Thoughts on the Business Cycle

07/25/2010 11:38 pm ET | Updated May 25, 2011
  • Alan Schram Managing Partner of Wellcap Partners, LA-based hedge fund

Lately, almost everyone seems melancholy about the prospects of the economy. So I thought I might share some anecdotal data points that suggest otherwise:

• The yield curve is still steep, which induces credit creation. Historically, a steep yield curve has been an excellent predictor of economic growth. The Federal Reserve expects GDP to grow 3.5% this year.
• M1 Money Multiplier, which tracks creation of new money by bank reserves, is up to 86.5 (compared to 83 a month ago) and steadily improving.
• Rail shipments are higher than last year and growing every month.
• Industrial companies Caterpillar and 3M both reported strong earnings last week, indicating their respective industries are not dipping back into recession.
• Companies are flush with cash: Non-financial companies in the S&P 500 have $1.8 trillion in cash, higher than any other time in the last 50 years (per the Federal Reserve). When they start spending that cash, the impact will dwarf any government stimulus, and it will be more durable.
• The WSJ ran a front page article a few weeks ago saying small investors lost faith in stocks. Exasperated with high volatility and low returns, people are fleeing equities, having developed a cautious mentality similar to that prevalent in the 1970's. No bells are rung when major shifts in market psychology occur, but the crowds bailing out on stocks is probably as close as it comes to campanology.

Meanwhile, smart money is doing the opposite: Bill Gross of PIMCO, aka the King of Bonds, is launching a new large cap equity fund, a new line of business for PIMCO. I doubt that is merely a coincidence.

• Most importantly, valuations of equities are appealing. Of the 25 largest companies in the S&P 500, more than half (13) trade at P/E's of 10 or lower (2011 forecast earnings). The earnings yield on the S&P 500 is 8.3%, more than 5 percentage points higher than a 10 year Treasury. The last time the gap between the two was that high was in the late 1970's (!).

The S&P 500 index has fallen at an annualized rate of 3% over the past 10 years, including dividends and adjusting for inflation. Gold is up 10% a year and treasury bonds gained 5% a year during that same period, after inflation. People extrapolate those trends forward and are therefore dubious of equities.

However, even in the unlikely event that we face an extended period of no real growth in GDP, consider the numbers:

• If inflation runs at just 1.5% annually and the typical US corporation does not grow at all, in five years earnings would be almost 8% higher, and if by then P/E's rose to their historical level of 15, stocks would have risen 5.5% a year plus 2.5% in annual dividends, or a total return of 8% annually. That would be in line with the historical long term return for stocks, all the while paying more cash than 10 year treasuries do.
• If in addition to the conservative scenario above companies use their excess cash to buy back stock, shareholders would have extra returns. And if earnings grow at 5% annually, then even if the P/E ratio remains below the long-term average, five year returns would be in the mid teens.

So even under the most conservative assumptions, returns from here are not at all bad.

The late 1980's saw a major wave of defaults in Latin America, not unlike events in Europe now. Then came the S&L crisis, which was a major shock to the country and its psyche. People were generally negative, and that's exactly when a major bull market for stocks started, and it lasted through the 1990's.

Markets reflect expectations. Investors need to know what expectations are discounted in the prevailing prices. By the time it is obvious the economy is doing better, stocks will already be expensive. As it turns out, ten years ago the best strategy was to buy bonds and avoid all stocks. It is probably the exact opposite now.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at