3/22/2013 Update

Federal Reserve gives the market a green light

Chairman Ben Bernanke gave a statement on Wednesday indicating the Federal Reserve will continue its quantitative easing program to stimulate the U.S. economy.  He explained that under the committee’s dual mandate of full employment and stable prices they view the U.S. economy as slowly improving while inflation should stay under their target rate of 2%.  As the statement from Bernanke below indicates, they do not have any current plan to take their foot off the gas pedal in the near future. 

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.  The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.  Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative”.

European Restructuring back in the news this week

The Banks in Cyprus were considering giving depositors a nearly 10% haircut on their funds as part of a 10 billion euro bailout agreement with other European Union (EU) nations. The Cyprus economy is in recession and there have been allegations of a connection with Russian money launderers.  Keep in mind that this is a tiny country with just one million citizens.  The markets reacted earlier in the week due to renewed fears of “contagion” if this small country exited the European Union over this crisis.  We think this is a unique issue with Cyprus and it will not bleed into the other European Countries as they work to rebuild the capital in their banks.

Stock Market Valuations are still attractive

Despite the recent move higher in the market, we still view stocks as attractively priced.  The media is talking about the market setting a record but they need to also point out the fact that earnings are much higher than in 2007.  The average estimate for total S&P 500 earnings for 2013 is $110.00 versus 2007 earnings of $84.53.  If we take the projected 2013 earnings multiplied by the historic average price to earnings ratio of 16 it equates to a fair value for the S&P 500 of 1,760.  The S&P 500 is at 1,546 today which is approximately 14% undervalued.

There are still a number of macro risks that are unresolved.  The European banking system is in the spotlight again with the Chaos in Cypress.  The U.S. Congress has not agreed upon the spending cuts or a budget.  North Korea and Iran both seem to be “talking crazy” again.  A pullback may actually be healthy for the markets at some point this year.  The S&P 500 has gone 114 days without a 5% or more short term pullback which is one of the longest stretches of the major bull markets in history.  A short term break in the run up would not be a sign of weakness in our opinion.  Historically, bull markets last much longer when there are some short term sell offs.  These pullbacks are often the pauses that refresh the bull market. When the market has avoided pullbacks for an extended period, the bull market has tended to be shorter and result in a bear market when the decline eventually came. For example, the long bull markets of the 1980s and 1990s had dozens of 5% or more pullbacks with many 10% or more, whereas the much shorter four-year (2003 – 2007) bull market did not have a single pullback of 10% or more and ended by erasing the entire bull market gain.  Therefore, pullbacks do not have to be viewed as always negative; instead we actually can at times benefit from them, since they help to sustain the bull market and provide opportunities for investors to put additional money to work at attractive prices.

Economic news

The number of people seeking U.S. unemployment aid barely changed last week, while the average over the past month fell to a fresh five-year low. The decline in layoffs is helping strengthen the job market.  Weekly unemployment benefit applications rose just 2,000 to a seasonally adjusted 336,000, the Labor Department said Thursday.  Over the past four weeks, applications have dropped by 7,500 to 339,750. That’s the lowest since February 2008.  Economists pay close attention to the four-week average because it can smooth out week to week fluctuations. The steady decline in unemployment claims signals that companies are laying off fewer workers. That suggests many aren’t worried about economic conditions in the near future.