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Sinais Economic and Market Perspectives

June 11, 2013

Contents Taking Stock of the Stock Market in the Financial Cycle Best-Yet-to-Come?.............. 1 Notable Valuation Shift 15 X from 14 X ....................... 3 The Financial Cycle in the Business Cycle ........................ 3 How Long Can the Expansion Go? .......................................... 4 Fair Value Estimates and RangesHigher Stock Prices Irregularly Over Time ............. 4 Broad Asset AllocationYet More Shifting Toward Equities .................................... 5 What Is Going OnThe Consumer and a Tight FiscalEasy Money Policy Mix ........ 5 Still Relatively Early in the Asset-Price Inflation Stage of the Business and Financial Cycle! ...................................... 5 Looking Ahead: Will Earnings Growth Reaccelerate?An Essential Element .................... 6 What Could Cause a Stumble? . 6

Taking Stock of the Stock Market in the Financial CycleBest-Yet-to-Come?

Allen Sinai and Andrew Husby

Equity markets had some stunning gains through May and over the past year, notably in the U.S. and Japan, but are struggling and volatile of-late. Indeed, after some huge increases that were clearly unsustainable, a couple of country stock markets, e.g., Japan, now are technically in a Correction.
Table 1 Stock Markets: U.S. and Selected Global (Year-to-Date and Past Year; As of 6/10/13)
Country U.S. Japan Singapore Taiwan Germany France Italy Switzerland Sweden U.K. Netherlands Australia New Zealand Year-to-Date Pct. Chg. 15.2 30.0 1.3 6.0 8.6 6.2 3.0 14.4 7.9 8.4 2.8 1.9 10.0 Past Year Pct. Chg. 24.0 59.8 17.1 16.6 34.8 26.7 24.6 32.9 22.2 17.6 20.7 16.6 29.7

Table Table 1 Stock Markets: U.S. and Selected Global ................................... 1

In the past, after early year rallies there has been a Sell in May and Go Away pattern. This certainly held true during 2012 and 2011, when equity market corrections of size occurred between May and late Summer-early Autumn. But this May did not see any selloff. Will June and beyond be the new May? There is a hint of this in volatility and where there are corrections. Or, is the Best-Yet-to-Come? The DE answer is the Best-is-Yet-to-Comefor U.S. economic activity and also for stock prices.

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In 2013, unlike past years, the macro fundamentals supporting U.S. and global equity markets are better and looking toward the future improving in most countries. Macro risks no longer are predominantly to the downside. DE expects a renewed growth upturn for the U.S. economy that could span another three-to-five years. Continuing relatively low interest rates, albeit higher, and 6%-to-8% growth in S&P500 Operating EPS, much better than growth in nominal GDP of 4%-to-5%, will provide support. Recent hesitation and volatility rest on uncertainty over the Federal Reserve and the effects of any coming Exit from the aggressively easy monetary policy that has been inprocess, in this case the possibility of tapering-down the pace of asset purchases from $85 billion per month plus the reinvestment of proceeds from maturing Treasury and mortgage-backed securities. Questions about non-U.S. regions, i.e., China, Europe and whether Japans QE will work also are troublesome. Until when, what, how and how much less Federal Reserve accommodation is clarified, the equity markets will be vulnerable and probably volatile. The uncertainty over the path of any Fed Exit and its potential effects, uncharted territory, keep the equity market volatile. Last Fridays Employment report was important for financial markets and monetary policy since the Federal Reserve has made QE contingent on the state of the labor market and presumably the unemployment rate. The data showed a relatively strong labor marketfor the second month in a row good gains in Nonfarm Payrolls (175,000 overall after a downward revised 149,000 for April), in Civilian Employment (persons working as opposed to jobs), a very large 319,000 after last months 293,000 and in the Labor Force (420,000 on the heels of Aprils 210,000). Thus, the rise in the unemployment rate, to 7.6 percent from 7.5 percent, must be discounted because both the supply of, and demand for, workers were much higher. The labor market looked to be improving, although not so much as some members of the Federal Reserve have indicated is needed to favor tapering-down the current QE. But, nonfarm payroll jobs do not have to average 200,000-and-more to signify an improving labor market, given slow growth in the labor force, in order for the unemployment rate to keep moving lower. A too strong labor market report would have bothered financial markets considerably on concerns that the Federal Reserve might overdo its reduction of stimulus. The labor market data were good enough to indicate an improving economy going forward but were not so strong as to clearly indicate that the Federal Reserve will move to a less aggressive monetary stance at its meeting next week. Indeed, though next Wednesday a major subject of discussion at the FOMC Meeting and likely to be clarified at the Bernanke Press Conference, hopefully so for the financial markets sake, actual actions to reduce the additions of securities to the Feds balance sheet are not likely until some time in the fourth quarter. Over time, increased and sustained higher economic growth should bring increased earnings and higher stock prices, but certainly not at the rate of increase earlier this year. A longer-than-average equity bull market should unfold that will see levels of stock prices not seen previously.

