Newsletters 2009 Newsletters Mid Year Update (8/7)
Friday, 07 August 2009 22:21
Defying an increasing number of pessimistic calls for a supposedly ominous technical pattern known as a “head and shoulders” top, the stock market rally off the March bottom ramped higher after a brief pause in June. All major market indices are now positive for the year, with the S&P 500 Composite, Dow Jones Industrial Average and NASDAQ Composite up 9.33%, 4.50% and 25.46% respectively for the year through July month-end.
We remain convinced that this type of “buying on dips” will continue for an extended period, driven by the considerable sum of dry powder that still sits idle in sidelined cash equivalent funds earning next-to-nothing. As of July 31, the total market capitalization of the S&P 500 Composite was $8.865 trillion and the total market capitalization of the S&P SuperComposite 1,500 (which also includes the S&P Mid Cap 400 and S&P Small Cap 600 companies) was just over $10 trillion. For comparison, recently observed Federal Reserve data indicates that there is $4.5 trillion in savings deposits, $3.7 trillion in money market mutual funds and $1.3 trillion in “small CDs” or CDs valued below $100,000 each. This is a total of $9.5 trillion in short-term cash savings, equivalent to 107% of the market capitalization of the S&P 500 and 95% of the market capitalization of the S&P SuperComposite. The money market cash alone could buy 42% of the entire S&P 500 at current prices!
With the Federal Reserve highly unlikely to make any changes to monetary policy until at least 2010, there is considerable incentive for cash investors to consider higher yielding alternatives. With interest rates on fixed investments so low and with the next monetary move by the Federal Reserve guaranteed to be a hike in the Fed Funds rate (you can’t cut rates below 0%), we sense a growing awareness by cash investors that bonds may not be the safe alternative they have been for nearly three decades. Bonds cannot possibly replicate the amazing run that has seen interest rates plunge from high double-digits in the early 1980s to low single-digits today. Anyone that has invested in bonds for the last thirty years has enjoyed a generational tailwind that simply no longer exists. We can’t help but prognosticate that at least a small percentage of the sidelined cash will find its way back into stocks. Having missed so much of the move off the bottom already, we suspect that cash investors will view market corrections as opportunities to invest.
Jack Ablin, Chief Investment Officer at Harris Private Bank in Chicago, reports that the stock market (as measured by the S&P 500) has enjoyed an average two-year rally whenever money market assets exceed 25% of the market capitalization of the S&P 500. By making cash investments so unattractive, the Federal Reserve is beckoning investors to climb the ladder of risk and helping engineer a liquidity driven reversion to the mean.
With the second quarter earnings season nearly complete, we now have a better view of how full-year corporate earnings are shaping out and feel more comfortable with our January 2009 predictions. Of the nearly 80% or 400 companies that have reported thus far, 75% have surpassed consensus expectations. As a whole, reported earnings for the second quarter are 15.4% ahead of expectations. And while the average earnings surprise from the financial sector has been an amazing 92%, the average 7% earnings surprise from all other sectors would rank as the third strongest quarterly upside surprise since 1987. It is becoming quite obvious that analysts had become far too pessimistic.
Most analysts extrapolate both good and bad earnings trends much too far into the future and end up following markets, in lemming fashion, rather than leading them. At the outset of the year, as reported in our January newsletter, the consensus earnings forecast for 2009 S&P 500 earnings was $71. Dragged down by escalating losses at banks and other financial companies, the 2009 consensus quickly dropped to a low of $55 and has crept slightly higher in recent weeks to just under $60. The lemmings were quick to lower their estimates and downgrade stocks when doom and gloom prevailed only a few short months ago, and now are revising estimates and upgrading stocks as the market recovers.
The current consensus for 2010 S&P 500 earnings is $75. Now that it has become clear that a recovery is underway and we are not heading down an economic black hole, it seems reasonable to apply a price-earnings (PE) multiple of 15 on forward earnings, especially in such a low interest rate environment. A forward PE of 15 on $75 of earnings implies a target of 1,125 for the S&P 500. With the S&P 500 hovering near 1,000 at press time, this implies a 12.5% potential return from current levels. Given the continued string of better-than-expected economic and corporate news, we would not be surprised if the current $75 consensus proves conservative.
In our January outlook, we used admittedly “fuzzy” math in estimating that earnings for the S&P 500 might be able to reach the 2006 $88 level in 2010. While this seems overly optimistic today, the current $75 consensus is only 15% below $88 and clearly moving in the right direction. While second quarter earnings reports have been driven by cost cutting initiatives that have boosted the bottom line, these bottom line measures will allow for substantial upside earnings surprises once top line growth recovers. With GDP now expected to be positive for the third quarter (with some estimates as high as 4.5%), we believe top line surprises are imminent and significant upside earnings revisions will follow.
In January, in the middle of the credit crisis and during a period of widespread pessimism, we wrote that “the last quarter of 2008 and the first quarter of 2009 will prove to be recession trough quarters for the economy and for earnings”…and “by mid-year, the market will begin to look toward more normalized economic performance toward the end of 2009 and into 2010”. We further prognosticated “an initial target of 1065 for the S&P 500” for the year. These predictions are right on track. If earnings estimates for the rest of the year and into 2010 prove to be conservative as we presently expect, our January published “year-end 2010 target of 1320” would appear to be on track as well.
In analyzing the composite of companies that presently comprise the Osher core global equity portfolio, the portfolio trades at a 2009 PE of 15.75 and a 2010 PE of 13.9. Earnings are currently expected to grow on average by 14.5% in 2010. A PE of 13.9 on earnings that are expected to grow by 14.5% and likely to be revised higher is a very attractive valuation.
In the “new normal” economic environment that we envision, the market will favor companies with fortress-like balance sheets and strong cash flow, companies that do not require excessive leverage to grow their businesses. Further, with the fixed income bull market now in the past, income investors will search for companies that can consistently and predictably increase their dividend. Finally, the propensity for inflation and a stubbornly weak dollar will favor foreign investments and U.S. companies that garner a significant share of earnings from their overseas operations. These characteristics (strong balance sheet and cash flow, consistent earnings and dividend growth, and well-entrenched foreign operations) have always been hallmarks of what we consider to be a high-quality equity investment. We are confident that investors (and lemmings alike) will continue to come to our way of thinking and expect that high-quality global growth investments will enjoy a sustained period of outperformance.
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