Mid-Year Update and Outlook 7/3/14

It is hard to believe we are at mid-year already.  The market has been very resilient in handling a number of new “worries” that showed up this year such as Russia’s aggressive moves in the Ukraine, renewed fighting in Iraq and slower economic growth to start the year due to cold weather.  The market at one point had sold off over 5% early in the year but eventually shook off the economic chill caused by a nasty winter and geopolitical risks abroad to post a solid gain of nearly 5% in the second quarter.  As of June 30th, the S&P 500 is up 6.1%.  The main driver of stock prices in the 2nd quarter was data that showed the U.S. economy was bouncing back from a dismal performance in the first three months of the year, when it contracted 2.9%.  The better than expected economic news continued today when the Labor Department announced that U.S. employers added a robust 288,000 jobs in June. The number of jobs created in May was revised up to 224,000 from the original 217,000. 

The “Surprise” the market may get is better than expected Economic Growth:

Investors are somewhat emotionally “programmed” to expect a negative event to show up to derail the stock market due to the historic volatility we have seen over the last ten years.  However, our outlook continues to be a trend toward an upside surprise in jobs and economic growth (GDP) rates in the second half of this year driven largely by better than expected corporate spending and acquisitions.  We definitely have seen CEOs start taking some action to invest and take some risk in 2014.  Our discussions with business leaders of all sizes indicate that they are tired of waiting and worrying what politicians are going to do with taxes, regulations, etc. and they are getting back into growth mode.  Another very big catalyst for economic growth and stock performance for the remainder of the year will be an increase in business loan demand.  This is one area that has not improved in any meaningful way thus far in 2014.  Banks have more capital available for loans than they have ever had in history thanks to the Federal Reserve’s quantitative easing programs.  The problem is that the money is not getting into the economy; instead it is sitting in bank vaults.  Business confidence has to continue to improve in order to see loan demand start to increase.  We will be monitoring all of the macro economic data as the year progresses and hopefully we will see business spending and loan demand increase. 

Disputing the Counter Argument for Slower Growth:

While we are forecasting a surprise jump in U.S. economic growth that helps boost the global economy,  a host of economists and commentators continue to predict a stagnant U.S. and global economic growth pattern due to the following three factors: 1) an aging population in the U.S., Europe and Japan 2) the lingering damage caused by the 2008 financial crash which they argue will result in a change in consumer and business spending behavior and 3) reduced government spending due to budget cuts and austerity in many countries that must get their deficit spending under control.  Our opinion is that their outlook is likely to be off the mark because: 1) the aging population are staying healthy longer and they will continue to spend money.  Also, the children they will leave trillions of dollars to will not hold back on spending the money; 2) the damage to confidence caused by the 2008 crisis did not change consumer behavior like it did after the great depression.  One of the factors that has led to our recovery after 2008 has been stronger than expected consumer spending.  If consumers are employed they will spend – once unemployment stabilized, consumer spending became a boost to the economy after the crisis.  The concern we have had is that Business spending has not risen to the level needed due to CEO’s lack of confidence in the political system and the risk of additional taxes and anti-business regulations in the U.S.  Over the past few months we have seen some improvement in business spending as many CEOs have decided to “work around” the political uncertainty as demonstrated by the number of business acquisitions and capital spending over the past six months.  3) Economic growth has already reduced the U.S. deficit more than anyone predicted in the wake of the U.S. debt debacle in Washington.  The crisis put the spotlight on our deficit and Government spending which did result in some positive action out of Congress.  Raising taxes also is having a big impact on lowering the deficit but Congress needs to focus on pro-growth policies in order to get our budget balanced over the long term.  Despite the political dysfunction we think economic growth will improve and as growth comes back Government spending will likely increase as it always has in the past. 

U.S. Corporate Earnings continue to propel the stock market forward:

Since hitting a peak in negative EPS guidance in Q4 2013, companies in the S&P 500 have issued fewer negative EPS preannouncements and more positive EPS preannouncements for the second consecutive quarter. For Q2 2014, 84 companies have issued negative EPS guidance and 27 companies have issued positive EPS guidance. The number of negative preannouncements is below the record high of 95 set in Q4 2013, and the number of positive preannouncements is above the record low of 17 also set in Q4 2013. If these are the final numbers for the quarter, it will mark the lowest number of negative EPS preannouncements since Q4 2012 (79) and the highest number of positive preannouncements since Q4 2012 (34).