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Equity market investors can expect hesitations, consolidations, and Corrections markets do not move, up or down, anywhere near straight. But over time, repeated and irregular new highs for broad stock market averages are in-prospectin the U.S. and elsewhere. Key is that economies and markets are in the Asset Inflation stage of the economic and financial upcycles. This stage typically is followed by increased economic growth and rising earnings. Support this time from accommodative central banks and low inflation is notable. With the passage of time, the seeds of increased economic growthpreviously lower interest rates, higher stock prices, a lower currency and lower inflation, in part from aggressively easy monetary policyshould bring increased economic activity and a self-reinforcing liftoff up to a higher pace of real economic growth. A gentle Tapering-Down of monetary policy ease would be appropriate at this point, however, even before increased economic activity appears, given the lags behind the seeds of future growth and their impacts, through various channels, on the economy. Markets would be advised to welcome such actions, not fear them. This kind of preemption is expansion-sustaining not expansion-limiting. Notable Valuation Shift15 X from 14 X New for DE is a valuation shift from 14 times Forward S&P500 Operating EPS to 15 times, an increase rooted in the fundamentals of business and financial cycles and its various stages. As the next stage unfolds in the U.S.better economic growth with better business activitythe Global Economy should follow. Historically, at such a time, valuations tend to rise. Not until long after when troublesome stages of the U.S. and Global business cycle expansion start to click-in do Bear equity markets begin. This is the cyclical reasoning behind the increased valuation to 15 and the notion that the Best-isYet-to-Come. The Financial Cycle in the Business Cycle The Financial Cycle stages are: 1) Recession or Growth Recession with rising, or high, unemployment and declining inflation; 2) aggressive Monetary Policy Easing, usually during and after the recession; 3) Asset Price Inflation; 4) Increased Economic Activity and Sustained and Sustainable Expansion as financial-real interactions stemming from asset price inflation, with lags, start to work; 5) Declining Unemployment and tightening labor markets; 6) Goods and Services Price Inflation; 7) Tighter and Tight Monetary Policy. There is overlap in these stages; they are not exactly serial nor sequential, nor with a clearcut beginning or end. Not until later stages of a cycle, when unemployment is much lower and inflation is rising, do central banks really start to meaningfully tighten monetary policy, setting in motion processes that lead to the next Bear equity market.

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How Long Can the Expansion Go? From beginning-to-end, the stages described can take anywhere from several years to as long as 10 years (the 90s). Currently, the expectation is for another three-to-five years that will add to the already four-plus years of Recovery/Expansion and the Equity Bull Market. Sneaky is the way the economic expansion is unfolding, really in two phasesDeep Recession and its Aftermath then a Growth Recession and its Aftermath. The functionality of these stages seems to be repeating. Functionally similar processes to those that come in a Recession and its Aftermath are occurring, except that this time what has occurred is a Growth Recession. Sticky-high unemployment and diminishing inflation are similar. Aggressive easing to accelerate economic growth and in some countries, notably the U.S. and Japan, to raise inflation, suggests that functionally these two economies are still in the early stages of the Financial Cycle. The Eurozone is behind the U.S., as is probably the U.K., with these geographic areas still dealing with fiscal restraint, or Austerity, more-or-less, as a complication. Asia and the Developing Countries are hesitating, behind the U.S. in renewed growth with equity markets to later behave sympathetically. Fair Value Estimates and RangesHigher Stock Prices Irregularly Over Time The shift up in the P-E valuation used to price S&P500 forward earnings is suggested by the functional stages in the U.S. business and financial cycle. In the DE P-E quantitative model used to assess DE S&P500 forward operating earnings, sustained and increased growth in nominal GDP and less downside risk around such a projection raise the P-E for a given assumption on monetary policy and projections of interest rates. Pricing at 14 times this years expected S&P500 Operating EPS of $110 plus a few dollars pulled forward from next years estimated Operating Earnings of $118-$119 gives point fair value for the S&P500 at 1582. DEs fair value estimate for the S&P500 is 1695 on a 15 multiple. Downside is limited to 1550 if economic growth and/or earnings disappoint, the Fed looks to taper-down QE more quickly than expected, or other negative macro risks move front-and-center, including a stock market that can move up too far, too fast for the fundamentals. On pricing estimated 2014 earnings of $118 later this year at 15, the yearend 2013 fair value estimate is 1770. Thus, 1700 is a reasonable directional expectation for the S&P500. A stretch target is 1750. Currently, for 2014, DEs S&P500 expectation is just under 1900 (based on 2015 earnings of $126). In 2016, DE sees an S&P500 over 2000 (based on 2016 S&P500 Operating EPS earnings of $135). These projections include assumptions and forecasts of rising interest rates, short- and long-term, but minimally so, with no recession or major persistent negative macro risks.

