The Dow Jones Index climbed again today, closing above 13,000 for the first time, as equities continued their torrid run for the month. Helped by by an extremely impressive run of earnings reports, the stock market has gained back all of its losses from February, and continued to perform well. The S&P 500 index, which is a broader measure of the market, closed the day at 1495.42, up 1.01% on the day's trading.
What should we make of the recent run up? Well, I think much of what we're seeing is a reflection of the excellent run of earnings reports we've seen over the last two weeks. The expectations by many analysts for first quarter earnings was very tepid, to say the least. Companies had been experiencing double-digit profit growth for the last couple years, and the expectation was for the general slowing of the economy, combined with the slowing housing market to produce earnings growth in the low single-digit percentages for growth. But, what we have seen are some extremely impressive reports.
Without going into too much detail, I think the strength in corporate profit is being driven by several factors. First is the continued expansion of the global economy which is providing a continued demand for products and services form U.S. multi-national firms. When you combine this with the weaker dollar, what we have is the perfect environment for a multi-national firm. Simply, a firm based in the U.S. is seeing increasing sales in a foreign country, and then converting those cashflows into dollars. Because the foreign currency has appreciated versus the dollar, those cashflows are translated into higher dollar cashflows. While this may be beneficial in the short-term, the long-term implications are not as rosy. A depreciating dollar will mean investors are less incented to move capital into the U.S. and purchase assets, lowering demand for dollar-denominated assets.
A second reason, is driven by purely technical factors. Companies have been increasing share buybacks as a form of distributing capital to shareholders. When a company repurchases its shares, it lowers the amount of outstanding shares, therefore spreading the amount of earnings over a smaller base of shareholders. Obviously this will drive the price of those shares up. This is another situation where it has the short-term benefit of increasing share prices, but at the expense of long-term growth. If a company is repurchasing shares what it is essentially saying is that it does not see opportunity to invest that capital in projects, or R&D, that will provide sufficient returns to shareholders. This will translate to lower capital spending by firms, resulting in less growth and less innovation.
Further reducing the amount of outstanding shares is the boom of private-equity deals. These deals are simply transactions where a group of private investors buys out a public company, usually by taking on a high amount of debt. The new owners then cut costs, and hope to increase margins and returns so they can sell the company a few years down the road for a large premium. The wealth of these transactions has taken a huge amount of stock off of the exchanges, resulting in a decrease in supply of shares, and thus providing price support to the market.
So, what should you make of all this? Well, enjoy the recent run wile it lasts. There are some factors that are driving this great short-term performance, which could have negative consequences for the long-term. I recommend taking a long position in Vodka and Olives.
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