China takes steps to stimulate their economy:

Chinese regulators increased banks’ capacity to lend money and bolster the slowing economy by changing the way loan-to-deposit ratios are devised.  Banks from today can include in the calculation negotiable certificates of deposit sold to companies or individuals, the China Banking Regulatory Commission said in a statement yesterday. They can also exclude loans advanced to small enterprises and the rural sector that are backed by bonds, the CBRC said. Bank lending is capped at no more than 75 percent of deposits to prevent an overextension of credit.

The changes in calculation may allow lenders such as Bank of Communications Co., which was approaching its limit under the previous methodology, to lower its ratio and advance more loans. Premier Li Keqiang is seeking to cut funding costs and feed credit into the world’s second-largest economy, which is forecast to expand in 2014 at 6% which is respectable but still lower than it has in over a decade. Easing the loan-to-deposit requirements will help amplify lending and could help stimulate economic growth. 

Initial Public Offerings (IPOs) Increase 42% year to date:

The quarterly count of companies that went public in Q2 grew 42% year-over-year. This figure surged over the past year, and the Q2 total of 88 marked the highest total since Q3 2000 (135). In addition, the 156 public offerings in the first half of 2014 have already surpassed the full year totals in 2011 and 2012 (136 and 137, respectively), and have amounted to more than two-thirds of the 2013 total (230). This uptick also showed no sign of reversal. The number of companies offered in June (35) grew 84%, and was the highest monthly total since August 2000.

Gross proceeds (including over-allotment) from initial public offerings (“IPOs”) grew 57% year-over-year and reached $22.6 billion in Q2. This marked the highest sum since Q4 2013 ($26.4 billion), and the second highest Q2 sum since 2000. June activity also showed strength in terms of proceeds—the $9.0 billion raised grew 131% year-over-year, and represented the highest amount since October ($13.4 billion). It was the highest June total since 2007.

Combined with Q1, the first half of 2014 has shown growth in gross proceeds of 51% year-over-year, and the $34.0 billion total was the highest first half total since 2000. In terms of the number of offerings, the first half total of 156 represented 66% growth year-over-year, and was also was the highest total since 2000.

Going forward, there are 104 companies that released initial preliminary filings in Q2. This represents growth of 51% year-over-year, and the highest quarterly total since at least 2007. Mapi Pharma, an Israeli pharmaceutical drug manufacturer, is scheduled to offer this week.

The Health Technology sector continued to drive the growth in IPO activity in 2014. The sector’s 52 offerings through the first half of 2014 have already surpassed the sector’s annual high since 2001 (51 in 2013), and represented one-third of all deals (out of 19 FactSet sectors). The sector is also on pace to break a previous peak for offerings set by the Finance sector in 2004 (60 IPOs). On the industry-level, the Biotechnology industry has been most active with 27 offerings in the first half of 2014 (as compared to 34 for the full year 2013). The Health Technology sector has also been bolstered by companies in Pharmaceuticals industries, which added another fourteen IPOs in 2014, and those in the Medical Specialties industry, which added another ten.

Business Acquisitions Jump Higher in 2014:

Corporate acquisitions have been strong so far this year, as many companies have been taking advantage of their large cash reserves and cheap available financing to make these acquisitions.  According to Thomson Reuters data, year-to-date global deal volume as of June 26 was $1.75 trillion, up 75 percent from the year-ago period. This is the highest level since 2007, when deal volume reached $2.28 trillion.  This is despite the fact that the number of deals has actually dropped since this time last year.  It makes sense for companies to take advantage of cheap available financing as yet another way to add value to shareholders.  Shareholders have generally reacted favorably to acquisitions this year.  Nearly 70% of the US acquisitions worth $1 Billion or more were followed by gains in the stock price of the “buyer” company’s stock.  We anticipate the M&A trend will continue for the remainder of the year, as it still appears we are in the early innings of a typical M&A cycle.

All of these factors are a large part of the positive trend in the U.S. and global stock markets in 2014.  We will continue to monitor the economic and earnings information.  Barring an escalation of geo-political issues in the Ukraine, Iraq, Iran, etc. we feel stocks are well positioned to continue to move higher throughout the remainder of the year.