Posted on April 17, 2013 by David Laidlaw
In early March, the Dow Jones Industrial Average eclipsed its previous peak reached in October of 2007. The S&P 500 also achieved an all-time high at the end of the first quarter of this year. The business media have been covering these new records feverishly with the implication that the trauma of the prior years has been overcome and that the markets will continue to establish new highs. We believe this characterization is too simple and that stocks may not keep increasing in value without pause.
Since the earlier highs, much in the investment world has changed; some of the developments have been positive, while others have been more problematic. The most positive development involves the deleveraging that has taken place among households and the banks. According to the New York Federal Reserve, household debt is now $1.3 Trillion (approximately 10%) below its peak in 2008 (see chart) even though the economy is larger than it was then.
The four largest banks including JP Morgan, Bank of America, Wells Fargo and Citi now average 7.3% in tangible common equity compared to 4.2% at the end of 2007. Therefore, these banks have over 70% more capital relative to their assets than they did at the prior market peak. Lower levels of consumer debt and stronger banks provide a much more healthy environment for stocks and the economy, since households and businesses will be more resilient to future shocks.
On the other hand, governments here and abroad are far more indebted now than before the financial crisis when markets were at their previous highs. US Federal debt has ballooned from roughly $9 Trillion at the end of 2007 to $16 Trillion now. This growth in debt has been mirrored by other developed nations over the same time period. Unless unforeseen economic growth lifts tax receipts, this debt itself will retard growth and could destabilize the markets.
The US economy has created jobs at a faster rate than expected over the past few months. During February, payrolls increased by 236,000. However, there are about 4 million less people working now than during late 2007 (see chart) even though the population has grown. Therefore, the economy needs to keep adding jobs at this level for the next couple of years to return to the employment levels of almost six years ago.
An external shock could also derail further market increases. Cyprus’s decision to confiscate over 60% of deposits above the insured level of 100,000 Euro did not cause a selloff. However, this event is the exact type of catalyst that could start a correction.
Even though we expect more volatility than experienced over the past few months, we are not bearish regarding long-term returns. Aside from the stronger employment reports, it appears that GDP growth that stalled in the 4th quarter will revive. The Federal Reserve is also continuing its extremely stimulative policy of injecting $85 billion every month into the money supply through its bond purchases. Corporate margins and earnings remain strong. Finally, stock valuations are not unreasonable and still very attractive compared to bond prices.