The level at which any security trades is part fundamental valuation, part supply/demand, and part assumption regarding future events. These conjectures concerning upcoming developments can be fickle especially as headlines impact investors’ attitude. In fact, Wall Street’s reaction to the news is often more telling than the news itself. In other words, when traders are bullish, good news is good and bad news is good. Of course, in a bearish backdrop, all news is lousy.
The current mentality is that all news is good. And to be sure, there have been some rays of sunshine that optimists can point to. Housing has improved, there are no U.S. troops in Syria (yet), and Congress took August off. The bad news, however, has been visible. Whether Mr. Market is viewing all bad reports as good because it leads to more quantitative easing or is just overlooking anything negative, we think it is dangerous to believe that all problems can easily be solved by loose monetary policy.
A recent example of Wall Street’s rose colored glasses was the markets’ reaction to the August employment data. The report’s headline numbers were pretty good with the unemployment rate falling to 7.3% (the lowest in 5 years) and an estimated 169,000 jobs created in the month. That brought the six month average job growth to 180,330. Unfortunately, this is below the 200,000 target that some policy makers have set.[i]
Disconcertingly, adjustments to July and June’s data showed softer employment growth. The estimated number of jobs added in July was reduced from 164,000 to 104,000 while June’s payroll gain was lowered by 16,000.[ii] Some strategists emphasize the size and direction of the revisions as a sign of the job market’s, and the economy’s, health. They are dismayed by these adjustments.
Further the decline in the unemployment rate was caused by a bigger drop in the overall labor force rather than job growth. The number of workers employed fell by 115,000 while the overall labor force declined by 312,000. This caused the labor participation rate (the number of people either working or looking for work as a share of the working-age population) to drop to 63.2%. This is the lowest level of participation since 1978 or 35 years ago.[iii]
This soggy job market is clearly a drag on the economy. Not only do consumers have less income, there are fewer and fewer workers supporting an increasing number receiving government benefits. Perhaps QE is not all that it’s supposed to be.
Stocks immediately fell after the report but steadily clawed their way back throughout the day and finished little changed. In the glass is half full view, the bad jobs data supported the Wall Street belief that that the Fed will not “taper” their $85 billion monthly bond purchases which have supported risk assets such as stocks.
After a monthly fall in August, equities have rebounded in September and, at the end of last week, have climbed back to approach 2013’s highs. Here are the year-to-date performances for the major indexes.
Dow Jones Industrial Average +17.3%
S&P 500 +15.2%
Nasdaq Composite +23.3%
Russell 2000 +24.1%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
While there are some other noticeable blemishes (last week we had lower than expected consumer sentiment and retail sales reports), it is not affecting investor cheerfulness. 45% of the respondents to the AAII survey were bullish (the long term average is below 40%).[v] This type of reading is often viewed as a contrary indicator (high bullish readings are bearish).
“It Seems Like Years Since it’s Been Here”[vi]
Another concern is the current high level of margin debt. Margin is debt that is financed with investment securities used as collateral. The amount of borrowings being financed has returned to levels that coincided with some not so pleasant times for the capital markets. As shown in the nearby chart, the previous times that margin debt was at the current levels were March, 2000 and July 2007.[vii] In case readers need a reminder, both dates were followed by material drops in the stock market.
Another troublesome observation is the return of market leadership by exciting, revolutionary companies. Upstart organizations that change the playing field are a constant part of a dynamic economy. The United States has experienced this creative destruction regularly. The automobile industry in the early part of the 20th century was followed by radio and then TV. More recent, of course, are computers, internet, and cell phones in the information technology area. In addition, medicine has experienced incredible bio-tech advancements, robots are becoming more prevalent, and energy sources are being discovered and recovered from heretofore unheard of areas.
As stated above, current investment prices discount future revenues and profits. And some of the companies offering new products and services seem to have unlimited potential. The debate over what to pay for this prospective success is being fought in the current stock prices.
We offer some examples. Tesla Motors, the manufacturer of electric cars, carries a $22 billion valuation in the stock market while their trailing 12 month (TTM) sales barely exceed $400 million. To be sure, $3.50 per gallon of unleaded allows for alternatively powered vehicles. However, in our opinion, a price-to-sales multiple of 55 times discounts some significant growth.
Yelp describes their business as “an online urban city guide that helps people find places to eat, shop, drink, relax, and play based on the informed opinions of a community of locals in the know”.[viii] Investors must have a pretty high outlook for this business because the stock’s worth in the markets exceeds $2.5 billion. We are not sure exactly how Yelp generates revenues but they are less than $150 million. Another bothersome detail for Tesla and Yelp is that they are both losing money.
Even the most primitive Luddite knows what Facebook is. While many will assign “failed IPO” to this social media leader, it has undoubtedly changed the way we communicate. The stock has returned to favored status recently. Mark Zuckerberg’s venture carries an $84 billion market capitalization as it generates $5 billion in sales. One distinction from Tesla and Yelp, is that Facebook has a bottom line. At a price in the mid-$40’s, the price-to-earnings is 190.
Energy exploration in shale formations is dramatically changing our economy. Cheaper energy is driving a manufacturing renaissance in the U.S. New plants are being built throughout the mid-west and south. Furthermore, the abundant natural gas is being targeted as an eventual American export. Many areas of the world are currently importing liquefied natural gas as an important energy source (Japan and Europe are two large importers).
Cheniere Energy is in the process of building one of the first exporting facility in the U.S. If all goes as planned, it will be operational sometime in 2015. Wall Street can not contain their excitement. The stock trades at a market capitalization over $7.5 billion despite only $260 million in sales and substantial red ink on the bottom line.
Returning to the overall landscape, the stock market has had many reasons which could spark a decline. While August was lower, it was shallow in comparison to 2013’s move. Investors returned from the Labor Day weekend and bid prices higher. There appears to be little to worry about. Of course this is much different from autumn 2012 when worries over the election, Europe, and the fiscal cliff caused investor angst and pessimism.
A year ago we advised clients that a lot of bad news was priced into the markets. It turned out to be somewhat correct despite a nasty selloff after the election. With the current environment so cheerful, we fear there is little risk associated with the future outlook for the economy. We hope for continued expansion but fear the markets’ expectations.
Past performance does not guarantee future results