Snowballs Eventually Melt
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Rising equity markets can do remarkable things. Like a snowball rolling down the face of a mountain, the equity market's rise seemed unconvincing at first but has built size and speed and grown to such girth that it appears unstoppable.
The S&P 500 is up over 150% since March 2009 and trades at higher trailing valuations than it did at the peak in 2007. This raises the question, what next? For a time, higher asset prices lead to higher asset prices. Bull markets feed upon themselves and buying begets more buying. On the other hand, stocks can and do fall–sometimes substantially. At some point stocks stop going up and start to decline. This is obvious though often forgotten.
Why do stock prices go up? Why do they go down? There are a myriad of answers, though Newton's first law of motion does great justice:
An object at rest stays at rest and an object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force.
That is, asset prices keep going up (or down) if the factors that influenced the direction remain in greater force than the factors that could cause a change in direction.
As the graphic attempts to convey, the investment landscape still carries more positives than negatives. In March 2009, we had an excellent landscape with which to begin a market ascent. Today, much of the same factors are in place that have positive impacts on equities, including an accommodating Fed, low interest rates, rising profits, a growing economy, recovering housing prices and construction, increasing auto sales, and seemingly fair forward valuations. This is the basis of the bull case.
The bear case is also sensible. Stocks are at all-time highs. Profits are also at all-time highs and margins are approaching new records. Valuations look more reasonable than they are due to these record profits. If you adjust for the business cycle, the equity market is quite richly valued. Therefore, future expected broad stock market returns are low. Analysts have failed to learn any lessons from sins of past and are forecasting earnings to continue to grow at double-digit rates for the foreseeable future with no possible recession in sight. That is to say, market participants are pricing equities to perfection.
This bear case is fact-filled, but Newton's first law of motion requests: what force or forces will offset low interest rates, rising profits, and an expanding economy?
We write all this so you gain a better understanding of the push and pull of the stock market. A lot of the questions we are asked concerning equity prices begin with "why" and "will" so Newton's first law of motion is rather instructive. Let us be clear: we do not know what stock prices will do in the coming weeks or months, nor do we base our investment decisions on possible near-term price moves.
We research and value businesses with a full economic cycle in mind and invest when these companies trade at reasonable discounts to their worth in hopes of owning them for the next three to five years. We also study the economic landscape and the business results of our holding companies as well as other economic bellwethers to gain insight into possible major inflection points, that is, when the economy moves from economic expansion to contraction. The rest is noise.
While the broad equity market is priced for low future returns, our positioning is, in our opinion, priced to deliver double-digit annual returns. We see the economy continuing to muddle along with the Fed holding rates near 0% for the next couple of years–that is to say, the snowball continues to expand, though at a slower pace. We are mindful that all snowballs eventually melt–and this one is likely closer to its demise than its birth–and therefore we are inherently cautious. Our processes are managing down our net exposure, but we remain optimistic and will be so until evidence tell us otherwise.
Black Cypress portfolios rose 4.9% net-of-fees during July and remain ahead of the S&P 500 2013 advance.
(c) Alan Hartley, CFA
Black Cypress Capital Management