to positions then.

Meanwhile, the stock market has surged by nearly 30% since late August – an even faster pace than during the first phase of the market upturn. The catalyst was the Federal Reserve’s launch of a second round of quantitative easing (QE2) that was designed, in part, to encourage investors to shift out of cash and treasuries into riskier assets.

While some believe the market’s rise is another bubble in the making, we believe it is buttressed by improved economic performance and continued strong profit growth. Indeed, prior to the Q4 earnings releases, U.S. corporate profits already had surpassed the previous peak in 2007, mainly on the back of extensive cost-cutting and improved profit margins. Based on the latest results, moreover, it now appears that corporate profit growth increasingly is being driven by top-line revenue growth.

Weighing these considerations, we continue to be constructive on the market, and believe it has further upside potential over the next year or two. That said, we have lowered our return expectations going forward and are also mindful of several risks that could trigger a sell-off.

One risk that is now being debated is the potential for inflation to pick up and for bond yields to continue to rise. Some commentators, for example, point to soaring food and energy prices as evidence that inflation is accelerating, and they are critical of the Fed for keeping interest rates too low.

My own take, however, is that rising commodity prices pose less of a risk for developed economies such as the U.S. than for the emerging economies. The principal reason is that materials and commodities comprise a relatively small share of overall business costs in the U.S. -- between 5%-10%. Labor costs are much more important, accounting for about 70% of overall costs in the U.S., and they have been falling on a per unit basis due to strong productivity gains and moderate wage increases. Therefore, I see little risk of a rapid acceleration of inflation. The more likely outcome is reflation, or a gradual rise in inflation, with the headline CPI rate gravitating towards 2%, while the core rate (which excludes food and energy) hovers around 1.0%. Accordingly, the Fed will likely keep short term rates near zero throughout this year.

By comparison, the main threat of inflation resides in the emerging economies. Their growth rates far exceed those in the developed world, such that they are operating closer to their productive potential, and commodities are a much bigger component of their domestic price indices. As inflation pressures have mounted, central banks in Asia, Latin America and the European periphery have begun to tighten monetary policies. EM equity markets, in turn, have lagged the developed markets by more than 10% in the past three months, after they had previously outperformed by a wide margin.

While the U.S. and other developed markets have taken rising costs of materials and energy in stride thus far, there are two developments that could cause the markets to re-assess at some point. One development would be evidence that rising input costs are causing profit margins to compress. According to a recent Morgan Stanley report (February 10, 2011), 25% of U.S. companies reported lower operating margins in Q4 from year-ago levels, and 12% of the companies reported two consecutive quarters of declining operating margins on a year-over-year basis. Hence, it appears that overall profit margins are close to peaking.

The second development that could trigger a reassessment would be a spike in oil prices linked to ongoing political turmoil in the Middle East. Thus far, the stock market has largely shrugged off political developments in Tunisia and Egypt because oil supplies were not disrupted. Nonetheless, as I noted in my previous blog, the spread of political unrest to other parts of the Middle East poses a danger that oil supplies could be affected at some point.

The developments in Libya this past weekend highlight the risk, as the price of oil spiked by $5-$6 per barrel on reports that oil companies in the company were suspending their operations. The price of West Texas Intermediate – the benchmark for crude oil in the U.S. – surged above $90 per barrel, while that for Brent crude – the benchmark for Europe – reached a two-year high of $105. While it is too early to tell whether this development will prove to be temporary or ongoing, the widespread unrest throughout the Middle East and North Africa suggests that the risk premium on oil is likely to increase. Therefore, we are continuing to monitor the situation in the Middle East closely and are not assuming that the issue of political unrest in the region has been resolved.

To conclude, my bottom line is that the U.S. stock market has enjoyed an amazing rebound over the past two years that few, if any, saw coming. For those investors who held on to their positions throughout the financial crisis, it may now seem to be just a “bad dream,” as they have recouped their lost wealth.

That said, the challenge investors now confront is whether to add to positions, pare them back or hold on when the main economic risk has shifted away from deflation towards reflation. Considering how far and how fast the market has come, I favor a “hold” strategy for those whose equity holdings are close to their strategic allocations, and a “wait” strategy for those who are underweight equities and wish to add.