Bull market shows no sign of death with Yellen support

A paradox for the ages as weak economy pushes stock prices higher

Dec 2, 2013 @ 3:36 pm

The weakest employment recovery in seven decades is proving a boon to equity markets.

Five years into a rally that has restored $14 trillion to share prices, U.S. payrolls remain 1.5 million below the level in 2008, according to data compiled by Bloomberg. Resistance to hiring from ConocoPhillips to Walt Disney Co. will help push Standard & Poor's 500 Index profit margins above 10% next year, the highest ever, data show. Below-average employment was cited last month by Federal Reserve chairman nominee Janet Yellen as the biggest obstacle to raising interest rates.

While American workers struggle, investors are benefiting as expense reductions and record low borrowing costs drive profits and underpin a 167% advance in the S&P 500 over the past 57 months. To bulls like Michael Holland at Holland & Co., equities will keep rallying as long as the Fed remains more concerned about employment than inflation.

“The weakness in jobs is continuing fodder for the Fed to fulfill its most recent and steadfast comments about the support of the economy,” Mr. Holland, who oversees more than $4 billion in New York, said in a phone interview. “Until the labor market gets better, the two parts of dual mandate have to be served,” he said. “I'm still pretty set in my position and prepared to see the market go higher.”


Employee compensation has declined relative to net corporate profits. The ratio of U.S. wages to earnings dropped to 3.2 in the second quarter, the lowest since 1966, according to data from the Bureau of Economic Analysis. Wages were the highest compared with earnings in 2008, just as the financial crisis was taking hold. The measure averaged 4.5 from 1947 to 2008, BEA data show.

Profitability at S&P 500 companies has increased, with each dollar of sales estimated to generate a record 9.9 cents in net income this year, data compiled by Bloomberg show.

ConocoPhillips, the largest U.S. independent oil and natural gas producer, cut its workforce three of the last four years, while profit margins expanded to 15% in 2012. That compares with 3.3% in 2009, data compiled by Bloomberg show.

Walt Disney Chairman and Chief Executive Officer Robert Iger has spearheaded a widening of operating margin, a measure of profitability, to 21% of sales in the most recent fiscal year from 13% in fiscal 2005, according to data compiled by Bloomberg. At the same time, the media company has fired hundreds of workers and closed offices.

Northrop Grumman Corp., the fifth-biggest U.S. government contractor, raised its profit outlook in October for 2013 after boosting net income by cutting jobs. The Falls Church, Va.-based company's workforce fell to 68,100 last year from 123,600 in 2008, data compiled by Bloomberg show. The profit margin was 7.8% in 2012, compared with 5% in 2009.

Shares of Burbank, Calif.-based Disney, the world's largest entertainment company, and Northrop have climbed more than threefold since March 2009. ConocoPhillips, based in Houston, is up 161% since then.

Rising margins helped S&P 500 earnings double since October 2009 even as sales growth slowed. Per-share revenue for the index rose an average 1.9% a quarter since the start of 2009, compared with 4.6% for the 18 years before that, according to data compiled by Bloomberg. Analysts say profits will increase another 10% in 2014, this time as sales grow faster. Revenue will expand 4.1% next year, twice the rate of 2013, Bloomberg data show.


The S&P 500's advance since March 2009 has surpassed the gains in the last bull market, which ended in October 2007. The index climbed 0.1% to 1,805.81 last week, ending 15% above the record before this year. U.S. exchanges were closed on Nov. 28 and had a shorter session on Nov. 29 due to Thanksgiving.

Stocks are up 27% in 2013, poised for the best annual gain in 15 years, as the Federal Reserve refrained from scaling back its third round of quantitative easing to stimulate the economy and corporate profits expanded as chief executives cut costs. The S&P 500 climbed 2.8% in November, a third straight monthly gain.

The index rose less than 0.1% to 1,806.50 at 11:21 a.m. New York time Monday.

Unemployment is “still too high, reflecting a labor market and economy performing far short of their potential,” Ms. Yellen told the Senate Banking Committee during her confirmation hearing on Nov. 14. More than half the gauges she uses to track the labor market are below pre-recession levels. The U.S. unemployment rate was 7.3% in October, compared with the 5.8% average since the 1940s, Bloomberg data show.

Weak employment will harm stocks in the long run, even with the Fed's support, according to John Carey, a fund manager at Pioneer Investment Management who oversees about $200 billion.

“An intangible is the effect on everyone's morale of seeing the continuing reporting on the difficult jobs situation,” he said. “It cannot be helpful for consumer confidence and business confidence to read day after day that the economy just will not get going.”

The Fed said after its October meeting that it will press on with its $85 billion in monthly asset purchases and continue to hold short-term rates near zero at least as long as unemployment is above 6.5% and forecast inflation is below 2.5%. Economists in a Bloomberg survey expect the central bank won't begin reducing its monthly bond purchases until March.


Analysts are too optimistic about margins and U.S. stocks are more vulnerable to shortfalls in earnings than other countries, said Mathieu L'Hoir at AXA Investment Managers, who helps oversee $730 billion. Should the Fed succeed in encouraging hiring, corporate profit margins would likely suffer from higher wage costs, he said.

“Betting on higher profit margins from here is betting the Fed will fail to boost employment,” Mr. L'Hoir, investment strategist at Paris-based AXA, said in a phone interview. “Profit margins are currently the risk and weak spot for earnings next year and therefore for U.S. stocks.”

Annual earnings have fallen 10 of the last 11 times that margins shrank, according to Bloomberg data since 1973. Profits declined an average of 11% in those years, compared with a 16% increase in years of expanding margins.

Mario Gabelli, the founder of Gamco Investors Inc., said investors betting interest rates are likely to remain low in the next 18 months due to a weak labor market may be disappointed. Ms. Yellen may find the economy is strong enough to lift borrowing costs even if employment remains below the Fed's target, he said.

“Do not assume that Yellen won't pull the trigger and raise rates without telegraphing that she is going to raise rates,” Mr. Gabelli, who helps manage $43 billion, said in a phone interview.

Analysts say profitability has room to improve. Margins will climb to 10.5% in 2014 and 11% in 2015, more than 11,000 estimates compiled by Bloomberg show. The previous record was 9.8% in July 2007. At the same time, S&P 500 revenue growth is forecast to reach 4.4% in 2015, according to the average of analyst estimates.

“American companies have been able to resize their balance sheets, to slim down their costs, and that has proven fairly favorable when we started to see some strong top-line growth,” Ilario Di Bon, who helps oversee $7.6 billion as head of equities at Alliance Trust in London, said. “Yellen has said, 'let's make sure that policy remains accommodative for a longer rather than shorter period of time to give the real economy time to adjust.' I would expect 2014 to be favorable to equities.”

(Bloomberg News)


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