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Can We Review The Bidding?

I don't play bridge, and I confess that I know precious little about the game, but I am told that in friendly games at least, during the play of a specific hand a player can always ask for a review of the bidding up to that point. Presumably, the information gained helps to plan strategy going forward. With the Standard & Poors 500 Stock Index at an all-time high and after a four year run now approaching 1600, it might be productive to do the same as part of an effort to plot an investment game plan from this point on. Looking back a few years at the various factors that have impacted stock prices might offer some insight into how stocks might respond to future developments.

Ever since the financial crisis and the many scandals in 2008-9 investor fears and lack of conviction have been as bad as at any time since the 1930s. In this environment the cacophony of extraneous "noise" has often drowned out the "signals" from an improving US economy with steadily rising corporate earnings. There is always a "wall of worry" that stock prices have to climb, but in recent years the bricks in this wall have been so numerous and often so frightening that it has been all too easy for individual and institutional investors to be scared out of their equity positions or to refrain from participating in the first place. The 24-hour news cycle, especially the financial news media, has trumpeted various macro worries, including recessions and financial crises abroad, fiscal deficits and political dysfunction at home and geopolitical fears of all sorts, so loudly that even seasoned investors lose sight of the most fundamental principle that governs equity values, namely the trend of corporate profits. The focus of the media with its instant (and often wrong) analysis seems to be aimed only at day traders, not investors, and as a result the hysteria surrounding short-term economic reports allows them to be blown way out of proportion to their actual impact on long-term corporate profitability.

In recent months investors have panicked over our unsustainable fiscal deficit, the dysfunction in Washington, the payroll tax restoration, higher tax rates and Obamacare issues, the much exaggerated impact of the fiscal sequestration, the many ups and downs in the European economies, financial and currency markets, and banking system, whether or not China is growing, as well as any little wobble in the high frequency economic data. Through all of this, the S&P 500 Index has more or less steadily recovered from the bear market low of March 2009 and now stands roughly 140% higher, with many individual shares having substantially outpaced the Index itself.

There is no doubt that the extremely accommodative monetary policies of the world's central banks have played the major role in supporting the current bull market, not only driving interest rates to record lows but also through various transmission mechanisms which have stimulated at least modest economic growth in the face of continuing fiscal drag. Bear in mind that the private sector in the US has been growing at better than a 3% rate for quite some time. Corporations have rationalized their cost structures, strengthened their balance sheets, entered new markets and are deploying their increasing cash flows to buy back stock and to boost dividends, yet the overall payout ratio is still at a near record low of just over 30%. Brisk merger and acquisition activity tells much more about management's confidence than the latest macroeconomic figures, though admittedly, many acquisitions are motivated by a desire to increase revenues in a slow growth environment. Throughout all of this, the majority of investors, still paralyzed by memories of the credit collapse and the scandals, as well as the unprecedented volatility of the equity markets, continue to accept negative real returns in the bond market, which is still regarded as a safe haven. In that regard, the minutes of the FOMC's mid-March meeting should give bond holders fair warning that the current ultra-easy monetary policy is likely to end sooner than most expect. There is no doubt that even a modest change in the Fed's stance will prompt a significant short term correction in stock prices, but as long as the economy is in a self-sustaining expansion, this should provide an entry point for the vast amount of cash still sitting on the sidelines.

Assuming S&P earnings of $110 this year, equities in the aggregate are valued at about 14.5 times these results and offer a 6.9% earnings yield, no longer deeply undervalued but certainly no worse than fairly priced, particularly when measured against BBB bond yields of about 5.0%. Nonetheless, committing new cash or refocusing the portfolio of a new client has become a more difficult task. It is no longer possible to simply throw darts at name brand companies selling at cheap valuations in the hopes for a profit recovery and some P/E expansion. In order to achieve worthwhile investment returns from this point forward one must apply stricter criteria to individual stock selection. We believe strongly that the US economy is in the early stages of a multiyear expansion powered by favorable demographics, lower cost energy leading to more competitive manufacturing, and the approach of energy self-sufficiency. These factors all lead to increased employment and incomes and support higher demand for housing, automobiles, high-tech capital equipment and gradual rebuilding of the country's physical infrastructure.

At this point, we are particularly attracted to those companies that in the past have not only demonstrated an ability to consistently execute a growth strategy, but in addition, have recently outlined a path for higher revenues, profit margins and per share earnings over the next several years. These companies articulate a growing addressable market as well as a strategy for gaining a profitable market share. Most large companies give guidance in their quarterly reports and conference calls for only one quarter ahead or, at best, for the remainder of their current fiscal year. The game they play is to lower investor expectations for the next quarter in order to beat the consensus and in doing so give their stock prices (and their options) a boost. Beating the consensus for quarterly earnings per share by one or two cents is hardly a strategy for consistent extended term growth. At this stage of the cycle the biggest risk to equity valuations generally, or in any specific company, is a compression of profit margins. Companies that are planning mainly for short term results are the most vulnerable. Companies that are not only reasonably valued but are willing and able to articulate a growth strategy for several years ahead, not merely the next quarter, are harder to find, but fortunately our persistence has been rewarded and should enable our clients to withstand the next market setback without panicking at just the wrong time.