Feeling bad, but still prosperous

August 16, 2012

The U.S. stock market, as measured by the S&P 500, has had an outstanding year so far, posting gains of 12.8 percent through August 10. Yet, there are plenty of reasons to feel pessimistic about the future: unemployment is at 8.3 percent, Europe continues to fumble for an answer to its debt crisis, and growth in emerging economies is slowing. How can stocks, which are supposed to trade on future earnings, be doing so well when the financial press is full of caution? We believe the answers to the apparent disconnect lie in the financial reports of U.S. companies for second quarter 2012.

For those watching closely, there has been a lot of good news for stocks. Of the companies in the S&P 500 that have reported second quarter earnings, more than 70 percent have beat Wall Street’s earnings estimates. That means that companies are making more money than analysts expected. As analysts adjust their future estimates to include the recent good news, prices of stocks rise. While earnings are surprising to the upside, revenue—or how much companies sell—has been surprising to the downside. Almost 60 percent of S&P 500 companies missed their Wall Street revenue targets. Companies are making more money than expected, but with fewer sales.

Companies are able to generate more profit per sale by controlling costs. Another way of putting this is that companies are squeezing more and more out of their employees; in economics parlance we call this productivity gains. Productivity gains are good, because it means that each employee produces more, which generally leads to higher wages and more disposable income. Higher disposable income in turn leads to more spending, which leads to higher revenue for companies. You get it—a virtuous cycle of growth. Yet while productivity is rising among those employed, we have a large pool of unemployed workers and that means that wages aren’t rising; try negotiating a raise when there are 3.5 job-seekers for every 1 job opening. Without rising wages, disposable income is stagnant, which means people aren’t buying more things, and that largely explains the missed revenue numbers.

The fact that we haven’t been able to enter the cycle of virtuous growth is part of the reason why the recovery has felt uninspiring. That said, even in this weak environment, companies continue to increase profitability as they squeeze workers for more output without increasing their wages. But, the current state can’t go on forever. Companies will eventually start hiring and that will result in higher wages. Either there will be virtuous growth OR companies will start to put up disappointing earnings. We don’t know which scenario will play out, but we are hoping, along with the rest of the country, for the former.

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ANATOMY OF AN IPO

June 7, 2012

Initial public offerings (IPOs) are associated in investors’ minds with enormous profits. These profits, however, tend to be more for the founders of companies and for investment banks rather than for retail investors or even institutional investors. Market observers always call to mind a few “hot” IPOs where the share price provided double-digit returns in a single day.
 
But what happens after the initial excitement? Studies have shown that, in general, investors are better off owning shares of seasoned companies as opposed to new issues through an IPO. While we don’t know for sure why investors overpay for IPOs, research also indicates that investors overweight the probability of extreme growth of newly listed companies and therefore apply too high a value to these shares.*
 
That brings us to the recent Facebook IPO. We don’t know if Facebook is fairly valued or not. We generally believe that the market fairly prices liquidly traded securities and therefore we do not believe we have much edge or insight into the valuation of any one issue. Given our belief that large, liquid stocks are generally fairly priced, and because of the long-term underperformance of IPOs, as a firm, Wealth Enhancement Group did not participate in the Facebook IPO and we advised our clients against participation as well. In general, we advise against participation in any IPO.
 
Not having edge or insight into publicly traded stocks sounds like a bad thing, but it’s actually a good thing. When all market participants are working with the same information, it limits the ability of more-informed market participants to take advantage of less-informed participants, who unfortunately tend to be working savers or retirees. In the case of the Facebook IPO, there have been allegations that not every investor had the same information. According to press reports, certain investment banks changed their forecasts for Facebook and communicated those changes only to institutional clients, leaving individual investors—their retail clients—in the dark. The effect was that those retail clients may have paid more than they would have otherwise been willing to pay for the Facebook shares. While we don’t know yet what happened at Facebook, we do know that the more widely information is disseminated, the better for individual investors, our clients and the functioning of the market as a whole.
 
Wealth Enhancement Group
 
*Ritter, Jay, 1991, The long run performance of IPOs, Journal of Finance 46, 3-q7.