Investing Caffeine

Stretching Rubber Band Creating More Value

July 15, 2011 at 12:17 am Leave a comment

Concerns over debt ceiling negotiations, European financial challenges, and overall economic malaise has reached a feverish pitch in the U.S., yet in the background, a valuation rubber band  has quietly been stretching to ever more attractive levels. Regardless of whether seniors might not receive Social Security checks, troops not obtain ammunition, and investors not collect credit rating agency love, corporations keep churning profits out like they are going out of style (17%+ growth in 2011 estimated earnings). We have barely scratched the surface on earnings season, and I’m sure better than expected earnings from the likes of Google Inc. (GOOG), JPMorgan Chase & Co. (JPM), FedEx Corp. (FDX), Nike Inc. (NKE), and Bed Bath & Beyond Inc. (BBBY) will not sway the bears, but in the meantime profits keep chugging along. Although profits have more than doubled in the last 12 years, not to mention a halving in interest rates (10-year Treasury yield cut from 6% to about 3%), yet the S&P 500 is still down approximately -4% (June 1999 – June 2011).

What Gives?

Could the valuation stretching continue as earnings continue to grind higher? Absolutely. Just because prices have been chopped in half, doesn’t mean they can’t go lower. From 1966 – 1982 the Dow Jones Industrial index traded at around 800 and P/E multiples contracted to single digits. That rubber band eventually snapped and the index catapulted 17-fold from 800 to almost 14,000 in 25 years. Even though equities have struggled in the 21st century, a few things have changed from the low-point reached about 30 years ago. For starters, we have not hit an inflation rate of 15% or a Federal Funds rate of 20% (4% and 0% today, respectively), so we have a tad bit more headroom before the single digit P/E apocalypse descends upon us. If you listen to Peter Lynch, investor extraordinaire, his “Rule of 20” states a market equilibrium P/E ratio should equal 20 minus the inflation rate. This rule would imply an equilibrium P/E ratio of 16-17 when the current 2011 P/E multiple implies a value slightly above 13 times earnings. The bears may claim victory if the earnings denominator collapses, but if earnings, on the contrary, continue coming in better than expected, then the sun might break through the clouds in the form of significant price appreciation.

Another change that has occurred since the days of Cabbage Patch dolls has been the opening floodgates of globalization. The technology revolution has accelerated the flattening of the globe, which has created numerous new opportunities and threats. Creating a company like Facebook with about 750 million users and an estimated value of $80 billion to $100 billion couldn’t happen 30 years ago, but on the flip side, our country is also competing with billions of motivated brains lurking in the far reaches of the world with a singular focus of sucking away our jobs, resources, and dollars. Winners recognize this threat and are currently adapting. Losers blind to this trend remain busy digging their own graves.

Future is Uncertain

As famous Jedi Master Yoda aptly identified, “Always in motion is the future.” The future is always uncertain, and if it wasn’t, I would be on my private island drinking umbrella drinks all day. With undecided debt ceiling negotiations occurring over the next few weeks, political rhetoric will be blaring and traders will be hyperventilating with defibrillator paddles close at hand. If history is a guide, stupid decisions may be made, but the almighty financial markets (and maybe a few Molotov cocktails at a local protest rally) will eventually slap politicians in the face to wake up to reality. Perhaps you recall the attention the markets earned from legislators when the Dow fell 777 points in a single September 2008 trading session. Blood on the streets forced Congress to approve the Troubled Asset Relief Program hot potato four days after the initial vote failed. And if that wasn’t a gentle enough reminder for Democrats and Republicans, then a few lessons can be learned from the interest rate sledgehammer that capital markets vigilantes have slammed on the Greeks (10-year Greek yields are hovering above 17%+).

Down but Not Out

The stories of debt collapse, hyperinflation, double-dip recessions, plunging dollar, secular bear markets, and government shutdowns are all plausible but remote scenarios. As Winston Churchill so eloquently stated, “You can always count on Americans to do the right thing – after they’ve tried everything else.” Voter moods are so venomous that if fiscal irresponsibility is not changed, politicians will be voted straight out of office – even hardcore, extremist elected officials understand this self-serving point.

Suffice it to say, as the political noise reaches a deafening pitch in the coming weeks and months, a quiet rubber band in the background keeps stretching. When the political noise dies down, you may just hear a noise snapping stock prices higher.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Performance data from Morningstar.com. Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, GOOG, and FDX, but at the time of publishing SCM had no direct position in JPM, NKE, BBBY, Facebook, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: economy, Politics. Tags: debt ceiling, globalization, inflation, interest rates, P/E ratios, PE multiples, Politics, rating agencies, S&P 500 earnings, S&P 500 profits, Winston Churchill.