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Broad Asset AllocationYet More Shifting Toward Equities DE Asset Allocations are now tilted even more to equitiesStrongly Bullish Equities, now 80% (from 75%) vs. a neutral 55%; Strongly Underweight Fixed Income, particularly longer duration, 20% (from 25%) vs. 35% neutral; Zero for Cash & Equivalent (no change). There is also a more negative tilt on Gold, now negative-toneutral, from a neutral-to-negative stance (three months ago). What Is Going OnThe Consumer and a Tight Fiscal-Easy Money Policy Mix Importantly, the changes outlined rest on economic outlook assumptions that are broadly similar to those held by DE for quite some timehistorically subpar but higher economic growth led by the consumer and housing, then afterwards by increased business capital spending and hiring. Tighter fiscal policy in the form of declines in real federal government purchases will restrain real GDP growth and make it harder to move above 3% growth, on average, in a sustained way. U.S. consumer spending should rise in a 2%-to-3% range, tilting up in growth, inflationadjusted; the housing sector evolve favorably in terms of demand and prices; and jobs growth roughly average 175,000-190,000 per month over the next six months-or-so. China will move sideways or even a bit lower in growth; Europe is no longer on the brink with an expected bottoming-out in its Recession in part from expectations of easier monetary policy and a relaxation of austerity. Policy actions in Japan should support better growth there and in the Asian region more broadly. DE research suggests that the Tight Fiscal-Easy Money policy mix in-place should produce better growth longer-run. Higher earnings growth by the fourth quarter should become long-lived, supporting equity markets. The last time a Tight Fiscal-Easy Monetary policy mix was seen was in the 1990s, a period of strong equity market performance. DE is not predicting gains of that magnitude, but the policy similarities should be noted. Still Relatively Early in the Asset-Price Inflation Stage of the Business and Financial Cycle! Crucial to the DE bullish equity view is that financial markets and the economy are still functionally in the early stages of an asset-price inflation cycle, despite the current bull equity market being in its fifth year. Central Banks are in an aggressive easing stage consistent with Recession, not late Expansion. The Fed began Open-Ended Quantitative Easing in late 2012. Japan, and the BOJ, is still in the early stages of its all-out war on deflation. Now, Korea and other regional central banks are cutting interest rates in response to strengthening currencies. Central bank easing occurs in the first stage of a financial cycle, typically aggressively so in the first portions of a recession and sometimes even longer, but this time also aggressively so when the U.S. economy disappointed relative to the objectives of the central bank.

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That confidence can be coupled with DEs view that the lags between central bank easing around the globe (from the Fed, BOJ, ECB, and others like Korea that are now responding to Japans actions) are in stages of transmission to real economic activity. This suggests the following:

Exposure to equities relative to fixed income is increasingly attractive as expectations of higher growth continue amid an environment of benign inflation around the globe. With fiscal headwinds in so much of the Global Economy, even if central banks move toward less accommodation, they will do so only gradually and gently, on persistent growth fears. Unlikely is a big spike in interest rates that would seriously damage equity valuations. One must also be aware of the possibility that inflation could continue to be surprisingly low.

For some countries, those seeing strong currency gains versus the yen, further reductions in interest rates can be expected. In the U.S., fiscal tightening will continue to be accompanied by easy monetary policy. Reductions of federal government purchases will impact GDP negatively, but actual federal government spending cuts can only impact a small portion of the economy. Looking Ahead: Will Earnings Growth Reaccelerate?An Essential Element S&P500 revenue growth came in weak in Q1, roughly 2% year-over-year, while earnings growth again came in stronger than expected, but still substantially diminished. Margins were again super! DE projections are for an acceleration of earnings growth to roughly 6%-to-8% per annum over the next several years. This is well above what is implied by top-line growth if defined by nominal GDP growth at a forecasted 4%-to5%. This pickup of earnings growth will be essential to how strong the equity bull market can be. The persistently higher rate of earnings growth over nominal GDP growth can be explained, in part, by the continued focus on maximizing shareholder value through cost-cutting, technology, and productivity improvements. This has persisted over the last several business cycles and there is little evidence of any shift in tendency. The pickup in U.S. and world economic growth, should it occur, will increase revenues on a now even lower expense base, levering-up an acceleration of earnings growth. When in the future the macroeconomic data are revised, the magic of continued corporate profitability may be less mysterious, with productivity-enhancing technology explaining much of the puzzle. What Could Cause a Stumble? Too much fiscal restraint, disappointing company earnings, a worsening of the Europe situation, a continuation of a sluggish 1%-to-2% growth path in the U.S. for longerthan-expected, or errors by the Fed are all potential sources of problems. Inflation could rear up, forcing the Federal Reserve to take restrictive action earlier. Non-U.S. crises in tangential countries could surface at almost any time to shake markets.

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But, back of all of this is the inevitable motion of the business and financial cycle, seemingly unfolding over time as has been true over so much of history, although kind of in disguise this time.

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