U.S. stocks had a lackluster 2006. It may seem churlish to say this, with the Dow Jones Industrial Average breaking a six-year-old record and rocketing above 12,000 and the Nasdaq Composite index finally touching the halfway mark of its March 2000 level. But in relative terms, the 10 percent to 16 percent gain for major Wall Street indices shone only when compared to the Japanese bourse. Stock markets in the euro-zone, Central Europe, Asia and Latin America mostly outperformed U.S. markets for the second year running — some by a very wide margin.
Moreover, many market analysts and financial advisors believe that 2007 could prove a difficult year for stock investors. The Advisor Confidence Index compiled by AdvisorBenchmarking.com, a subsidiary of Rydex Funds, has been losing ground in recent months. True, the U.S. Federal Reserve has stopped raising its interest rates, and oil prices have softened from record levels seen in mid-2006. But analysts see risks to economic growth, especially if there is more turbulence in the real estate market affecting consumer confidence.
Yet Wall Street began January on an upbeat note. There are reasons to believe that this is not an aberration but the start of a solid rally lasting well into 2007. It is the longer term that could present greater difficulties.
Mountains of Cash
It is no secret that profits in the U.S. corporate sector have been growing at a breakneck pace. Earnings in the non-financial sector have been increasing by 10 percent or more on a year-on-year basis every quarter since mid-2003. Earnings at companies comprising the S&P 500 index rose 18 percent in the third quarter 2006. Profit margins stood at 11.8 percent, their highest level since 1951, when U.S. industry was working flat out to satiate demand from post-World War II reconstruction in Europe and Japan.
By all measures, profit growth has been running ahead of all other gauges of economic growth. Earnings before interest, tax, depreciation and amortization (EBTIDA), the favorite among stock analysts, grew by about 40 percent since hitting bottom in 2002. Earnings per share, meanwhile, have more than quadrupled.
More to the point, net profits now stand at 8.5 percent of GDP, the highest share since World War II. This means that not only have profits grown substantially, but they have increased at the expense of other sectors of the economy.
While earnings in the U.K. have been growing by a similar margin, and in Europe and Japan even faster, profit growth in those countries has accelerated only recently. What is extraordinary about the pace of profit growth in the United States is how long it has been sustained.
In fact, a key reason why equity analysts have been bearish on the stock market is the fear that the period of rapid profit growth has come to an end. However, even if profit growth does slacken, another factor is likely to bolster stock prices. It is the unprecedented amount of cash that has accumulated on corporate balance sheets.
Non-financial companies in the S&P 500 index now hold nearly $700 billion in cash, double the amount only five years ago. Some companies pack so much cash they could probably be reclassified as mutual funds. Google (NYSE:GOOG), for example, is sitting on a cache measuring over $10 billion. According to a recent report in The Wall Street Journal, the increase in interest income contributed 2 cents to its third-quarter earnings per share growth, or around 10 percent.
The list of other cash-rich companies includes such names as Exxon (NYSE:XOM), 3M (NYSE:MMM), Black & Decker (NYSE:BDK) and Colgate-Palmolive (NYSE:CL). In fact, 8 percent of the market value of the largest U.S. non-financial companies comes from their cash balances.
Initially, U.S. companies were repairing their balance sheets after the scary economic downturn in the early 2000s. But in 2006, they already started to make use of their cash in the form of growing merger and acquisition activity. According to Dealogic, a capital-markets information systems company, the value of announced M&As last year set a record, surpassing $4 trillion. In the United States alone, over 7,200 deals were announced, valued at $1.54 trillion. Cash-only deals, which accounted for three-quarters of all M&A activity, were driven by hedge funds, of course, but companies were also spending their cash troves rather then using their shares to buy rivals, as they did during the previous merger craze in the late 1990s.