He is joining me today and telling me what he is seeing in the market, and he's going to give me a stock idea for those who may have an optimistic bent.
Also when you look at bank balance sheets, they've had roughly two years worth of earnings to repair their balance sheets via accumulated earnings, and a lot of these have cut their dividends, so they are indeed accumulating those earnings. The bank balance sheets, at least at the large banks, are looking much better than they were, and they certainly have money to lend.
Larson: That's my second point, is that the corporations are actually in much better health than they were early on in the recession. They've already done their restructuring. They've got rid of the excess capacity that they had, and they've also trimmed the fat. They've pushed their existing workers exceptionally hard, and this is reflected in the profit margins, which are near an all-time high for private corporations.
And also when you look at the corporate balance sheets, these are also in aggregate in excellent condition. Cash balance levels at their highest absolute level that they've ever been. Now, some of those cash is indeed parked overseas and can't get back in to the U.S. unless they pay taxes on it, but the absolute level of cash is still very, very high, right now.
Stipp: So, corporations have cut as much as they've cut. Do you think that those margins are sustainable or if we'd see a pickup in economic activity, might they have to bring on some more expenses just to meet increasing demand?
Larson: Well I think you bring up a good point. And that is, if we do see an uptick in demand the companies are going to have to bring on more people to actually service that demand because the worker productivity is already peaking, and they can't push the existing workers much harder than they've already pushed them.
So that would mean good things for the employment market, if we do get that uptick in demand, and hopefully, we'll get the economy on more sound footing and get that engine running more smoothly. We've been in recovery for a while, but I don't think anyone would think that we are in a vigorous recovery. You know, the economic engine is running, but it's sort of sputtering right now, and it'd be nice if we saw that uptick in demand and get the economic engine of more wages, more spending, more wages, growing.
Stipp: Sure. The third point you have, Paul, this is an area that I think a lot of folks still are pretty pessimistic about, but you have a number of different sayings that you had characterized, the real estate market as today, and it's one of points of optimism. Can you explain why that is?
Larson: I think, the real estate market, you can pick metaphor, whether it's the pendulum going too far or the spring coiling, whatever you choose. I think the situation in the real estate market is indeed a reason for optimism looking forward, a lot of the bearish prognostications I see for real estate are all backward looking, and I would agree that the view out the rearview mirror is quite ugly. But looking out the windshield, it's much brighter.
And one reason for this is, when you look at the median household mortgage payment per income level of the household, and the average is right around over a long period of time, right around 23% and at the bubble, peak of the bubble, we saw this number at 35%, which was obviously too high. People were stretching their incomes way too much to try and buy as much house as they could. This has reverted all the way back down to the low-teens level in most markets. And housing affordability is at a generational high at this point in time.
Stipp: So even though housing may look like it could be more affordable for folks, what's the inventory situation looking like because I know there had been an overhang for a while?
Larson: Going into the bubble in 2008, it looked like we had about two years' worth of excess inventory that too much – too many houses that were built, and guess what? We're about two years beyond the real prick in the bubble. So, now the inventory situation is much more in line with even levels of supply and demand, but when you look at the housing production, we're actually producing about 25 to maybe one-third, the number of houses that we need to service, the growing population over a long periods of time. And that's not a sustainable situation. Eventually, the excess inventory is going to be totally gone, and that housing construction is going to have to at least triple in order just to serve the growing population that we have.
Stipp: Speaking of the pendulum, it also affects investors and investor behavior, and we're certainly seeing the pendulum swing in a certain direction right now. Could also be another reason for optimism for the stock market. Can you explain a little bit about what you're seeing there?
Larson: So, far we talked about the economy. Another reason for optimism in the stock market, and in the markets in general is, when you look at the fund flows. So far in 2010, and this is a continuation of a trend that we saw in 2009, investors have been flooding in the bond markets. We've seen fund flows in bond funds of all stripes grow at double digit rates for the better part of two years now.
While investors have been taking money out of stock funds, even recently in the month of September, fund flows in stock funds were still negative even though the stock market did exceptionally well in September.
Usually, if you bet against what the crowd is doing, you tend to do quite well. We saw the opposite of the flows in the year 2000 time period, where people were taking money out of bond funds and putting all their chips on stock funds, and we all know what the past decade has done, and now we seen the reverse of this, people putting significant number of chips on bonds and really shying away from stocks, and that is actually a positive signal for future returns in stocks.
Stipp: So, Paul, certainly it sounds like some compelling reasons for optimism, but some folks will say, every silver lining has a cloud. What are some of the things that you're worried about? What are some of the risks here to your story, and some of things that may keep you up at night?
Larson: Well, I would say an external shock to the system, a so-called Black Swan. We might have an unexpected war or a new pandemic going around the world. We just never know what's going to come out of the left field and really throw a wrench into the works.
And then also when you look at governments, I think this is still a negative, the austerity measures; we still have large budget deficits. It's not just here in the United States, but in a vast majority of countries and around the world. And so, I think higher taxes in aggregate are pretty much assured, and that's going to weigh on growth.
Also lower government spending, this is a negative in the short term because government spending does contribute to GDP and as governments reduce that spending, it's going to lower GDP growth, but I think this is actually a positive in the long run because recessions are all about creative destruction and weeding out the least efficient parts of the economy and redeploying capital to the most efficient parts, and I think we're seeing that with the government, where the governments are really getting rid of the least efficient parts of them and then hopefully, that will be a good thing for the long term.
Stipp: Paul, while I have you here, I always like to ask you for a stock pick. If you're going to look at some of the silver linings that you just outlined and have a stock that you might consider, if you buy into some of these silver linings, if you think that they could be something that could bring good results in the future, what would that stock pick be?
Larson: Well, one company that should do quite well, should we get a more vigorous recovery in the future, is Lowe's, the home improvement retailer.
Right now, when you look at the stock price, and it's been in this way for a while, the market is basically assuming that the conditions in the real estate market that we've experienced over the past three years, that those poor market conditions are going to persist in perpetuity in the future and that this company's same-store sales are never going to be in positive territory again, and that their profit margins are going to be permanently compressed.
We don't think that's the case. This company will indeed have positive same-store growth in the future and that their profit margins will rebound, maybe not to the levels that we saw in 2006, but part of the way back, and if you believe that the stock is worth $36 versus in the low $20s where it trades today.
Stipp: Well Paul, thanks for the bright spot and thanks for the stock idea. It was a pleasure speaking with you.
Larson: Thanks, for having me.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.
