Keep Your Eye On The Ball

by: Rick Lear

Fundamentals Vs. Fear -

Worry About Your Worries

The members of our Portfolio Management Team coach two baseball teams, two soccer teams, one T-ball team and one basketball team for our collective young children. Thus, we find ourselves stressing the basics. Learning the fundamentals of how to catch a pop-up will eliminate some of the fear of getting hit in the face. In 2012, we found many parallels to the capital markets as our portfolios posted high double digit returns in the face of fear. Fueled by the media, bad memories and political shenanigans, many investors took their eye off the ball and missed another great year of wealth creation in the capital markets.

Auld Lang Syne - Should Old Acquaintance Be Forgot…

This song, written in 1788 by Scotsman Robert Burns, is traditionally played at the stroke of midnight on New Year's Eve. At SWM, we thoroughly enjoy the process of penning our year-end letter. We discuss the events in our lives as they relate to events in the capital markets -- giving merit to the highs, cursing the lows and making sure we learn from both -- and no acquaintances are forgotten. Part of our process is to review our past year-end letters to make sure they are worth the paper they were printed on. (Our past musings can be read at We realize this is a humbling business, but also feel it's appropriate to highlight the results of our hard work and thoughtful research. The following are some highlights of our research opinions from last year -- based on the fundamentals, and not fear.

-Stocks outperform bonds (we believe this trend will continue in 2013).

-Homebuilding industry rebounded, and the sector was one of the best performing in the stock market -- Consider an ETF like iShares Dow Jones U.S. Home Construction (BATS:ITB) to invest in homebuilders.

-Corporate spending on technology increased, and so did the price of the tech stocks -- look to the First Trust NASDAQ-100-Tech Index ETF(NASDAQ:QTEC) for an equal weighted index to remove large APPL bias, and the Technology Select Sector SPDR ETF (NYSEARCA:XLK) to include AAPL with a 17% weighting.

-Germany thrives on weak euro -- Investors can gain exposure to the second-highest returning developed country in the world in 2012 via the iShares MSCI Germany Index ETF (NYSEARCA:EWG).

-Volatility caused by global hedge funds and computer programs continued.

-Low yield on bonds will drive money to equities (look for floating rate closed end funds like the Invesco Senior Income Trust (NYSE:VVR) and the Nuveen Credit Strategies Income Fund (NYSE:JQC).

-This current decade has high probability of being profitable for stocks.

Globe Trotting - Technology Continues To Shrink The World

In 2012, an estimated one third of the world (over two billion people) now has access to the internet. The summer Olympics served as a further reminder of how the world is connected, as did the returns of the global capital markets. In the U.S., the resilience of our stock market and our economy was on further display after super storm Sandy and the "Fiscal Cliff" failed to hold down our nation. We hope the phrase "Fiscal Cliff" will soon be forgotten.

Das ist Gut ("This is good" in German) - As predicted in our previous letters, the European Union remains intact and the financial crisis on the other side of the pond did not take down the global economy. In last year's letter, we discussed our investment in Germany. It was the second-best performing developed country in 2012. In the emerging world, China seems to have engineered a soft landing and looks to grow around 7.5% per year, while India will grow at a rate of 6.5% annually. The emerging markets continue to fuel growth around the world as the largest demographic shift in the history of mankind occurs, with over one billion people making their way above the poverty line in the coming decades. Once over the poverty line, one tends to improve their eating and transportation and increases overall consumption of goods and services.

Best Kept Secret - Valuations Matter

Let's review the fundamentals of stock valuation to discuss the current state of the stock market.

Earnings - When purchasing a stock, you are buying a stream of future earnings. The earnings of the S&P 500 in 2011 were the highest in history at over $96. That record did not last long, as 2012 is forecast to be in the $100 range. The consensus estimates for 2013 is $112. Despite all of the events of the year, many companies posted record earnings. Our portfolios were up 16.5%, while U.S. GDP is estimated to grow at only 2.5%, to prove again that portfolios can go up and corporations can make money while the economy muddles along.

Multiples - The second part of the picture is the multiple placed on those profits. This multiple is the premium an investor is willing to pay for these future earnings. The current price-to-earnings multiple (P/E) of the market is 13 times 2013 earnings estimates. The average multiple when interest rates are this low is closer to 16 times earnings. In conclusion, with a modest increase in earnings and a more normalized multiple, the stock market could be poised for further gains in 2013.

Rebound - Underestimating The Housing Recovery

We predict the domestic economy will continue to grow modestly for the fifth straight year. The recovery in housing will be a fundamental reason and lead to the aforementioned multiple expansion. We believe the effects of the housing recovery are being greatly underestimated. Home building helps many industries beyond its namesake. Home building creates jobs in concrete, lumber, light fixtures, heating and cooling, real estate agents, mortgage brokers, lawyers and many others. In addition, it creates property tax revenues that fund communities and even education. The National Association of Home Builders estimates that three jobs are created for every home built.

Aside from these positive effects to the economy, an improvement in home prices creates confidence. In most cases, the home is a family's largest asset. The increase in price of your largest asset creates financial stability and wealth, which fuels multiple expansion.

Disclosure: I have positions in ITB, QTEC, XLK, EWG, JQC and WR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.