Is Focusing on Productivity Productive?
More economic data was released this week pointing to an expanding economy. The ISM manufacturing survey jumped 5.8 points to 62.8, which was the highest level since December 1983. This also marked the fifth month over 50. The strength was wide spread as every component pointed to economic growth. Production jumped 5.7 points to 68.3 and new orders soared 9.4 points to 73.7. Both of these components were at the highest level since December 1983. Even employment rose to above 50, the first time since September 2000.
The non-manufacturing survey was not as strong, but still showed healthy expansion. The service sector business activity dropped 4.6 points to 60.1, remaining above 60 for the sixth straight month. Similar to the manufacturing survey, almost all components point to sustained growth in the immediate future, even employment remained over 50, for the fifth time in the past six months.
This was the first time since last December that the manufacturing survey showed more growth than the service sector. In fact, in the 77 months that both surveys have been done, there have only been five months when this has happened. This is also the first time that both surveys have been over 60 at the same time. These surveys also indicate that the service sector is staring to moderate at the same time the manufacturing sector begins to expand. Consumer spending has started to moderate from the stimulus induced frenzy this summer, but remains strong. Even thought personal spending has been down 0.3% and flat for the previous two months, these are month-over-month growth rates. Personal spending increased 5.4% in October on a year-over-year basis. While this was lower than the previous two months, it is higher than all but five months since the beginning of 2001. So consumers are slowing down a bit, but not in any meaningful way as of yet.
The kick-off to holiday sales went good, but it was not stellar. The Bank of Tokyo-Mitsubishi reported that weekly chain store sales dropped 0.1%. This includes the Friday and Saturday after Thanksgiving. Sales were still 5.6% ahead of last year, but this is the slowest year-over-year growth for the month. Estimates for holiday sales are clustered around 5% growth over last year. This would be the largest increase in four years. The consumer should not be written of yet. That has proven to be a losing bet, but it is interesting to note that as the stimulus has worn off, spending has moderated. It is also likely that this is only a hesitation as once the larger tax refund checks are received, consumers will be back in action. This could lead to a second-half slowdown next year. Retailers will report November sales on Thursday, which should shed additional light on how the holiday season is shaping up.
Also out this week was the Department of Labors revised third quarter productivity report. Productivity was revised upward by 1.3 basis points to 9.2% for third quarter. Economists love to discuss these huge increases in productivity. Unfortunately, productivity is perhaps the worst economic statistic that is reported. Not only is it nebulous on how it is calculated, but it is being used as the holy grail on why the economy can expand at a rapid rate without causing inflation. Additionally, there has been very little debate about the usefulness of the productivity data. Stephen Roach, economist at Morgan Stanley, is one of the few that as questioned this data series. His latest commentary, Productivity Paradox, focuses on how the transition to a service sector based economy complicates how productivity is calculated. Roach contends that the Bureau of Labor does not accurately calculate the number of hours professionals work and that is one way the number is skewed. The BLS calculates that average professional/manager works 35.5 hours per week. Roach says that the advent of smaller communication devices along with the internet allows workers to more easily work from home, or while traveling. He also notes that a large increase in productivity is helped by corporate layoffs that obviously reduce the amount of hours worked. He further states that an increase in productivity "is fleeting when it is driven simply by downsizing and longer hours."
While Roach touches on some important issues, but I think there is a lot more that is boosting not only productivity but the economy as well - inflation. Inflation is too often defined by the change in price of goods. When if fact inflation is the increase in the amount of credit or money. One way inflation can be experienced is by an increase in consumer prices. But it can also be seen through an increase in the trade deficit or a rise in asset prices. Another outlet is though substitute goods. Instead of brewing coffee, consumers can choose to go to Starbucks and get a café latte. This is essentially spending more money for just about the same item, or to keep the purchase at the same retail establishment, a switch from buying coffee at Starbucks to a café latte. Interestingly, this would also increase productivity. Since a café latte is roughly twice the cost of a cup of coffee, this change increases the Starbuck's workers productivity. Also since it takes a little longer to make a latte, productivity per drink actually drops.
While I'm on a soapbox, recent valuation analysis is starting to drive me nuts. Analysts typically use a historical average PE to give investors a relative basis on whether the current valuation is cheap or expensive. Far too many analysts are hastily using five-year averages as justification that stocks offer good value. The problem is that the past five years includes one of, if not the biggest equity bubbles ever. These periods should not be included in what the average historical PE is since it is doubtful that valuation multiples will ever get that lofty again. By using just the last five years as the relative base, of course equities would look inexpensive now. The trailing 12-month PE for the S&P 500 is currently around 20. This looks low when compared to the five-year average of 24, but is much more expensive if compared to the average PE over the previous fourteen years, which is 20. By excluding the bubble years, 1998-2001, the average drops to 18. By using 18 instead of 24 as a base for analysis, the level at which the S&P 500 is trading at an historical average valuation drops from 1,300 to 974, which means the market is slightly overvalued instead of undervalued. This also assumes that corporate earning growth will continue to grow at historical rates. This is also happening regarding valuation targets on individual companies. In the sprit of giving praise when praise is due, Katherine Styponias, analyst for Prudential did just that. She excluded the valuation multiples from 1998-2000 when calculating Viacom's historical PE ratio. Here is the part of the research report that mentions the valuation analysis:
Based on our historical valuation compilations (1992-1997 plus 2001 and 2002; we've excluded the bubble years of 1998-2000), Viacom has traded at an average of 9.8 times enterprise value (EV) to forward EBITDA on the low end of the range and at an average of 14.7 times at the high end. Based on Friday's close, the VIA.B shares are trading at 10.6 times our 2004 EBITDA estimate of $6.7 bil. Assuming that the shares could reach the average low of 9.8 times, it would imply a price of $34.50 or 9% downside risk from current levels. Our $49 price target assumes the VIA.B shares could get to a 13.5 multiple, implying upside of 30% from current levels.
Staying atop my soapbox, a few market commentators are offering up a solution to the late-trading of mutual fund by doing real-time pricing for investors to purchase at any time throughout the day. While on the surface this sounds like it would solve the problem, it would actually hurt long-term investors. The biggest way mutual fund times hurt the long-term investors in the mutual funds was by diluting those shareholders. Here is a simple example. A mutual fund has assets of $100 million with 10 million shares out, which gives a net asset value of $10.00. Then there was an event after the market closes, which causes the market to rise 10% the following day. The fund increases to $110 million and the NA rises to $11.00. Now, a hedge fund was allowed to purchase $10 million after the close. This increases the assets to $110 million and the number of shares to 11 million. Unfortunately, the mutual fund manager was not able to invest those additional assets and is only 91% invested ($100 million / $110 million). Now when the market rises by 10%, assets rise to $120 million (remember the $10 million from the hedge fund does not participate) and with 11 million shares outstanding the NAV is $10.91. The nine cent shortfall is how the long-term investors were hurt. If mutual funds are required to publish an NAV in real-time for whenever an investor wants to buy or sell the fund, it would exacerbate these problems as mutual fund managers would constantly have to be trading the fund to invest or raise cash resulting for subscriptions or redemptions. It seems much easier if the current rules were simply enforced. Additionally, mutual funds are intended for longer term investors who should be less worried about whether their order was filled at 11:30 or 1:30. For those that do want to "trade" there is a whole host of exchange traded funds (ETFs) for traders to pick and choose from.