Markets Race Out of 2012 Gate

February 3, 2012 at 2:25 pm 4 comments

Article includes excerpts from Sidoxia Capital Management’s 2/1/2012 newsletter. Subscribe on right side of page.

Equity markets largely remained caged in during 2011, but U.S. stocks came racing out of the gate at the beginning of 2012. The S&P 500 index rose +4.4% in January; the Dow Jones Industrials climbed +3.4%; and the NASDAQ index sprinted out to a +8.0% return. Broader concerns have not disappeared over a European financial meltdown, high U.S. unemployment, and large unsustainable debts and deficits, but several key factors are providing firmer footing for financial race horses in 2012:

•  Record Corporate Profits: 2012 S&P operating profits were recently forecasted to reach a record level of $106, or +9% versus a year ago. Accelerating GDP (Gross Domestic Product Growth) to +2.8% in the fourth quarter also provided a tailwind to corporations.

•   Mountains of Cash: Companies are sitting on record levels of cash. In late 2011, U.S. non-financial corporations were sitting on $1.73 trillion in cash, which was +50% higher as a percentage of assets relative to 2007 when the credit crunch began in earnest.

•  Employment Trends Improving: It’s difficult to fall off the floor, but since the unemployment rate peaked at 10.2% in October 2009, the rate has slowly improved to 8.5% today. Data junkies need not fret – we have fresh new employment numbers to look at this Friday.

•   Consumer Optimism on Rise: The University of Michigan’s consumer sentiment index showed optimism improved in January to the highest level in almost a year, increasing to 75.0 from 69.9 in December.

•   Federal Reserve to the Rescue: Federal Reserve Chairman, Ben Bernanke, and the Fed recently announced the extension of their 0% interest rate policy, designed to assist economic expansion, through the end of 2014. In addition, Bernanke did not rule out further stimulative asset purchases (a.k.a., QE3 or quantitative easing) if necessary. If executed as planned, this dovish stance will extend for an unprecedented six year period (2008 -2014).

Europe on the Comeback Trail?

Source: Calafia Beach Pundit

Europe is by no means out of the woods and tracking the day to day volatility of the happenings overseas can be a difficult chore. One fairly easy way to track the European progress (or lack thereof) is by following the interest rate trends in the PIIGS countries (Portugal, Ireland, Italy, Greece, and Spain). Quite simply, higher interest rates generally mean more uncertainty and risk, while lower interest rates mean more confidence and certainty. The bad news is that Greece is still in the midst of a very complex restructuring of its debt, which means Greek interest rates have been exploding upwards and investors are bracing for significant losses on their sovereign debt investments. Portugal is not in as bad shape as Greece, but the trends have been moving in a negative direction. The good news, as you can see from the chart above (Calafia Beach Pundit), is that interest rates in Ireland, Italy and Spain have been constructively moving lower thanks to austerity measures, European Central Bank (ECB) actions, and coordination of eurozone policies to create more unity and fiscal accountability.

Political Horse Race

Source: Real Clear Politics via The Financial Times

The other horse race going on now is the battle for the Republican presidential nomination between former Massachusetts governor Mitt Romney and former House of Representatives Speaker Newt Gingrich. Some increased feistiness mixed with a little Super-Pac TV smear campaigns helped whip Romney’s horse to a decisive victory in Florida – Gingrich ended up losing by a whopping 14%. Unlike traditional horse races, we don’t know how long this Republican primary race will last, but chances are this thing should be wrapped up by “Super Tuesday” on March 6th when there will be 10 simultaneous primaries and caucuses. Romney may be the lead horse now, but we are likely to see a few more horses drop out before all is said and done.

Flies in the Ointment

As indicated previously, although 2012 has gotten off to a strong start, there are still some flies in the ointment:

•   European Crisis Not Over: Many European countries are at or near recessionary levels. The U.S. may be insulated from some of the weakness, but is not completely immune from the European financial crisis. Weaker fourth quarter revenue growth was suffered by companies like Exxon Mobil Corp (XOM), Citigroup Inc. (C), JP Morgan Chase & Co (JPM), Microsoft Corp (MSFT), and IBM, in part because of European exposure.

•   Slowing Profit Growth: Although at record levels, profit growth is slowing and peak profit margins are starting to feel the pressure. Only so much cost-cutting can be done before growth initiatives, such as hiring, must be implemented to boost profits.

•   Election Uncertainty: As mentioned earlier, 2012 is a presidential election year, and policy uncertainty and political gridlock have the potential of further spooking investors. Much of these issues is not new news to the financial markets. Rather than reading stale, old headlines of the multi-year financial crisis, determining what happens next and ascertaining how much uncertainty is already factored into current asset prices is a much more constructive exercise.

Stocks on Sale for a Discount

Source: Calafia Beach Pundit

A lot of the previous concerns (flies) mentioned is not new news to investors and many of these worries are already factored into the cheap equity prices we are witnessing. If everything was all roses, stocks would not be selling for a significant discount to the long-term averages.

A key ratio measuring the priceyness of the stock market is the Price/Earnings (P/E) ratio. History has taught us the best long-term returns have been earned when purchases were made at lower P/E ratio levels. As you can see from the 60-year chart above (Calafia Beach Pundit), stocks can become cheaper (resulting in lower P/Es) for many years, similar to the challenging period experienced through the early 1980s and somewhat analogous to the lower P/E ratios we are presently witnessing (estimated 2012 P/E of approximately 12.4). However, the major difference between then and now is that the Federal Funds interest rate was about 20% back in the early-’80s, while the same rate is closer to 0% currently. Simple math and logic tell us that stocks and other asset-based earnings streams deserve higher prices in periods of low interest rates like today.

We are only one month through the 2012 financial market race, so it much too early to declare a Triple Crown victory, but we are off to a nice start. As I’ve said before, investing has arguably never been as difficult as it is today, but investing has also never been as important. Inflation, whether you are talking about food, energy, healthcare, leisure, or educational costs continue to grind higher. Burying your head in the sand or stuffing your money in low yielding assets may work for a wealthy few and feel good in the short-run, but for much of the masses the destructive inflation-eroding characteristics of purported “safe investments” will likely do more damage than good in the long-run. A low-cost diversified global portfolio of thoroughbred investments that balances income and growth with your risk tolerance and time horizon is a better way to maneuver yourself to the investment winner’s circle.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in XOM, MSFT, JPM, IBM, 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.

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