Fourth Quarter Outlook
Insight NewsletterIssue #06
Suspended animation…while the Dow Jones made headlines and history hitting new all-highs over the last month, the other indices such as the S&P 500 and the Russell 2000 have failed to make new highs. We aren’t going to claim that the stock market is levitating, but investors clearly are willing to give the benefit of the doubt to equities.
So what has been happening you ask? Well, we believe that stock and bond valuations are high. While corporate earnings are rising, price to earnings ratios are gradually falling and corporate profit ratios have probably peaked. Many pundits and other talking heads (think CNBC) proclaim the attractiveness of equities. We take a different stance. We believe that price to earnings ratios are in a long slow descent to attractive valuations (somewhere between 8x and 15x earnings for most companies. Presently most companies are somewhere between 10x and 25x earnings, so we foresee mediocre average returns for the foreseeable future (5+years) in equities. Long bonds are still paying just 5-7%, so there doesn’t seem to be much value there either. Shorter fixed income paper including higher yielding paper can fetch between 6% and 8% which seems pretty okay. We also still like cash, lots of it.
The fourth quarter is a seasonally strong time of the year when a lot of qualified money (401k, SEP contributions) comes into equity markets. At the same time, US corporate profitability has never been higher. We believe that many companies and individuals are looking to shelter those gains with larger contributions to their qualified accounts. And irrespective of our big deficits, inept government, and profligate consumption, the US financial markets continue to seem to be an outstanding place for foreigners (think Asian Governments, Middle East Sheiks and the upper class of Asia) to diversify their wealth. In sum, we believe equity and bond markets are continuing to benefit from a lot of sustained virtuous cycles. However, we take our guidance more from Buffet and Graham, who said that in the long term the market is not a voting machine, but a weighing machine – value will prevail. We don’t see much value in a lot of equities or bonds, so we will take most our marbles and allocate them differently.
Some of our favorite sectors remain Energy and Precious Metals. These two also gained some love, too much of it in fact, from hedge funds, earlier this year the result was indigestion on excessive capital gains. Since those May highs these two markets have been digesting their large advances. We believe that the valuations in Energy stocks are low and attractive. While we have little confidence that immediate short term trading gains can be had in these areas, we do believe that longer term capital gains in the double digit arena can be had over the next 2 to 4 years in Energy and Metals.
The economy: is it stupid, is it slowing? Well it’s pretty certainly slowing (GDP growth fell to 1.6% in the 3rd Quarter from 5.6% in the 1st quarter), it’s big, and it’s global. That makes it confusing for all. In a slowing economy just after an election, the chances of continual slowing due to persistent high energy prices, falling real estate prices, and an inverted yield curve, is pretty high. In a slowing economy we want to be defensive, very defensive.
But it’s not just the economy; we currently don’t see a lot of opportunity for average investors. We don’t see many fat pitches. The dirty secret in the investment business is that just like batters and NBA shooting specialists, we miss the ball a lot, certainly 50% of the time or more (but we are better than Economists). Right now we don’t sense any large edge; said differently, the market pricing on equities and fixed income is not offering any compelling risk/reward ratios.
So where are we putting client money you ask? Healthcare and Pharmaceutical companies seem to make some sense now, so do some international equities (dollar diversification) and cash, and gold, and some shorter corporate bonds, even some longer corporates should do alright.
We think the odds of a recession, or slow growth economy next year are real good, and it is likely that some opportunities will be coming our way. Suffice it to say that we reiterate our defensive stance, with over weighting in tangibles (sans real estate) and cash. In the next issue of Insight, we will dig deeper into Municipal Bonds. Our next letter will come out around November 16th.
Daniel Barnes, CFA