Valuentum's Outlook For The Market

by: Brian Nelson

The past several weeks have been jam-packed with news, from PIMCO's Bill Gross calling the "cult of equity" dead and billionaire start-up genius Peter Thiel dumping his a large pre-IPO stake in Facebook (NASDAQ:FB) to CEO Mark Zuckerburg finally making his first public appearance since the "Faceplant" offering. Apple released its highly-anticipated iPhone 5 and Bernanke announced monetary policy expansion with unlimited-duration quantitative easing. There was also the downgrade of the US government debt by credit-rating firm Egan-Jones and Moody's threatening to do the same unless budget negotiations lead to a downward trend in the government's debt/GDP ratio. And then there's House Speaker John Boehner saying he's not sure that Congress and President Obama will reach a deal to avoid the fiscal cliff. That's no shortage of news-and yet with all of this, the stock market, as measured by the S&P 500 SPDR Index (NYSEARCA:SPY), has reached levels not seen since late 2007--before the fall of Lehman, Bear and AIG (NYSE:AIG)-- five-year highs!

Could you imagine if you had listened to bond-king Bill Gross (please note he is not the equity king), Marc Faber (author of the Gloom, Boom & Doom report) or the Economic Cycle Research Institute (ECRI), which called for a recession in September 2011 - some 30% in the S&P 500 ago (yes, 30%!). Aside from being incorrect, bearish economic prognosticators fully admit that their expectations have little to do with what may happen to the equity markets in the future (as Bernanke's unlimited QE has shown). Still, such admissions do not stop many intelligent investors from rushing to the exits at the first out-cry of a recession possibility. We continue to encourage investors to keep a level head, and we reiterate that those that place too much emphasis on economic prognostications can be left behind as the market pushes ahead (as it has for the past several months). We think long-term equity prices are driven by expectations of the discounted (risk-adjusted) future free cash flows and earnings of companies through all aspects of the economic cycle (both upturns and downturns). It's also very important to note that, despite the constant media fear-mongering by perma-bears, the equity markets have now fully-recovered from the Great Recession. What a ride it has been.

So what should investors think of the health of the economy? Well, certainly the domestic economic recovery is fragile, and we are witnessing weakness from the likes of bellwethers such as FedEx (NYSE:FDX) and Intel (NASDAQ:INTC), which hasn't been very comforting. Certainly, less favorable exchange rates, slowing growth in China, a recession in many parts of the Eurozone, and meager earnings expansion during the third quarter are not topics to dismiss recklessly. But a look at the Fed Beige Book, released August 29, suggest conditions aren't as bad as many pundits may lead you to believe:

Reports from the twelve Federal Reserve Districts suggest economic activity continued to expand gradually in July and early August across most regions and sectors. Six Districts indicated the local economy continued to expand at a modest pace and another three cited moderate growth; among the latter, Chicago noted that the pace of growth had slowed from the prior period. The Philadelphia and Richmond Districts reported slow growth in most sectors most Districts indicated that retail activity, including auto sales, had increased since the last Beige Book report, although Cleveland, Chicago, St. Louis, Dallas, and San Francisco noted the retail improvements were small. Atlanta said that retail growth had slowed, while Philadelphia indicated growth in retail sales was somewhat faster than in the previous report. Boston, New York, Richmond, Atlanta, Minneapolis, and San Francisco recorded strong performance in tourism...

...real estate markets were generally said to be improving. On the residential side, all 12 Districts cited increases in home sales, home prices, or housing construction. Reports on commercial real estate markets were also generally positive, although San Francisco noted stable demand, Boston indicated conditions were not much changed since the last report, and Richmond, Chicago, and St. Louis said commercial real estate conditions were mixed. District reports indicated that energy and mining activity was generally high and increasing.

