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Through The Looking Glass

At this writing the Standard & Poors 500 Stock Index is on its way to the best January performance since 1994. Daily stock exchange volume continues to be anemic because an entire generation of investors has abandoned equities for the perceived safety of bonds. Mutual fund redemptions approached $150 billion in 2012, although there has been some inflow into equities in January reflecting normal beginning-of-the-year reinvestment flows and perhaps a reaction to the move-up in the 10-Year Treasury yield, which is now approaching 2.0%. Nonetheless, a number of Wall Street pundits are predicting a disappointing 2013 with profits falling short of expectations and stocks expected to decline for the year. We don't pretend to forecast either the economy, corporate profits, interest rates or the stock market indexes. To the extent our clients entrust us to manage a portfolio of equities we try to find attractive situations on a bottom-up basis to gain exposure to what we perceive to be long-lasting, overarching investment themes, such as the pent up demand for new autos, a recovery in residential housing, the drive toward energy self-sufficiency, the renaissance of American manufacturing and export competitiveness; and, of course, many areas that benefit from the aging of the population.

The current consensus expectations for S&P 500 profits are, in round numbers, $100 for 2012 and $110 for 2013. Whether or not these forecasts prove correct is not of great importance except to note that at today's 1500 on the S&P Index the forward P/E would be about 13.6 times forecast results, with an earnings yield of 7.3%, which is more than 250 basis points above BBB bond yields. On the other hand, it is worthwhile to note that equity valuations expanded by about two multiple points last year, and even if the optimists prove to be correct, the overhang of uncertainty stemming from a dysfunctional US government as well as various geopolitical risks around the world, is likely to limit further expansion of valuations. Stocks are no longer enjoying a sharp rebound from deeply undervalued levels brought about by the financial crisis and the ensuing recession. Moreover, interest rates appear to have bottomed after a 30-year bull market, and without doubt as the employment picture strengthens, the Fed is likely to begin gradually to withdraw its extraordinary provision of liquidity. For example, if the country were to begin creating 200,000 jobs per month in what appeared to be a sustainable trend, the current QE3 program, which purchases $85 billion per month of Treasuries and mortgage-backed securities, would likely taper off. The old saw, "The Federal Reserve Board always writes the market letter," would be acknowledged by at least a short correction in the market's uptrend. This would by no means be the end of a bull run, but even periods of consolidation can be painful.

Given our view that stock prices are likely to do little more than track aggregate earnings this year we believe 2013 will be one in which significant investment outperformance will be achieved via ownership of a potpourri of "special situations." These come in many shapes and colors, to wit: companies developing a "new, new thing" that is truly disruptive; companies riding the crest of strong macro themes as mentioned above; companies undergoing a significant change in management; companies breaking up into more than one entity to maximize shareholder value; companies selling or spinning off non-core assets to enhance productivity, and companies exiting bankruptcy. For the most part, the managements of these entities are seriously interested in creating a higher shareholder value, including, of course, the worth of their own stock options. Many times these special situations are hiding in plain sight and are often rejected by investors due to lingering memories of a poor past record. But they are around, and many activist funds are constantly on the prowl for these opportunities.

As long as the macroeconomic backdrop is favorable, indeed improving, as long as financial market liquidity remains abundant with forecast earnings yields well above bond returns, the trend of the market will likely remain up, and setbacks caused by exogenous factors will prove to be attractive entry points for latecomers.

The biggest risk for the year ahead, in our judgment, would be a compression of profit margins. Recent results for many high quality companies highlight this concern, which will likely persist as long as domestic economic growth is below 3% in real terms. Thus, to the extent that there may be only limited headroom in terms of valuation expansion, the case for special situations, as opposed to companies whose success is driven largely by macro factors, is made even more compelling. That said, the remainder of this bull market will require longer holding periods for new investments to provide worthwhile returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.