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Morningstar's Paul Larson sees reason for optimism in liquidity trends, improved corporate health, and housing.
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Four Reasons for Optimism and One Pick for Stock Investors
Stock Investing with Paul Larson
Jason Stipp: I’m Jason Stipp for Morningstar if dim and gleam headlines have got you down recently. Morningstars Paul Larson has a few reasons for optimism for you to consider. He’s joining me today and telling me what he’s seeing in the market and he’s going to give me a stock idea for those who may have an optimistic bend. Thanks for joining me Paul.
Paul Larson: Thanks for having me again.
Jason: So first question for you there does seem to be what you called a drought of optimism for several different reasons but you also see some points of optimism out there that maybe people could hang their hats on. What are some of the things that you’re seeing?
Paul: Right one reason for optimism is the liquidity that we have in the market in late 2008 we obviously had a liquidity drought the credit markets freezing. We’re well beyond that today. We have a flood of liquidity yet again much like we had in 2006-2007. This is evidenced by the very low rates that we’re seeing on offer with both treasuries as well as corporate bonds corporations being able to come to the bond market and sell debt at very, very low rates is evidence of the excess liquidity that we have floating around and also when you look at bank balance sheets they have had a roughly 2 years worth of earnings to repair their balance sheets via accumulator earnings and a lot of these have cut their dividends so they are indeed accumulating those earnings and the bank balance sheets we just took the large banks are looking much better than they were and they certainly have money to lend.
Jason: So corporations obviously finding it a little bit easier than to tap the bond markets to get funding that way but just a generally corporations are looking at a bit more healthy now than they were during the crisis before the crisis. They’ve done some you know— they gotten a bit lean and mean right?
Paul: Yeah that’s my second point is that the corporations are actually in much better health than they were early on in their recession. They have already done their restructuring. They got rid of the excess capacity that they had and they’ve also trim the fact. They’ve pushed their existing workers exceptionally hard and this is reflected in the profit margins which are near an all time high for private corporations and then also when you look at the corporate balance sheets these are also in aggregate in excellent condition.
Cash balance levels at their highest absolute level that they’ve ever been. Now some of this cash is indeed parked overseas and they can’t get back into the U.S less they and they pay taxes on it but the absolute level of cash is still very, very high right now.
Jason: So corporations of cut as much as they have cut do you think that those margins are sustainable or if we would see a pick up in economic activity might to have to bring on some more expenses just to meet increasing demand.
Paul: Yeah well I think you bring up a good point and that is if we do see an uptake in demand. The companies are going to have to bring on more people to actually service that demand because there are already the work of productivity is already peaking and they can’t pus the existing workers much harder than they’ve already pushed them and so that would mean good things for the employment market if we do get that uptake and demand and hopefully we’ll get the economy on more sound footing and get that engine running more smoothly.
We’ve been in recovery for a while but I don’t think anyone would think that we’re in a vigorous recovery you know the economic engine is sort of it’s running but it sort of sputtering right now and it would be nice if we saw that uptake in demand and get the economic engine of more wages, more spending, more wages growing.
Jason: Sure. The third point you have Paul this is an area that I think a lot of folks still are pretty pessimistic about but you have a number of different sayings that you have characterized a real estate market as today and it’s one of your points of optimism can you explain why that is?
Paul: Right, well I think the real estate market you can pick your metaphor whether it’s the pendulum going too far or the spring coiling whatever you choose I think the situation, the real estate market is indeed a reason for optimism looking forward a lot of the various prognostications I see for real estate are all backward looking and I would agree that the view out the rear view mirror is quite ugly but looking out the windshield it’s much brighter and one reason for this is when you look at the median household mortgage payment per income level of the house hold and the average is right around over long periods of time right around 23% and at the bubble, peak of the bubble we saw this number at 35% which is obviously to high people were stretching their incomes way too much to try and buy as much houses as they could.
But this is reverted all the way back down to the low teams level and most markets and housing affordability is at a generational high at this point of time.
Jason: So even the housing it look like it could be more affordable for folks. What’s the inventory situation looking like because I know they had been an overhang for a while?
Paul: Right going into the bubble in 2008 it looked like we had about 2 years worth of access inventory that too much, too many houses that were built and guess what we’re about 2 years beyond the real prick in the bubble and so now the inventory situation is much more in line with even levels of supply and demand, but when you look at the housing production we’re actually producing about 25 to maybe 1/3 the number of houses that we need to service the growing population over long periods of time and that’s not a sustainable situation.
Eventually the excess inventory is going to be totally gone and that housing construction is going to have to at least triple in order just to serve the growing population that we have.
Jason: Speaking of the pendulum it also affects investors and investor behavior and we’re certainly seeing the pendulum swing in a certain direction right now could also be another reason for optimism for the stock market can you explain a little bit about what you’re seeing there?
Paul: Right, yeah so far we talked about the economy, another reason for optimism in the stock market and in the markets in general is when you look at the fun flows. So far in 2010 and this is a continuation of a trend that we saws on 2009 investors have been flooding in to the bond markets we’ve seen fund flows in the bond funds of all stripes grow at double digit rates for the better part of 2 years now while investors have been taking running out of stock funds even recently in the month of September fun flows and stock funds are still negative even though the stock market did exceptionally well in September.
Usually if you bet against what the crowd is doing you tend to do quite well. Now we saw the opposite of the flows in year 2000 time period where people were taking money out of bond funds and putting all their chips on stock funds and we all know what the past decade has done and now we’ve seen the reverse of this people putting significant number of chips on bonds and really shying away from stocks and that is actually a positive signal for future returns in stocks.
Jason: Certainly it sound like some compelling reason for optimism but some folks will say the server lining has a cloud and what are some of the things that you’re worried about. What are some of the risks here to your story and some of the things that may keep you up at night?
Paul: Right well I would say external shock to system as a so called black swan. We might have an unexpected war or a new pandemic going around the world. We just never know what’s going to come out of the field and really after wrench into the works and then also when you look at governments I think this is still a negative. The osterity measures, you know when you still have large budget deficits not just here in the United States but in the vast majority of countries around the world and so I think higher taxes in aggregate are pretty much assured and that’s going t o weigh on growth.
Also lower government spending this is a negative in the short term because government spending does contribute to GDP and as government’s reduce that spending it’s going to lower GDP growth but I think this is actually a positive in the long ruin because recessions are all about creative destruction and weeding out the least efficient parts of the economy and redeploying capital to the most efficient parts and I think we’re seeing that with the government where the governments are really getting rid of the least efficient parts of them and then hopefully that will be a good thing for the long term.
Jason: So Paul I have you here I always liked to ask you for stock pick. If you’re going to look at some of the several lines that you just outlined and have a stock that you might consider if you buy in to some of these silver lines if you think that they could be something that could bring good results in the future what would that stock would be.
Paul: Right well one company that should do quite well should we get a more vigorous recovery in the future is a lows the home improvement retailer right now when you look at the stock prices has been this way for a while the market is basically assuming that the conditions in the real estate market that we’ve experienced over the pat three years at those poor market conditions are going to persist in perpetuity in the future and that this companies seems to our sales are never going to be in positive territory again and that their profit margins are going to be permanently pressed, we don’t think that’s the case that this company will indeed have positive store growth in the future and that their profit margins will rebound maybe not to levels that we saw in 2006 but part of the way back.
And if you believe that the stock is worth 36 versus in a low 20s for trades today.
Jason: Well Paul thanks for the bright spots and thanks for the stock idea. It was a pleasure speaking with you.
Paul: Thanks for having me.
Jason: For Morningstar I’m Jason Stipp, thanks for watching.