The S&P 500 Index ticked up to an all-time high on April 23, led by sectors that had lagged the broad market, namely healthcare and banks. It’s hard to see this as a growth story. Real (inflation-indexed) Treasury yields continue to plunge, which is inconsistent with strong economic expansion.
The US growth story is mediocre and the global growth story – except for China – is terrible. Last week, the Markit purchasing managers’ indices for the US showed manufacturing in contraction and, surprising, services barely expanding, leading Markit economists to predict 2019 US growth of less than 2%.
CapEx still looks weak, with inflation-adjusted orders for nondefense capital goods down 1% year-on-year. Sales of existing homes (the bulk of the housing market) were reported down 5.4% year-on-year, while new home sales were up just 3% year-on-year, a disappointing result after a sharp fall in mortgage rates.
Globally, the news remains grim; Taiwan reported March industrial production 10% below the year-ago level, and Japanese machine tool orders were down 28% year-on-year.
Today’s US stock market performance brings to mind Woody’s remonstration to Buzz Lightyear: “That’s not flying. It’s falling, with style.” Today’s best-performing stocks offer reliable cash flows in a mediocre economic environment.
This is a story about quality of cash flows rather than growth. Wall Street strategists continue to debate whether the US faces an earnings recession (as Morgan Stanley’s Mike Wilson insisted in a CNBC interview today) or a modest improvement in earnings. Meanwhile, the market winners were stocks with reliable cash flows and modest growth prospects.
There’s been a noteworthy bifurcation in the S&P 500, with the tech sector trading at about 125% of its average valuation of the past five years, and banks trading at just 80% of their average valuation until a few days ago (using the forward-looking price earnings ratio as the valuation metric). But the market isn’t buying cheap stocks: It’s buying cheap stocks with reliable cash flows. The winning combination appears to be value plus quality.
Banks were the swashbucklers of the early 2000s with returns to equity at or nearly 20%, driven by adventurous derivative structures and unprecedented amounts of leverage, as I reported yesterday. After ten years in a regulatory straitjacket, the banks have become a boring, conservative sector with returns to equity in the 12% range.
It’s not surprising that small banks are showing strong earnings growth. After the Trump tax cuts took effect in late 2017, the year-on-year growth rate of small banks’ commercial and industrial loans leapt from a tepid 4% to nearly 14% before tapering off to a respectable 8%. Prior to Trump’s tax cuts, small banks had lagged their larger peers in loan growth.
The expansion of small banks’ business is consistent with the shift in employment growth from large companies to small companies, who (as I have reported in the past) accounted for more than 100% of 2018’s job growth.
The banks can trundle along earning 12% return on shareholders’ equity, growing at not quite 10% a year. That’s not a sure bet, but a reasonable reliable one. Healthcare providers have been beaten up by negative political news, but still offer long-term growth independent of economic conditions.