Thursday, December 6, 2012

November – From Terrible to Satisfactory

From the Desk of Joe Rollins

After President Obama was reelected in early November, the equity markets took a noticeable hit. Many investors perceive Obama to have little regard for satisfying the current deficit, intent on increasing taxes and being anti-business, and therefore, the equity markets sold off to the tune of an over 6% loss in just over one week. Fortunately, however, the markets rallied prior to the end of the month, closing the month essentially flat.

For the month of November, the Standard & Poor’s Index of 500 Stocks ended with a .6% gain. The NASDAQ Composite was up 1.3%, and the Dow Jones Industrial Average was down a marginal .2%. Year-to-date, the S&P is up exactly 15%, the NASDAQ is up 16.9%, and the DJIA is up 9.3%. If you recall, at the beginning of the year I expected the S&P to have a mid-double-digit gain for the year, and that expectation has now been reached. If the month of December remains steady, excellent returns will have been realized for 2012. In spite of the negative news, 2012 has been a great investment year.

Although the equity markets have been especially volatile the first two months of the 4th quarter, the S&P is down an only marginal 1.4% for the 4th quarter so far. Given the high volatility, you might expect for the loss in equity markets to have been greater.

Historically, December through May of the following year are the best months for the equity markets; this is not a coincidence. Many corporations – and individuals, to a lesser degree – fund their retirement plans during these months. Corporations are obligated to fund their pension plans, 401(k) plans, and matching contributions during the month of December through the first quarter of the following year. Traditionally, this has allowed the equity markets to float up during this period. The term ’Santa Clause Rally’ has been used by Wall Street almost since the beginning of time, and it’s not at all based on Christmas sales. Rather, it’s based on corporate funding of retirement accounts at year-end.

While it makes some sense to review prior year trends when making stock market projections, at Rollins Financial we believe projections should be based on more than just theory. As I have explained in prior posts, the best projections come from analyzing corporate profits. Therefore, the current fiscal cliff fixation is relatively immaterial to long-term investing. Going over the cliff could certainly create hefty, short-term swings, but in the end, it is not likely to have much of an overall negative long-term effect.

Unfortunately, the bozos in Washington can’t seem to focus on reality. Neither side is currently making a valid attempt to negotiate the issues. I find it unbelievable that the President’s answer to solving the country’s deficits is to dramatically increase taxes and increase spending, moves that have proven in the past to only increase deficits. And while Republicans have conceded to some tax increases, they are also too fixated on not increasing marginal tax rates which must be negotiated if they are committed to getting something done.

History documents that higher tax rates do not lead to higher revenue for the government, but it doesn’t appear to me that President Obama has read any of those reports. For example, in fiscal 2010-2011, Britain instituted a 50% income tax rate on millionaires (the previous rate was 40%) causing the number of taxpayers declaring income of £1 million for the year to fall more than 60% from the prior year.

Britain’s goal in this 10% increase was to raise an additional £2.5 billion in revenue. But at the 50% rate, Her Majesty’s Revenue and Customs yielded £6.5 billion from millionaires whereas in 2009-2010, British millionaires paid £13.4 billion in taxes. Even though results such as these are well-documented, we continue hearing remarks like, "We're going to have to see the rates on the top two percent go up and we're not going to be able to get a deal without it," from President Obama.

President Obama seems totally unable to deal with the U.S.’s long-term fiscal issues, but neither side is proposing anything that resembles a meaningful plan to solve the huge and growing deficit. Perhaps we would all be better off going over the cliff. If that happens, at least there is a plan in place to solve the deficit problem. However, you can call me Pollyanna, but I still believe that some compromise will be reached despite the gross incompetence in Washington.

We have prepared a few charts and supporting exhibits that will hopefully leave you feeling a little more optimistic about the markets and the economy. The chart below reflects that the performance of the stock market closely follows the performance of corporate earnings.

As the chart above indicates, stock prices increase as corporate earnings rise. The reality is that for most of the 2000 years, the S&P 500 was selling at greater than corporate earnings. In recent years, corporate earnings have increased dramatically higher than the stock indexes even with the reality of lower interest rates. We believe this bodes well for higher stock prices in the future. See Exhibit 1 for more details.

Historically, the average price/earnings multiple for the market is about 15 times earnings. The reasonable price for the S&P 500 is currently 14 times 2012 earnings estimates of approximately $102, which means that it is slightly undervalued at the present time.

However, there are many reasons that the current P/E multiple may be low. Given the current low interest rate environment of practically zero, arguably, the market could easily sell at a much higher multiple than the historic rate of 15. Additionally, over the last several years, there has clearly been a recession in Europe and a slowdown in Asia. Many argue that corporate earnings of the 500 largest U.S. corporations could explode to the upside if Europe solves its problems and Asia begins accelerating again. See Exhibit 2 for more details.

The unemployment chart below further illustrates my foregoing point. Unemployment has not improved dramatically, but it is gradually improving. Again, while job growth is still lackluster and unemployment is way too high, the chart does demonstrate how corporate earnings could be positively impacted if unemployment dropped to a more normal level. With more people working, corporate earnings will be higher. See Exhibit 3 for more details.

The chart below reveals that housing has finally turned the corner. The recovery has not been an upward explosion, but even a minor improvement in housing has a major positive economic impact. So many people are employed, directly or indirectly, in the housing market. While we all consider contractors to be dependent upon the housing market, there are also many suppliers who are dependent upon the housing market. Many industries sell to the housing industry that will be positively affected in the way of earnings if housing recovers to the pre-boom years. See Exhibit 4 for more details.

Corporate bonds in November were basically flat while high-yield bonds and foreign bonds had gains almost equal to the S&P 500. Undoubtedly, we are in an interesting time. Under normal circumstances, we would expect interest rates to begin accelerating upward as the economy improves. However, the Federal Reserve has essentially guaranteed that short-term rates will not increase before 2015. Never in the history of American finance has the Fed provided such guarantees. Therefore, even though it’s intuitive and reasonable to believe that bonds would suffer major losses in 2013 due to this artificial restraint of interest rates, it’s unlikely that we’ll see an increase in overall interest rates paid by corporations. This low interest rate environment and moderate increase in inflation is positive for corporate earnings, and therefore, also bodes well for higher stock prices. See Exhibit 5 for more details.

The final exhibit reflects some of the political developments presently at hand. These are short-term issues we are facing, and none of us can know exactly how this political ping pong match will end. Regardless of the outcome, my argument from an investment standpoint is that we are better off investing using the information we have at hand rather than attempting to invest based on uncertainties. See Exhibit 6 for more details.

I wanted to provide you with real information rather than hyperbole. Rather than attempt to evaluate the investment environment in the future, we want to provide you with facts that should provide a level of comfort that the market is not in for a major downturn for the long-term. In fact, we anticipate that the market could gradually move higher over the next 13 months. Moreover, I expect returns for 2013 to be approximately 10%, or an amount five times the current rate of inflation – but with high volatility along the way. With mid-double-digit returns in 2012 and double-digit returns in 2013, we should have nice two-year returns, building wealth for our clients.

If you aim to build true wealth for your retirement years, no other investment vehicle offers you the potential for gains going forward than the equity markets. I am often stunned by an investor’s apprehension to invest early in a year. If you want to maximize your IRA returns, the very best time to invest is in January of each calendar year.

As always, we welcome the opportunity to meet with you and discuss your financial goals and strategies. If we do not see you during the holidays, we certainly wish you a happy and healthy season.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins