Here's a huge surprise: Americans went shopping on Friday. Economists everywhere were caught flatfooted as consumers flooded the malls and spent 7.2% more over Black Friday weekend than they did last year, according to the National Retail Federation.
After weeks of solidly negative headlines and progressively gloomy forecasts, shoppers headed out Friday to buck expectations, and they surely did. After reports showing real consumer spending dropping 0.5% in October, the fifth consecutive monthly decline, prospects for Black Friday looked dark indeed. Instead, the American consumer, who may actually lack for alternative entertainments having foresworn board games and touch football years ago, came through in grand style. What should investors read from this turnaround?
One conclusion comes from portfolio manager David Giroux of the venerable money management firm T. Rowe Price (NASDAQ:TROW), who said at a press briefing last week in New York, "Most predictions about the future are based simply on extrapolations of current trends." He is so right. It is a rare projection that does not simply carry today's circumstances forward. If oil prices are rising, they will surely go to $200 a barrel; if they are falling they will drop to $40. If house prices are going up, they will always go up; if they are collapsing, they will collapse forever.
Correctly calling a turn is so rare that an individual like hedge fund manager John Paulson can make billions -- literally billions -- by correctly anticipating and acting on a reversal in the previously buoyant mortgage-backed securities market. This is a serious investment insight, because with the sheer volume of economic news being thrown at us these days, it is pretty hard to clear your head of groupthink. That's especially true when the media clearly benefits from creating the most alarming possible headlines. Stories entitled "Most people still have jobs" aren't nearly as catchy as "Job losses soaring."
Still, the consumer's pluck is not only to be admired, but also needs some explanation. It may be that, like investors in recent days, consumers simply decided that in the words of Brian Rogers, T. Rowe's Chairman and Chief Investment Officer, "Statistically speaking, the world does not end that often."
T. Rowe Price, founded in 1937, has pretty consistently over the years outperformed its rivals. T. Rowe opinions, therefore, are of value. The company manages around $345 billion, of which roughly 60% is invested in U.S. equities. Half of the funds come from institutions, the other from individuals. According to the company, more than 80% of its funds beat their Lipper peer group averages for the three- and five-year periods that ended Sept. 30, while 79% have done better than their rivals over 10 years.
Benefiting from this performance, shares in T. Rowe Price climbed by a market-thrashing 7% annual average during the past five years. Currently selling at about half its high hit last year, the stock is reflecting the expected loss of earning power suffered by money management companies like Legg Mason (NYSE:LM) and Franklin Resources (NYSE:BEN) as assets under management decline. But T. Rowe has no debt, with cash reserves and investments of about $1.5 billion. Its funds under management are down from a peak level of roughly $400 billion, entirely because of market losses. (I should admit here that as a longtime equity analyst I also love this group for employing 153 analysts around the world! Who says research is dead?)
The team at T. Rowe offered up a review of various markets that basically had this in common: when everyone is relentlessly pessimistic, it's a good time to look for value. The overview types at the company believe that the Fed programs are gaining traction, and that all-important housing will bottom next year. Like others, they consider the sharp drop in oil prices to be akin to a massive tax cut and they think Americans are optimistic about Barack Obama's ability to improve the economy. It was noted that this expectation may be more important than whether or not the President-elect actually can turn things around. (Expectations and sentiment are key, as the final motivator of shoppers as well as investors.)
Various stimulants to the market include a probable pickup in corporate deal activity next year, since share prices are so low, and the normal discounting mechanism, which will tend to lead the market higher in advance of the economy. It should be noted that the firm's economist Alan Levenson is appropriately gloomy, citing "aggressive consumer de-leveraging" now under way and looking for GDP shrinkage of 4.5% this quarter and a subsequent drop of 1% to 1.5% in the first three months of 2009. He is forecasting unemployment of 8.4% next year, and slightly higher in 2010. However, beginning in the second quarter of next year Levenson looks for comparisons to turn flattish and by the fourth quarter expects real GDP to be up 0.7%.
Giroux, who manages the Morningstar-rated four-star Capital Appreciation Fund (PRWCX), said that the collapse of Lehman Brothers in September and subsequent market drama led to a "step down" in consumer behavior, including a drop in auto sales, as well as to accelerated job losses and reduced spending projects. The good news is that November did not see a similar step down. (In my view, recent retail activity confirms this.) Giroux pointed out that weakening fundamentals have been compounded by some $500 billion in forced stock sales by hedge funds. He further said there is a lot of cash on the sidelines, with the percentage of assets in money market instruments hitting an all-time high. His conclusion? Valuations today are compelling, with the S&P 500 selling at 13 times trough earnings, excluding financials, and with stock yields at an all-time high.
So what are the domestic equity managers at T. Rowe Price doing? According to Giroux, they are investing in early cycle stocks, including media and cable companies. They are also adding select retailers with solid balance sheets, and especially those they deem capable of adding to market share like Kohl's (NYSE:KSS) and Best Buy (NYSE:BBY). They are also overweighting industrial stocks that "are trading at trough multiples on perceived worst-case earnings in 2009." They also find utilities attractive, which have not held up as well as they have historically in bad times; they are especially focused on "nuclear-exposed utilities with non-regulated generation assets." At the same time they are underweighting normally safe-haven stocks like health care and consumer staples because of relatively rich valuations, "decelerating international growth and foreign exchange headwinds."
