I recently had a major “disagreement” with my oldest son Jonathan regarding his homework.  The argument took place very close to bedtime and we both went to bed a bit perturbed.  The next morning, we woke up and it seemed like nothing had happened.  We had breakfast together and all was right in the world.  I’m sure many of you have been there.  The reason I’m sharing this story is because that seems to be EXACTLY what has happened in the equity markets from 2011 to 2012.  Last year was a volatile and frustrating year driven by a lot of economic fits and starts.  But, when the calendar turned, investors woke up happy and trusting that our economic fortunes are improving.  Fortunately, we tend to agree. 

One of the things that really stands out to us, for the first time in a long time, is that the right groups are leading this rally.   Over the past several years, we’ve seen the industrial, technology and precious metals sectors lead us on rallies of various lengths and distances.  However, these weren’t the groups that led us into this economic malaise and we felt that these rallies wouldn’t gain significant traction for a meaningful recovery until two groups LED; financials and homebuilders.  

Fast forward to our 2012 rally and it is very easy to see that we are being led higher by the exact groups that started the recession and this is VERY encouraging action for  a more meaningful run. 

On a “not-so-rosy” note, the one thing that stands out to us is that this market  looks eerily similar to the rally from a year ago.  The markets got hit hard in June of 2011 and we’re not so naïve to think it can’t happen again.  As we see it, there are still two major concerns that are potential potholes:

1. China—For as long as we can remember, the Chinese government has been professing their economic growth will continue at 8%.  Understand, China is a communist country so you pretty much have to take them at their governmental word.  Recently, the government came out and made the statement that they believe  growth in China will slow to 7.5%, but many analysts think it will be closer to 7%.  This type of deceleration would be a major drag on the global economy.  Further, China is currently experiencing a 5% inflation rate so their real growth would only be 2%. 

2. Israel/Iran—Needless to say, war is typically not good for the global psyche and Israel seems to have a pretty short fuse.  It appears Iran is doing more to appease the rest of the world, but this is another situation that bares watching.  

The good news is that confidence is coming back in corporate America.  Our 4Q GDP of 3% is a catalyst and the markets should be able to extend their current gains if the economy can build on it’s recent momentum.  As a firm, we don’t like to chase market momentum.  But, if we go through a normal corrective phase, we would feel much better about building more dollars into the equity markets.

First and foremost, “NO” that is not a picture of me or anyone at our office.  But, it is pretty telling of how consumers and corporations are feeling in this economy and our seemingly endless market volatility.   But, make no mistake about it, we are not suffering through a wealth problem, like we saw in 2008, we’re suffering from a crisis of
confidence.

Let me outline our current economic/market situation for you:

Exceptionally low interest rates— It goes without saying that rates are at levels  we haven’t seen in the past fifty years.  This translates to lower borrowing costs in our economy for consumers and businesses.  Low interest rates are typically a strong catalyst for economic growth.

Banks ARE loaning—There is a real misconception in our economy that banks are hoarding cash and not making loans.  Well, it’s not true.  Banks are holding heavy cash levels, but they’re also loaning.  Standards have gone up, which needed to happen, but money is available.   

Corporate America is Wealthy—As of the end of 2010, corporate America was sitting on some $2 trillion of cash and short-term equivalents.   I would guess that amount
has gone up by 10-15% in 2011.  Again, what we’re experiencing is not a wealth problem, corporations simply don’t have enough visibility or confidence to expand their businesses and create new jobs.

Valuations Look Attractive—Corporations have the potential for continued earnings growth, yet we haven’t seen multiples rebound from 2008-2009 levels. The S&P 500 index currently trades at about 13 times its forecasted earnings for next year. Historically, the index has traded a few points higher than that. If we throw in the fact that earnings have been exceptionally strong over the past two quarters, we are trading at VERY low valuations.

If we were in a blind conversation and I outlined the above economy, you would think we’re in the middle of a massive bull market.  I’ve just defined a strong economic environment with the potential to drive stocks higher.  Then, why are we suffering through all this volatility?

Our “confidence crisis” stems from several things.  We don’t see a lot of cohesive leadership on the political front in our country today and confidence stems from the top.  Further,
as a country, we don’t have a lot of confidence in our European brethren.  Greece doesn’t seem to know if it’s coming or going and won’t get out of it’s own way to help itself.  So, globally there are reasons for concern.   If you were a CEO, would you stick your neck out in this geopolitical environment?

