A glass half-full

An investor doesn't have to look too far to find reasons to fret. From the Middle East to the Far East, events are reshaping our world at a dizzying pace. Even in the U.S., changes are afoot that require us to rethink some basic ideas about the role of government. After referring to the old adage that "markets climb a wall of worry," one market observer recently quipped, "the current list of worries looks more like the Great Wall of China!"

Despite economic and political worries, we see three reasons to be cautiously optimistic about the future.

  1. The markets have established momentum that should help propel it forward.

  2. Continued corporate profit growth bodes well for equity valuations.

  3. Economic fundamentals are supportive of further equity market gains.

Of course, we fully expect to go through down periods in the market in coming months. It would be unrealistic to expect the market to maintain the current rally without an appreciable pullback at some point. Nevertheless, for now, we feel the factors remain in place to deliver a return in 2011 in line with general capital market expectations.

"Market's got mo"

Momentum or "mo" can be a strong factor in market returns. Newton's first law of motion says that a body in motion tends to stay in motion unless it is acted upon by an external force. This applies to markets, as well. Over the past two years, the U.S. equity market has built up tremendous momentum, enjoying the strongest rally since 1956.

The rally continued in the first quarter. Small cap stocks led the pack with a 7.94 percent advance, while large cap stocks grew by 5.92 percent. International markets lagged as investors struggled with turmoil in the Middle East, the earthquake and its aftermath in Japan, and the ongoing fiscal problems in the Euro Zone.

Despite the massive rally, we believe stock valuations still look attractive. We gave our reasons in a February post titled Room to Run. Our five reasons are as follows:

  • Operating profits in S&P 500 companies continue to advance rapidly.
  • The ratio of market price to operating earnings (P/E ratio) has room to expand further.
  • Moderate expansion in the P/E ratio will lead to large percentage increases in the index.
  • Dividend growth is increasing.
  • Stock buy-backs will like increase in the future.

Economic fundamentals are mixed, but the weight of evidence points toward continued recovery and therefore continued gains in the equity markets.

Digging out

The labor markets continue to dig out from the dramatic implosion that accompanied the 2008 meltdown. In terms of jobs lost, 2008 dwarfs every other economic recession since World War II and recovery will take some time. "Glass-half-empty" observers will see this as a reason why equities have limited upside. We prefer to see the coming job creation as impetus for further market growth. Labor market gains will be the engine for profit growth and those profits will fuel further gains in the equity market.

A question of confidence

Recent global events have hurt consumer confidence. The two most influential surveys on consumer sentiment registered significant declines in March, though both remain well above 50. (A reading above 50 means more responses were favorable than unfavorable.) Given the improving labor markets, we expect these surveys to show increasing confidence in the months ahead.

Other confidence indicators are much more bullish. The Conference Board's survey of CEO confidence hit 67 in the first quarter--its highest level since 2004. This indicator bodes well for the labor market as firms ramp up hiring to take advantage of opportunities perceived by corporate leadership.

Consumers are still at it

Sentiment may have taken a hit, but you wouldn't know if from the consumer behavior. If anything, their level of consumption is increasing. Even after two years of recovery, when year-over-year comparisons should be getting a lot harder, retail sales growth is accelerating. Our most recent observation, February's 8.9 percent growth, was the fastest year-over-year growth rate since March 2000.

Inflation

The potential for higher inflation has been a serious concern of ours for several months. We track expectations for future inflation by comparing the yield of regular U.S. Treasury notes with the yield of their inflation-protected counterparts. The difference between the two is the amount of yield demanded by investors to compensate for inflation over the life of the investment. In other words, the difference represents the market's expectations for inflation. Though inflation expectations are clearly rising, at 2.2 percent they are only slightly above average and well within boundaries typically considered acceptable.

The core of the issue

There is ongoing debate about the validity of so-called "core" inflation. Core inflation exclude the more volatile food and energy components. A quick trip to the gas station or the grocery store reminds us that food and energy inflation is every bit as painful as other types of inflation, but policy makes at the Federal Reserve spend most of their time focused on core inflation. Why?

The answer can be seen in the following chart comparing the Consumer Price Index ("headline CPI") with the Core CPI. The blue line plots the headline CPI; the red line plots core CPI. Core CPI is much more stable than headline CPI. Food and energy inflation is transitory, causing headline CPI to bounce around the trend established by the core CPI. While headline CPI gives us valuable information about immediate price pressures, core CPI tends to give us much better insight into the long-term inflation picture (something the Fed cares a lot about.) At present, both are within reasonable bounds.

Interest rates

 The Federal Reserve's program of quantitative easing (QE2) has driven down interest rates for all maturities of US Treasury debt. But interest rates won't stay this low forever. The question is, how high will they go when they start to rise and will that derail the economic recovery and the market?

Using the relative levels of current interest rates we can get an idea of the market's expectations for future interest rates. The following chart plots the expected rise in 7 year Treasury yields two years into the future. Over the next two years, the market expects the yield on 7 year Treasury notes to increase by about 1.50 percentage points to 4.3%

A 1.50 percentage point increase in yields will be painful for bond investors and we are in the process of reviewing all bond positions to see if an adjustment should be made. However, if the increase in rates is orderly, we believe this level of interest rates is sustainable and even appealing for an economy experiencing annual GDP growth of 3 to 4 percent. The stock market should be able to withstand a move of that magnitude. The key is achieving a orderly transition from QE2's hyper-stimulative policy to a more normal policy regime.

Conclusion

Discipline is the key to investment success. Confronting the "wall of worry" may be intimidating at times, but astrong investment philosophy founded on proven principles can help maintain discipline. We believe the factors are in place to support a positive direction inthe equity markets for the rest of the year. While we expect bond markets to struggle as interest rates inevitably rise, we believe healthy corporate profits, improving labor markets and well-behaved core inflation will allow equities to deliver acceptable returns.