1-18-2013 Update

The big news this week (besides the unfortunate stories about the Boeing Dreamliner and Lance Armstrong) has been earnings.  Thus far, it appears that U.S. corporations as a whole continued to grow their earnings in the 4th quarter of 2012 even as the “fiscal cliff” uncertainty plagued headlines.  Many corporations are still benefiting from cost efficiencies and appear somewhat reluctant to increase capital expenditures.  However, corporations will not be able to maintain profit growth going forward by continuing to deleverage and they will eventually be forced to focus on organic growth, which will require increasing capital expenditures (hiring and technology).  We are starting to see this happen and this is evident with the gradually improving labor market.   Certainly, clarity out of Washington would help expedite this process. Several companies reported earnings this week.  Goldman Sachs was the first major financial institution to report on Wednesday with earnings 48 percent above expectations.  Bank of America reported positive earnings suggesting they are positioned for growth and are optimistic going forward as the number of troubled home loans has been significantly reduced. They did have additional law suit settlement costs and continued to hold back on releasing reserves, which put some pressure on the stock thereafter.  General Electric reported better earnings and revenues than expected as they continue to see improvements across various segments and growth in emerging markets.  Apple reports next week and this should be another key variable for the overall market sentiment going forward.

Company multiples are still very attractive from a valuation standpoint.  The average P/E ratio of the S&P 500 over the past 20 years was 16.1, yet valuations on 12/31/12 put the ratio at 12.5.  If you apply the historic average P/E multiple to the current earnings on the S&P, a fair value assessment would have the S&P 500 trading above 1,800, which is a premium of approximately 21 percent from today’s price.   Indeed, at least some of the current discount priced in the market can be attributed to the uncertainty in Washington.  We also continue to see companies hold massive cash positions which we believe should ultimately lead to more mergers and acquisition activity, share buybacks, and dividend increases.  Even with the apparent discount associated with equities, we are still seeing massive inflows into fixed income investments.  As interest rates rise and confidence improves, we expect to see investors start to rotate out of fixed income investments and into dividend paying stocks, which should push equity markets higher.

With the fiscal cliff behind us and corporate earnings continuing to improve, the next big issue facing the markets and the economy is the U.S. debt ceiling deadline.  However, political dysfunction in Washington has become somewhat commonplace for many investors and the markets may have already discounted a new debt ceiling fiasco.  The debt ceiling debacle in 2011 was a classic example of fear vs. fact and after a significant “media driven” fear selloff the actual outcome was not an economic calamity.  Instead this event provided a very good buying opportunity for disciplined investors.