Halftime Performance
If you only looked at the returns for the last three months, you’d conclude that the just completed quarter was extremely uneventful. After fees, your growth portfolios appreciated 6/10ths of 1% on average while the S&P 500 was up 1/10th of 1% and the global benchmark, the MSCI All Cap World was up ¼ of 1%.
Year to date, your growth portfolios are up 7.7% on average, substantially outperforming the S&P 500 return of 6% and the global benchmark return of 4.7%. Even your balanced portfolios are beating the S&P 500 with a return of 6.3% year-to-date. Over the last year the growth portfolios are up a robust 29% and the more conservative balanced portfolios are up an average of 22%.
Investors Have Doubts
The last three months have been very eventful. After the Japanese earthquake the global supply chain was temporarily interrupted. Shortly after, unrest in Libya sent oil prices soaring. Gasoline prices vaulted over four dollars a gallon, shattering consumers’ fragile confidence.
U.S. politicians gained little traction in coming to an agreement on raising the debt ceiling, while European politicians engaged in their own brinkmanship with Greek politicians over the terms of Greek bailout. No one agrees on the implications of the end of the Federal Reserve’s “quantitative easing” program.
The Recovery is Slowly and Steadily Advancing
If you only focus on the long list of unknowns it’s hard to see that stocks are a very compelling investment today. If we focus on the factors that got us into trouble in 2008, it appears that substantial improvement is occurring. James Paulsen, chief investment for Wells Capital Management, “the financial situation of the average household has improved far faster and far more than everyone thought it would two years ago.”[1] Federal Reserve data indicate that delinquencies have dropped 30 percent in two years and consumers have reduced debt by more than $1 trillion in the last two and a half years. The ratio of consumer-debt payments to incomes is the lowest since 1994. Improving credit gives households the ability to increase their borrowing as confidence improves.
Even the issues that are grabbing the headlines are improving. Japan’s industrial sector is quickly rebounding, oil prices are down 20% from their peak and gas prices are falling. The Europeans seem to have at least a temporary solution that will postpone a Greek default.
The remaining wild cards are what will happen after quantitative easing, and will the U.S. avoid defaulting on its debt. Most Washington observers claim that the parties will come to some sort of a last minute agreement that allows for increasing the debt ceiling. And if banks continue to increase lending, the impact of the Federal Reserve reducing its quantitative easing should be negligible.
A Slow and Steady Economy Is Ideal for Stocks
Assuming all of the potential external shocks to the market are manageable, the market should eventually trade based on valuations and earnings prospects. Historically, a slow growth environment is optimal for stock performance. Investors tend to get very concerned about future inflation when the economic growth rate exceeds three percent. It doesn’t appear that this worry will occupy investors anytime soon. Assuming the economy continues to muddle along at a two to three percent pace in the second half, stocks should continue to outperform all other asset classes.
Companies are guiding earnings expectations for 2011 and 2012 higher. Total S&P 500 earnings are projected to exceed $112 in 2012. If this occurs, earnings in 2012 will be 30% higher than the previous earnings record from 2006. At today’s value of 1,340 the S&P is still almost twenty percent below its all-time high. Low interest rates, moderate economic growth, rising earnings expectations and widespread skepticism are the primary ingredients for a strong, sustainable bull market.
Today, Execution is More Important than Valuation
Within the stock portfolios, we continue to favor larger, high quality growth stocks. In today’s environment, investors are more compelled by solid execution and visible earnings growth than low valuations. We’ve been moving out of some of our cheapest companies like Hewlett Packard and Medtronic and we’re replacing those with solid growth stocks like John Deere and SL Green.
Over the last couple of years, some of our most regrettable trades have come from selling good companies at high prices. For now, we’re choosing to let our winners like Tractor Supply and Deckers run for a bit longer than usual. Though we would never buy these companies at current prices, investors seem to have an appetite for them as long as they continue to beat earnings expectations.
As confidence in the economy improves, the defensive sectors like electric utilities and consumer staples will become less compelling. Sectors that are leveraged to economic growth, like industrials and consumer discretionary should lead the market over the next twelve to eighteen months.
The Fundamentals Look Great
There is a lot of noise in the world today. Some of the risks have an impact on stock prices, but much of it is completely irrelevant. Valuations and earnings have always been our North Star when it comes to navigating the markets. I can’t remember ever constructing a portfolio with such strong growth characteristics that was priced at such low valuations. As long as that’s the case I’m very enthusiastic about the prospect for substantial appreciation over the next eighteen months.
[1] “Best Consumer Credit Since ’06 Reveals Loan Rebound,” Bloomberg, 7/5/2011.
