Thursday, September 12, 2013

Pent Up Demand: A Future Driver of Economic Growth

Pent Up Demand Pushing Cyclical Stocks

We are coming out of a lengthy period of decreased spending in the wake of 2008-09, which has built pent up demand for automobiles, housing and capital expenditures.  The average age of vehicles on the road has reached a record high of 11.4 years.  Demand for new houses fell off dramatically since the Great Recession.  The average U.S. home was built in 1974 and continues to age. 

As people have chosen to fix rather than replace their vehicles and homes, we’ve seen the replacement-type industries do very well.  Auto Retail’s 2nd quarter sales and earnings per share were up 14.7% and 18.6%, respectively.  Home improvement retail grew sales nearly 10% with earnings up 20% from 2nd quarter 2012.

Adding to the pent up demand for housing is the number of young people living with their parents rather than buying or renting on their own.  According to real-estate marketplace Trulia, the number of “missing households” (Americans who would currently be owning or renting a home if pre-recession economic trends had continued) was up to 2.4 million in March.  More than half of these missing households are 18 to 34-year-olds.

This pent up demand extends beyond just the immediate products being bought by consumers.  Businesses have held off replacing durable goods since the recession.  All of this excess demand will have to be released at some point.  Eventually, these homes and vehicles will exceed their useful life and need to be replaced.  To meet the need for the excess demand, companies will not be able to hold off re-investing in new plant equipment. 

We’ve seen the beginning of this demand in 2013 and believe there is more to come.  The market is buying into this as well, as more growth and manufacturing oriented sectors – such as Consumer Discretionary and Industrials – have performed well over the near-term. 

Share prices for stocks in the Industrial sectors are moving in advance of their fundamentals.  Emerson Electric is a perfect example.  They have missed earnings in 3 out 4 of the past quarters, yet their stock has recently hit a new high. 

Figure 1: Emerson (EMR) Stock Price Last 12 Months

This would ordinarily be suspicious; however, we saw the exact same trend occur in the automobile business – where stock prices moved higher well in advance of fundamentals.  Industrials are driven mostly by large institutional investors who have access not only to company management, but also to their own economic models.  Taken together, that gives them a view into the future that may not be readily apparent to the average investor.

Falling Stock Correlation: What It Says About Consumer Spending

 As we mentioned in the Take Aways from the August 26th Investment Policy Committee meeting, the correlation index has been steadily declining.  In 2008-09, macroeconomic events drove nearly every stock downwards.  Specific sectors and stocks moved in tandem with one another.  Today, stocks and sub-industries within each sector are performing very differently – which indicates a return to a more normal stock market environment.

The Consumer Discretionary (also known as Consumer Cyclicals) sector is an example of an industry that has been rewarded for its fundamental success over the past 12 months.  As a whole, the sector grew sales 6.1% and earnings 9.2% in the 2nd quarter - much better than the 1.4% sales and 3.3% earnings growth of the S&P 500.  While the overall sector did well in the 2nd quarter, the table below shows how differently the 5 sub-categories of Consumer Discretionary performed:

As we drill down even further, sub-categories of sub-sectors differ even more dramatically.  Below is a snapshot of the Retailing sub-sector and its notable components:

Specific stocks within each sub-category are varying in performance as well.  General Merchandise retailers were significantly differentiated in the 2nd quarter.  Target’s adjusted EPS were up 6.1% from 2012, while Dollar General and Dollar Tree’s earnings were up nearly 12% and 9%, respectively.  

The differences in sales and earnings growth amongst these different industries tell a story.  The economy is not improving enough that people feel like they can let go and spend money on pure pleasures, but it is improving enough that they can afford to replace their cars and fix the doors on their houses.  As these items wear out and need replaced, we expect the pent up demand will drive increased economic activity from consumers – which will trickle down into businesses and have a very positive impact on the economy.

Will Syria Impact the Stock Market?

Political unrest in Syria and the potential for U.S. military action has created some uncertainty for investors.  In the event that military action would be taken, we would expect there to be some increased volatility in the stock markets.  However, we would expect it to be minor to moderate in its impact.

With all of the pressure to keep U.S. action narrowly limited in both time and scope, we don’t expect any market reaction to be long-lasting.  The markets have been given plenty of time to discount the potential for military action into its prices.  In addition, the companies we invest in have very little aggregate exposure to the Middle East.  Their direct business interests in that region are immaterial to their overall earnings performance.

However, military actions can have unintended and unforeseen consequences.  We remain alert to those possibilities.  In the event that there is a market drop that we judge to be temporary, we would be on the lookout for buying opportunities.

Disclaimer: Donaldson Capital Management owns shares of EMR.