The good news is that confidence is a finicky thing; it comes and goes like the wind.  The positives outlined earlier are significant catalysts for what we feel could be a major market run, but that’s a longer-term perspective.  The short-term will more than likely remain choppy, but we see a real silver lining to this economy.  When business and consumer
confidence firms, we should see the markets put together a nice long-term run.

The markets started 2011 with a nice rally but, much like last summer, they have now entered into a consolidation phase.  We’re continuing to experience a strong “underbelly” to this market with strong internals.  Thus, we feel this corrective phase will eventually give way to higher prices. 

Following a two-year rally in stock prices, it’s natural for investors to wonder if equity prices are now fairly valued or perhaps even overvalued.  In our view, global equity markets still offer attractive valuations and the potential for continued upside growth. Our outlook on stocks reflects the favorable characteristics we are continuing to see in our economy; low-interest-rates, strong corporate balance sheets and attractive valuations.  Additionally, we’re on track to create about 2.5 million jobs in 2011, which would be a big positive for our continued recovery. 

Borrowing Costs Remain Low—While the yield curve is steeper than it was a year and a half ago, interest rates are still relatively low. Companies that need to access the capital markets can do so at attractive interest rates. Rates could, and probably should, rise at some point in the future in response to inflationary concerns.  We aren’t seeing significant inflationary pressures to date, but that can change very quickly. 

Balance Sheets Getting Stronger—Coming out of the financial crisis, corporations have done a good job of conserving capital and cutting costs.  With a high level of cash on their balance sheets, they have been able to pay down debt, increase dividends, and in some cases buy back shares.  When we first started to see earnings improve, it was often attributed to cost cutting (i.e. layoffs and shutting down factories).  Now, we’re seeing earnings improve from operations because companies invested wisely during the downturn.

Valuations Look Attractive—Corporations have the potential for continued earnings growth, yet we haven’t really seen multiples fully rebound from the 2008-2009 levels. The S&P 500 index currently trades at about 13.5 times its forecasted earnings for next year. Historically, the index has traded a few points higher than that, so we believe the U.S. market may be undervalued. Profit margins look like they may have peaked in the short-term and this may be working to compress valuations. 

We also believe that growth stocks are more attractively priced than value stocks at this point in the economic cycle. Historically, growth companies have traded at a nine multiple-point premium to a value company, whereas today they trade at a two multiple-point premium. So not only are stocks in the U.S. cheap in general, we believe there’s a real opportunity to buy undervalued growth companies.

Economic and market  trends remain strong.  We seem to be hitting a soft-patch in the short-term, but that’s normal in the stair-stepping action of an economy or market.  We are cautiously optimistic for the remainder of 2011 and 2012 and feel our current market doldrums will eventually give way to higher prices for 2011.

The US economy grew at an annualized rate of 1.8% in the first quarter of 2011, a sharp deceleration from the 3.1% pace in Q4 2010. Economic growth was also well below the US economy’s “trend” rate of around 3%. This is important because even if the US economy grew at an above-trend 3.5% this year (we think it will grow at a more modest 3%) the unemployment rate will only fall to about 8.4% by year end. This is still a long way from the Fed’s “mandate-consistent” target of 5-6%. Of course, policymakers know this and are likely to prefer easier monetary policy as long as inflation does not flare up. However, therein lies the policy dilemma. The FOMC “hawks” worry about headline inflation and prefer a more immediate end to accommodative monetary conditions. The “doves,” including Chairman Bernanke, view headline inflation pressures as transitory and are more worried about slow economic growth and unemployment. Our view is that recent increases in headline CPI are driven primarily by motor fuel prices, not generalized inflation. In fact, if you exclude the motor fuel category from the headline CPI, the headline CPI measure mirrors the core CPI, up just 1.2% over the last 12 months.

Nonetheless, the division among FOMC members suggests that the bar for additional easing (beyond QE2) is fairly high. Absent a further deterioration in economic growth prospects and a resulting resurgence in disinflation concerns, the FOMC’s “exit timeline” is likely to unfold as follows:  end QE2 on June 30, end reinvestment of MBS proceeds into Treasury securities (this shrinks the Fed’s balance sheet and marks the initial phase of “tightening”), remove the “extended period” language from the FOMC statement, and initiate the first rate hike “a couple of months” later, in Bernanke’s words. We still see Q1 2012 as the earliest possible date for this rate hike.