Popes, Politicians, and Bulls

Roman Catholic Cardinals met in secret to choose a new Pope to lead more than 1.2 billion followers. White smoke billowed from the Vatican chimney at 7:07pm. Pope Francis I was introduced to the world about 90 minutes later and offered prayers for all the people of the world. The entire election process lasted less than 48 hours. This is an amazingly efficient process.

Meanwhile, the US Congress debates Paul Ryan’s budget proposal. (Feel free to groan at will. But don’t groan for long.) Bullish investors are brazenly driving share prices higher.

Last night on CNBC’s The Kudlow Report, I found myself in a very familiar role of voicing caution to my bullish pals Jack Bouroudjian and Larry Kudlow. Jack began, “I am a bull, Larry. You buy every 3-5% dip. This is a breakout year.” Then Larry said, “If you got 3% growth — 3 — I don’t know that, but if you got 3% growth, the ten-year treasury will go to 2.5%, it might go to 3% and the market might stub its toe for 20 minutes but will rise along with it”.

Jack Bouroudjian may be right. In 1994 the Dow Jones Industrial Average soared through 4,000, and in 1996 Alan Greenspan mentioned “irrational exuberance” as the Dow passed 6,000. Eight months later, it crossed 8,000. The underlying economics were different, but the awesome, inexplicable surge felt similar. These were great years for Farr, Miller & Washington, but those clients who have been with us that long will remember that my TV appearances then were also cautionary. I said, “We won’t buy stocks that don’t have earnings.” I also said, “I don’t know what a ‘concept’ stock is, and I certainly don’t know how to value one”; “85% of these dot-coms will not exist in five years”; and “Anything that can go up really fast can go down really fast.”

Bull markets and bull market sentiment are powerful and mysterious. We have never experienced a market climb against an economic backdrop built on endless Quantitative Easing and perennial trillion-dollar deficits. Maybe it will prove wildly successful for investors; indeed it has so far. Share prices are some 34% higher over the last 18 months and are up well over 100% since the market bottom in March, 2009.

While our clients invested in our Large Cap Growth Composite did well throughout the late 1990’s (please see our full disclosure of our GIPS-compliant audited performance.), I was called a “wet blanket who just didn’t get it.” As much as I’m enjoying market returns, I’m again suffering from “I don’t get it” puzzlement.

Retail Sales data show that the US consumer is incredibly resilient in the face of tax hikes and fiscal uncertainty. To assess the sustainability of robust consumer spending, we must look at both the consumer’s willingness AND ability to continue spending. The consumer’s willingness will likely be determined by his confidence in the economy, labor market, and government. While Consumer Confidence (reported by the Confidence Board) is still well below the levels prior to the financial crisis, it has been trending steadily upward over the past several years and is close to five-year highs. However, we suspect that the government’s inability to address the problem of deficits, debt and entitlements will continue to weigh on the consumer’s psyche. This will be a continued drag on spending going forward as there will be continued uncertainty about taxes in the future.

The consumer’s ability to spend will be determined by the labor market, income levels, his financial condition, and access to credit. Most of these issues have improved in recent months. Home prices are up 6-7% from the lows of early 2012 (Case Shiller 20-City index). Household net worth is up nearly $15 trillion from the lows of the financial crisis. Consumer credit is growing again after a period of contraction. The unemployment rate has come down to 7.7% as an increasing number of jobs is added each month.

However, our major concern is that the middle class consumer continues to see her income decline (adjusted for inflation). According to the US Census Bureau, median household income in 2011 was at the lowest level since 1995. Meanwhile, the middle class consumer has seen the price of basic necessities (food, energy) rise dramatically over that time frame. We continue to believe that the middle class is getting squeezed, and that a healthy and vibrant middle class will be the key to growing the economy over the longer term.

We remain cautious regarding the economic recovery until we see the kind of widespread job and income growth that can lead to sustainable increases in middle-income consumer spending over time.

Economic data are improving, and the fuel of government dollars continues in force. Earnings at S&P 500 companies are being generated at near peak margins, and the index is moving to all-time highs. Two sayings haunt me: buy low and sell high, and as Mae West said too much of a good thing can be wonderful! If Jack Bouroudjian is correct, we can all rest easily and count our money…for a while. We are not market timers, so my caution or optimism doesn’t change our allocations, but our keen focus on balance sheets, leverage, and earnings growth let’s me sleep a bit easier. Viva il Papa!