I love the ‘Lowering of Expectations Season’ which precedes the release of corporate earnings. It gives those of us who are bullish the ability to use market-needed drawdowns – such as the 4% pullback we experienced – as a way to add to profitable positions and shake out the weak longs.
For the last few years, ever since Sarbanes Oxley was introduced into the capital market structure a decade ago, companies have ‘lowered expectations’ with vigor in order to avoid the perception of a violation of the rules. It’s a pattern that has repeated itself quarter after quarter. Unfortunately it keeps money on the sidelines at the worst possible time. Worse yet, people find themselves in investments which are immediate losers. Buying a 10 year bond that yields 1.95% with inflation (as measured by CPI) at 2.9% is all risk and no return.
Even with the remarkable performance of the various indexes since Q4 of last year, stocks are still undervalued. This is NOT a ‘sell in May and walk away’ market. This is a May to buy some added protection and watch the market go higher. There are four fundamental reasons to stay invested:
- China. The global growth story – more specifically, the China story – is far from over. What were once US companies doing business abroad are now global corporations which happen to be listed here and dollar denominated. They lowered growth and inflation levels to sustainable levels. They are now, and will continue to, participate in this once in a lifetime global growth phenomenon. China has had a ‘soft landing’…period. And most importantly, they have started to ease reserve requirements for banks.
- Europe. More portfolio managers, who are sitting in cash, use the uncertainty in Europe as the reason they are not willing to commit. The European situation was and continues to be a political situation, not an economic issue. The template is created for QEE (Quantitative Easing Europe). For portfolio managers and investors still worried about Europe, I say, “Get over it, that’s yesterday’s news.” As I have been saying all along…In Europe, failure is NOT an option.
- Liquidity. The overwhelming opinion was that if the Fed is no longer going to support things then markets will not stay at these lofty levels. Nothing could be further from the truth. There is a big difference between omitting further QE from the Fed Chairman’s testimony (and ‘hawkish’ talk by Fed governors) and an all out drain of the system. Weak economic releases will only confirm the need for QE3. Overwhelming liquidity is here for a while. Let there be no mistake. The Fed, ECB BOE, the BOJ and every other central bank are in a coordinated effort to maintain liquidity even at the cost of higher inflation. The enemy, as explained in detail by every central banker, is deflation or continued disinflationary pressure (yes, even the Chinese with 4% inflation see Deflation as the real enemy). So don’t look for the Fed to start raising rates any time soon.
- Equities. If the first three reasons were not enough for you to start looking for ways to get exposure to the markets then the one fundamental that should rise above all else is valuation. The proof is in the numbers. Even with the lowered expectations, corporate America as measured by the S&P 500 is on track to earn just under $105 a share. With the present market trading around 1400 that gives us a P/E of roughly 13.3. A decade ago the averages traded around the same levels yet earned 50% of what they earn today. If stocks were to trade at a 14 or 15 multiple, still below the norm of 16, it would measure out to a 20% move higher up to a new all time high. Without much fanfare, corporate America has become leaner, meaner, and sitting patiently with more cash on their balance sheets than ever before in history. Look for multiples to expand and for M&A activity to pick up along with stock buybacks. Isn’t that bullish?
In spite of the lack of pro-growth, anti-business policy being dished out of DC by my fellow Chicagoan, corporate America is stronger than it has ever been. Earnings don’t lie and this earnings season should tell investors that the story behind the rally in US stocks is better than expected. As a product of the Reagan era it’s easy to imagine how much higher stocks would be if government helped business in America flourish instead of becoming an obstacle to growth. But, as I was always taught by my optimistic Armenian mother, this too shall pass.
By Jack Bouroudjian