Although high budget deficits, subsidized interest rates and a significantly expanded Federal Reserve balance sheet (through quantitative easing) continue to be concerns, it is interesting that excess liquidity is being drained from the financial system. The US economy is showing signs of life. Manufacturing is growing nicely. But one important measure of liquidity is not. Inflation adjusted M2 (real M2), one of the leading economic indicators, has flattened after rising sharply in 2008. When we divide real M2 by industrial production, we have a measure of excess liquidity to fund asset purchases. After spiking in 2008 into 2009, it is now starting to trend downward. The declining trend in excess liquidity will likely pressure P/E ratios and frames our outlook for stocks and sector preferences.
It is no secret that the US economy is consumer driven. Consumer debt started rising in the early 1980s when interest rates began their secular decline. But in the 1990s, consumer spending generally grew proportionately with wage and salary compensation. During the most recent decade, consumer spending grew more rapidly than compensation. Tax cuts and debt financed spending pushed the spending to income ratio into the stratosphere (over 130%). In the last 2 years, additional tax cuts and significant increases in government transfer payments replaced borrowing as the primary reasons consumers were able to keep spending more than their compensation. In 2009, employee compensation declined 3.2%. Personal consumption declined by only 0.5%.
Looking ahead, high debt levels, high energy prices and scheduled increases in taxes will limit consumer spending. Consensus estimates for revenue growth appear optimistic. Although many are anticipating a cyclical rebound, we still favor consumer staples over consumer discretionary stocks. Keep in mind, though, that a strong dollar will negatively affect revenue growth in many names in the consumer staple sector that serve international markets. We still favor the sector because valuations are cheaper than the broader market and dividend yields are higher, a healthy combination.
Energy prices have been volatile in recent years. Prices are now at mid-year 2007 levels after spiking, crashing and climbing again. Oil is still expensive, maybe because it is now held as part of a commodity asset class in many portfolios. Consensus estimates for increasing oil prices are suspect, particularly if US household consumption does not increase. We favor international companies that pay attractive dividends and have strong exploration and production capabilities. Energy does act as a counterweight to geopolitical risk factors.
As consumers reduce their debt obligations, banks will be forced to right size their balance sheets. Outstanding bank loans to GDP have fallen somewhat but must decline considerably before they reach healthy historical norms. While the steep yield curve favors banks, earnings expectations still seem to be on the high side. We like banks with clear advantages in executing mergers, in securities processing and in asset management.
Health care promises to command increasing consumer dollars. Uncertainty in health care reform has created some interesting opportunities in the sector, particularly in medical devices and biotechnology. Although dividends are meager, both have outperformed the S&P 500 and the health care sector this year. Pharmaceuticals have disappointed.
Interestingly, there is a good correlation between payroll employment and spending on technology equipment and software. Technology spending declined 7% last year. Spending on technology has turned up as employment has bottomed. Also worth noting is that many of the large US based technology companies have a high percentage of their sales in Europe. Progressive dollar weakness last year boosted revenue and earnings. Dollar strength in 2010 will be a headwind. We are looking at semiconductors. Forward P/Es are reasonable and the industry has a high exposure to Asian economies.
In an environment of declining excess liquidity, with the resulting pressure on earnings multiples, lack of consumer purchasing power and consensus estimates that may prove to be high, the challenge is to invest in stocks with genuine prospects for earnings growth. Investing in a US market index may prove disappointing.