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The Month of May - A cruel month.

The Markets: The Month Past - May
Views of Gordon Higgins.CA, MBA, CFA
HIGGINS INVESTMENT GROUP INC.
 
The Markets
May was the cruellest month in more than a year. Major markets suffered declines that erased much, if not all, of the gains for the year. The Dow was down almost 8%, while the broader S&P 500 declined 8.2%. This is the worst one month performance for the S&P since February 2009. The technology heavy Nasdaq Composite moved down 8.3% in May. The TSX was declined 3.7% in the month.
Fears of a Greek default weighed heavily on financial stocks. Although the Greek economy is smaller than Ontario’s, the implications of a country being forced out of the Euro have led investors to ponder whether the entire Euro zone may go into a recession. Greece and some other European countries have announced significant fiscal budget cutbacks to reduce the impact of increasing debt levels. Unfortunately the people in those countries have protested the reduced government expenditure – everyone wants a cure but no one wants to take the medicine. While bodies, such as, the International Monetary Fund have indicated their willingness to help, they still require action by the debtor nations.
They say “the market climbs a wall of worry”, however in May; the market fell off the wall.
The real story of the month was the “flash crash” that occurred on May 6th. In less than 20 minutes, a thrashing powered by computerized trading nearly erased more than $1 trillion in market value.  This was the largest intraday point decline in the history of the DOW. In the 1987 the market meltdown was greater in percentage terms but lower in points. Regulators are still trying to determine what caused the temporary decline and have commented that declines for individual stocks were “inconsistent” with well-functioning markets and pledged to make “structural” changes if necessary
THE DOW MAY 6th 2010
FLASH CRASH
A senior member of the SEC summarized it best, “The events of last week are unacceptable,"
 
 
The Markets: Why we continue to like them
1.      Valuations  are supported by economic Growth
2.      Earnings growth is higher than analysts’ forecasts
3.      Valuations are reasonable.
 
1.      Valuations are supported by economic Growth
Newspapers told their readers the market decline was caused by concerns of global economic slowdown. The risk Greece might default on its debts, or have to leave the Euro, weighed heavily on the markets. Fears that China might stop buying bonds denominated in Euros also put investors on edge. If China stopped buying Euro denominated debt, then European interest rates would rise. The fears continue to include a decline in the Euro leading to a European recession. The Chinese, although not capitalist, are rational and would not intentionally create weak economies in one of the best customers for their manufactured goods. I will not belittle the risks, as they are very real but the same people who warned of economic calamities have been warning of a slower economy in the first quarter of this year. Many commentators felt the rate of growth experienced in the fourth quarter of last year was not sustainable yet, so far, we have not witnessed a slowdown 
The Canadian economy grew at 6.1% in first quarter of 2010. Growth, exceeded analysts’ expectations and was the highest in a decade. Even if you adjust for the portion of economic growth attributable to inventory rebuilding, the economy grew at greater than a 3% annual rate. The US economy had reasonable growth of 3.0%. The US number is slightly disappointing as the preliminary data released by the government was 3.2%. Despite concerns over unemployment and a consumer constrained by housing woes, consumer spending grew by 3.5% in the quarter Even India’s, GDP expanded by 8.6% in the first quarter - this after a 6.5% spurt in the last quarter of 2009. 
Both developed and emerging market economies remain in a growth mode. We should be aware of the risks of slowing economies but also, of the opportunities if forecasters are too bearish.
When you buy a stock you are buying ownership in the company’s future earnings. All things being equal, if a company earns more than people estimate then its price should rise.  The Cassandra’s who have been spouting warnings of economic weakness leading to weaker earnings have been wrong. Even this weekend the local business paper warned of the “D” word or deflation. Deflation is insidious as anyone who has seen pictures or talked to relatives about the dirty thirties. If prices are on a constant decline companies earnings are sure to follow. We are not believers in the coming earnings decline or even the “D” word.
According to Morgan Stanley calculations first-quarter profits of S&P 500 companies have been more than 12% better than expected. Closer to home, almost ½ the companies that reported earnings for the first quarter beat expectations. When you consider analysts expected a 19% increase in earnings: better than expectations earnings data is quite impressive
2.      Valuations are reasonable
“A cynic knows the price of everything and the value of nothing. “
At the end of the day, it does not matter if the world economies are growing or if last quarter’s earnings were better than expected, if stocks are already pricing in the good news. One merely needs to remember the technology bubble of 2000 when price earnings could not be used so investors came up with “price to eyeballs” to value websites.
Today we have extremely low interest rates supporting the markets. I have borrowed this chart from the May 27th issue of The Economist. The author indicates the markets are still pricy yet markets haven’t been this “cheap’ in more than the 10 years. For instance, the S&P 500 is trading at less than 14 times next year’s earnings. If the S&P trades at 15 times earnings investors will receive a 10% return including dividends. The Canadian market is trading at a similar level.  Reasonable ,but not overly cheap.
Conclusion
We expect the markets to remain volatile over the rest of this year. It will take a while to resolve the economic situation in Europe. We have seen the market rally when it appears there is a solution to the Greek debt problem only to see the markets slump when there is uncertainty over the commitment of the parties involved. Political risk factors are also percolating including North Korea and more recently Israel. Markets do not like uncertainty, and we definitely have many unknowns. Over the next year we must remember the major equity markets remain supported by these 3 factors:
1.      Valuations  are supported by economic Growth
2.      Earnings growth is higher than analysts’ forecasts
3.      Valuations are reasonable.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Disclaimer: This material is for information purposes only and is not an offer to sell or the solicitation of an offer to buy any security. The opinions reflect those of the author and are not to be relied on for investment decisions. The comments are provided to give the reader something to think about and is not investment advice.