Infants and Giants
01/15/10
Each of the major averages lost ground last week. The Dow shed almost 0.1%, while the S&P 500 declined by 0.8% and the Nasdaq tumbled 1.3%. U.S. markets will be closed Monday in observance of Dr. Martin Luther King Jr. Day. But a full slate of quarterly reports will be coming the rest of the week. It is that time of the year again. They call it silly season, when brokers and research outfits predict corporate earnings with scientific aura and erudition that bamboozle some people some of the time, but not all the people all the time. Standard & Poors for example predicts that the S&P 500 earnings for the year 2010 are going to come in at $76.36. I hesitate to hope that this number may come through because it is certainly not enough to make the market surge like last year. However, it may be enough to keep us on a gentle upward slope without much deviations. Profit comparisons will get tougher each successive quarter of 2010 that much is certain. As we get further down the road market participants will be asking more and more what the new catalysts will be to drive this market higher. The answer is clear and straightforward: Revenue growth (as opposed to earnings growth) is needed at this point in the game. The second, just as important ingredient is interest rates that stay low. If both prerequisites can be met, we will have another good year. How likely is it? What is the majority of market pundits and participants thinking? Just ask yourself this question. Are your people telling you more often what can go right in the coming year or are they telling you more often what can go wrong? There you have it. Nobody is thinking about what could go right yet everybody is eager to point out what could go wrong. Let me refer (again) to my newsletter from November 2006 entitled: "Bears are Smarter but Bulls Make More Money". I wrote "Why is it that professionals have become so cynic that they can not believe a good thing when they see it? I know the temptation, God knows. Bears usually have the aura of being more realistic than the bulls have. Bears see all the pitfalls and potential landmines out there, whereas the bulls have no particular insight rather than their own rose colored glasses and their naïve optimistic disposition. Bears always sound intellectually superior to the bulls. Professional money managers make a living from sounding smart and intellectually superior and therefore seem to gravitate towards the bear camp more often. I am not saying that one should ignore the potential pitfalls or to ignore intellectual arguments." All this is still true today. I am saying, however, that at this particular point in time, just as 11 months ago, the bulls still have powerful arguments. Let us look at some charts:
The chart above depicts the earnings yield for the S&P 500 (operating earnings of $76.36 for 2010, at an index level of 1,144 results in an earnings yield of $76.36/1144 = .067 = 6.7% ) and compares it to the riskless earnings yield of government bonds of currently 3.85%. The comparison of the two assets shows that the S&P 500 is trading at a 20% discount to its "fair" value. Stocks are still inexpensive, even though not dirt cheap anymore. I also recognize the headwinds that this economy (and the stock market) is still facing. The chart below for example shows you the leverage that different sectors of the economy are experiencing. The financial, business and household sector are clearly de-leveraging, while federal and state and local governments are still leveraging up. At the current pace, I expect this de-leveraging process to continue for another couple of years. Businesses are probably in better shape than banks or households. Financial institutions are deleveraging faster than the other sectors and may hit their target of say 100% of GDP by the end of this year or first half of 2011. This also means that lending and thus inflation (as explained in this space four weeks ago) will be subdued for at least that long ... and that is great news for stock market investors because it means that interest rates will stay low through the entire year. Thus one of our two prerequisites above is met. The other prerequisite for a benign stock market is revenue growth. Revenue growth is based on true economic expansion and business confidence. Both are present at the moment. Look at the second chart below:
I took the liberty to insert a 4% GDP growth number into the chart above. It is my expectation that this or a higher number will be released on January 29th. I think we are headed straight for the 7.5% target line that I had pointed out in our October 31 newsletter. There are many factors that are supporting my view. Inventory building chief among them. Revenue growth therefore should become evident in quarterly earnings reports of the coming weeks. Granted, the fourth quarter so far saw stabilization in inventories, not outright inventory buildups yet. But springtime is almost around the corner – literally and figuratively speaking. I was very gratified to learn that Bill Miller of Legg Mason shares my opinion. A Financial Times article on January 5, 2010 said : "The US economy will grow by 2.6 per cent this year, according to consensus estimates, and by 2.7 per cent according to the Federal Reserve – but Mr. Miller believes there is a "good chance" that growth will be higher, and possibly as high as 8 per cent." I love this kind of company. So again, I urge people to focus at least as intensely on what could go right and not only on what could go wrong. It seems everybody is focusing on the latter. In a recent CNBC interview Bill Miller also said that he can still find great, solid bargains all over the place. During that interview he pointedly quoted Cambridge economist A.C.Pigou who once said: "The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born, not an infant, but a giant." Is that not exactly what has been happening for the last 12 months? Think about it ... and continue to buy stocks on weakness. All the ingredients for a continued stock market rally are still present.
Hermann Vohs
"One hundred percent of the shots you don't take don't go in."
Wayne Gretzky, former National Hockey League superstar
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