Further, the data that we've been receiving from the domestic housing markets has been very encouraging as of late. Though negative equity remains a concern (roughly 30% of US homeowners with a mortgage are estimated to be underwater), the housing market is certainly showing signs of life. Not only are all the builders seeing strong increases in housing backlogs, but we're finally seeing home value appreciation. The June reading on the Case-Shiller index, released August 28, marked the first time since the summer of 2010 that all three headline composites - the national, the 10-city, and the 20-city-were higher at the end of the second quarter. The national composite advanced 1.2% in the second quarter of 2012 versus the same period a year ago and up 6.9% sequentially. We're growing more confident with each data point that the housing recovery is underway (and that the bottom is finally in).

And after a somewhat weaker July, where the SAAR came in at 13.8-14.0 million units, auto sales rebounded aggressively during August. estimates the August SAAR at 14.2 million units, while Edmunds anticipates the SAAR to come in around 14.5 million units for the month. AutoData estimates the SAAR came in at 14.52 million units. Yet, the most bullish of all, forecasting firm LMC Automotive thinks sales hit their highest levels in 4.5 years during the month and pegs total light-vehicle sales for 2013 above 15 million. Best Ideas Newsletter holding Ford (NYSE:F) saw total August sales surge 13% year-over-year, selling 197,249 units, higher than expected.

There are several other bright spots in the economy. For one, we are heavily exposed in our Best Ideas portfolio to the coming boom in commercial aerospace deliveries via the supply chain, as order backlogs at both Boeing (NYSE:BA) and Airbus (OTCPK:EADSY) represent roughly 7-8 years' worth of production. Very few industries have both this visibility and expected growth. EDAC Tech (NASDAQ:EDAC) remains our top pick in the space, as we think shares are worth north of $20 each (offering substantial upside). We also continue to hold small-cap favorite Astronics (NASDAQ:ATRO) and mid/large cap idea, Precision Castparts (NYSE:PCP).

E-commerce sales also continue to perform well, with data from the US Census Bureau, released August 16, showing the second quarter measure increased over 15% from the same period a year ago - a nice pace. We think this bodes particularly well for the payment processors we hold in our portfolio, namely Visa (NYSE:V) and eBay (NASDAQ:EBAY). In fact, ChannelAdvisor recently noted that eBay saw same-store-sales for July jump nearly 28%, the highest growth number the firm has seen since they started tracking data.

And finally, Bernanke's announcement of unlimited monetary accommodation will certainly aid in the domestic recovery in that it won't choke it off prematurely. Lessons learned from the Great Depression reveal such policy is the right course of action. An inflationary response to this expansionary endeavor may indeed be positive if it causes in this order: higher housing prices (which is happening); greater consumer confidence due to reduced negative equity in underwater mortgages; increased spending on high-priced (inflated) goods as a result of greater confidence; higher sales growth and profits for better-managed firms as a result of more consumer spending, higher equity prices due to greater profit expansion at companies; and finally, greater wealth for Americans as a result of stronger housing and stock markets. Bernanke is well aware of this virtuous cycle.

As we had indicated the last time the credit rating agencies threatened a downgrade, rating revisions of the US debt offer no new information to the markets and have limited implications (absent some technical considerations regarding investment shops that can only hold certain top-rated issues). For one, investors are well aware of the credit quality of the US (meaning a downgrade won't change their opinion one way or the other), and as it relates to the possibility of a greater likelihood of default, the US government can simply print additional currency. Under this event, an inflationary response from a larger money supply may indeed be positive, as we noted above.

Further, we believe the coming 'fiscal cliff' will be resolved in a pro-economic way that will not jeopardize the domestic economic recovery, despite current Congressional rhetoric that runs to the contrary at this time. After all, Congress' very own Budget Office predicts that economic contraction will occur if the so-called "fiscal cliff" is not thwarted. All things considered, there are many uncertainties out there, but we remain laser focused on generating continued outperformance in the portfolio of Valuentum's Best Ideas Newsletter.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Some of the firms mentioned in this article are included in the portfolio of our Best Ideas Newsletter.

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