Friday, September 6, 2013

Say Goodbye to Summer...

From the Desk of Joe Rollins

It’s hard to believe that September is already here; summer came and went in the blink of an eye, without a whole lot of sunshine. I don’t recall playing a single round of golf the past few months that wasn’t on soggy ground. Despite the rain, it was a pretty eventful summer for me and my family.

In August, my son, Josh, began his first week as a freshman at Auburn University then shortly after, my daughter, Ava, began her first week at Peachtree Presbyterian Preschool as a 2 year old. Poor Ava just cannot grasp the fact that although she and Josh both go to school, they do not attend the same one and cannot ride a school bus together. I guess this concept will take a little while for her to understand, which is fine by us as this show of innocence is just another one of her endearing qualities.

Josh's first day

Ava's first day

In addition to the start of a new school year for my children, August also brought my 64th birthday as well as having owned my own company for literally half my life. When I began this firm in my living room in 1981, I really didn’t know what the future would hold. I felt relatively sure I could get a few clients, but figured if all else failed I would just go back and work for another CPA firm. Thirty-two years later we are still growing every day, adding new clients located throughout the United States and even overseas. Despite my optimism, I truly never believed I would still be at it more than three decades later. It has been an amazing run but I’m not even close to the finish line.

People ask me all the time when I intend to retire, and my response is easy and simple - possibly one day, but definitely not right now! When my daughter is 18 years old, I will be the ripe old age of 80, so most likely they will have to carry me out from behind, or under, my desk.

But now let’s move on to more important matters. While virtually all financial assets were down for the month of August, we still managed to have an extraordinarily good first eight months of 2013. The Standard & Poor’s 500 index (S&P 500) of stocks was down 2.9% for the month of August, yet it is still up a sterling 16.2% through August 31, 2013. The NASDAQ has been the best performer for this year, up 19.9%, despite being down 0.9% for August. The Dow Jones Industrial Average was also down 4.2% for August, yet continues to be up 14.9% for 2013.

It really did not matter what you were investing your money in during August, essentially everything was down. Almost all international equity funds were down similarly to the U.S. markets. Even bond funds were down for the month. I cannot help but think that people panicked at the mention of potential military conflict in Syria and began selling financial assets, whether stocks, bonds, or otherwise. This is just another example of how the uninformed often react spontaneously.

As I have discussed in these blogs so many times before, we are investors, not traders. Whatever happens in Syria is not likely to have a long-term effect on the financial markets or corporate profitability. Since Syria produces very little oil, the logic for the oil prices skyrocketing is ridiculous. While it’s perfectly possible that the conflict in Syria could spread to other countries, it is highly unlikely given the scope of the engagement being considered. After all, we have already told them when and where we will be firing off what is sure to be some of our old, outdated missiles and have also informed the citizens of the country to avoid the area where they may land. Therefore, this most likely will not become a financial issue worth considering.

In October, we are expecting the next fight on the extension of the federal debt limit. We could all debate this for months on end, but the truth of the matter is that at the end of the day they will extend the federal debt. While the markets may be volatile during these discussions, you may rest assured that in the end an extension will be in order. It seems like more than ever the players in Washington want to have their five minutes in the spotlight, and this gives them a perfect opportunity to do so. There will be some horse-trading that occurs behind the scenes, but at the end of the day it will have no long-term investing implications for us, thus giving us no reason to trade around this event.

So where do we stand going into the last four months of 2013? I have reviewed all of the economic data and now believe the S&P 500 will end the year at around 1750. As of September 3, 2013 it was 1634. If we were to in fact reach that level, the S&P, including dividends, would be up an outstanding 20% for the year 2013. I have looked at a lot of data and feel comfortable with the notion that we will be somewhere in high double digits rather than the low double digits that I previously projected.

What gives me this level of comfort is that it looks like the S&P earnings for 2014 will be roughly $120 per share. If you give those earnings a reasonable multiple of 15, the S&P should be trading at 1800 during 2014. Since the market tends to forecast the future rather than reflect the past, a 1750 year-end balance would be a reasonable estimate of the market going forward. All of these numbers appear to be seasonable and therefore illustrate that the market is not over-valued at the current time.

In May of 2013, the Federal Reserve made an announcement that they would begin tapering their purchases of bonds before the end of 2013. At the time of their announcement, the ten-year Treasury bond was selling at 1.6%. Today, the ten-year Treasury bond yield is selling at almost 2.9%, having almost doubled in the last four months. Such a move in interest rates is almost without parallel. As a result of the skyrocketing interest rates, virtually all bonds are trading negatively for the year. In most years, bonds are a nice addition to stocks in that they take the volatility out of the market and reduce risk. Unfortunately, this has not been the case in 2013.

The "Fed Model," which is a formula for a fair stock market valuation often attributed to Alan Greenspan, is calculated by taking next year’s S&P earnings and dividing them by the ten-year Treasury interest rate. Currently, next year’s earnings are considered to be $120 divided by 2.9% which would reflect a current valuation of 4137. As previously mentioned, the S&P is currently at 1634. Therefore, interest rates would need to be over 6% to justify this level of the S&P.

That analysis indicates that either the market is grossly undervalued or that interest rates are way too low; at the current time it appears that interest rates continue to be too low signifying that the market is not being undervalued. My suspicion is that interest rates will continue to go up for the remainder of 2013, resulting in a negative rate of return for bonds. Every time I mention interest rates, I like to remind people that in October of 2008, the ten-year Treasury bond was at 4%. That was considered to be the beginning of the financial crisis, and five years later interest rates have not approached anywhere close to that level.

From a true economic standpoint, the status quo continues to be constant. The GDP was updated recently for the third quarter up to 2.5 from 1.7. While certainly not tremendous GDP growth, it’s still a long way from negative. As employment improves and housing stabilizes, the economy continues to show a slow but steady increase leading me to believe that none of the economic circumstances we are seeing today will alter my forecast for the end-of-the-year stock market levels.

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

Best regards,
Joe Rollins