10,000 Dow is it Justified? Now What?

We still face rising unemployment, foreclosures and weak consumer spending. Yet most economists and the Fed believe that the economy will grow slowing for the rest of 2009 and into 2010 before it turns up more sharply.  Slow economic growth is better than the deep recession that began in December 2007.

The Dow¹ psychological milestone was reached after 3^rd quarter earnings started coming in once again much better than expectations. Better yet many companies were seeing solid revenue growth not just profit growth due to cost cutting from layoffs. Amazon.com and Apple’s huge beat of both profit and revenue estimates for 3^rd quarter is especially important since most of their businesses are consumer driven.

Strong Rally – As a guest on CNBC said, probably 30 percentage points (about half the gain) of the current rally was because markets were valued at the bottom based on panic that we could be going into a Depression. We avoided Depression and now are looking at a recovery.

Valuations - The S&P Index Service weekly consensus estimate for S&P500¹ 2010 earnings keeps increasing. As of 10/20/09 it is at $73.88 - a 34% gain over 2009 earnings. The forward P/E ratio is a very reasonable 14.8. This supports the view that the market still has plenty of upside potential from both earnings growth and P/E expansion, especially in this early recovery stage.

For 2^nd quarter 2009, 72% of S&P500 companies beat their earnings estimates. As of 10/20/09 79% of early reporting companies were beating expectations for 3^rd quarter. According to Bespoke, the current beat rate is well above any other quarter since at least 1998. ”Even with analysts raising estimates significantly leading up to the earnings season, companies have still managed to come in better than expected so far,” they said.

“Rubber Band” Potential - Some analysts such in Financial Times 10/5/09 suggest a “rubber band” or “rubber ball” potential. Many companies have lots of excess capacity and trimmed down employee costs.  Increases in revenue go mostly to bottom line profits and earnings could potentially shoot up more rapidly than current estimates.  Rehiring typically occurs once revenue growth is seen as sustainable and more workers are needed.  

“The rally may be much more sustainable than some people think. We forced corporations to prepare for a Depression. Then not only no Depression - but now a recovery which gives you massive profit leverage.” (Wells Capital Chief Investment Strategist CNBC 10/15/09)

 

 

Pullbacks - In the recovery from the March 9^th (Dow¹ at 6,547) we have had periods of scary pullbacks. With the corporate earnings outlook very good going into 2010 and with expected economic growth – even if slow – the market has quickly recovered from pullbacks and rebounded. More pullbacks are to be expected, but the outlook over the next few years is favorable by most measures.

Capitulation Potential – Many investors gave up and sold as the market tanked causing a further plunge in stocks.  Soon, more investors may reinvest as the opportunity seems greater than the danger at this point in the cycle. “$3.5 trillion is still in money market funds with almost no yield. There is a big wave of money that still needs to be invested to achieve the returns necessary for people to retire. Cash just won’t do it.” (CNBC 10/14/09)

Recommended Strategies - We recommend three investment strategies depending on your objectives, time horizon and outlook.

1) Recovery strategy to maximize potential market rebound over the next few years after the greatest financial crisis since the Great Depression.

2) "Participate yet Protect" strategy especially for longer term funds to protect from future market crises.

3) Pure Protection strategies such as various cash options or annuities.

The three strategies can be combined within a portfolio depending on your objectives.

For our recovery strategy, we do not recommend just index returns but funds that have historically consistently outperformed the “dumb” indexes or ETFs with positive Alpha (outperformance vs. risk taken). Past performance does not guarantee future results.

I continue to be very proactive, suggesting changes as warranted to take charge of investment opportunities - not be a victim of static allocations, models or just average index investing.

Small vs. Large – Historically smaller companies have led in recoveries. However today it is much harder for smaller companies to get financing. Until recently almost no companies could raise capital. But lately larger companies have been able to raise new equity or debt with public offerings.  Smaller companies are more dependent on banks for capital which is still a major problem.

 

Foreign Outlook² - A few months ago the U.S. looked like it would lead the world out of recession. But now the outlook is also looking good in much of Europe, Latin America and especially in Asia (except Japan) which may have the fastest rebound.

 

Overall the global recession is over but the nascent recovery is not quickly gaining traction, according to the results of the latest Survey of Business Confidence of the World by Moody’s Economy.com. “Businesses remain more upbeat about the outlook into next year and broader economic conditions, and dourer when considering the strength of their sales and intentions to hire. South Americans are the most positive and North Americans generally the most negative.”

 

“Singapore, which led Asia into recession, pointed the way to further regional recovery with strong third-quarter economic growth … GDP expanded 14.9% in the June to September period, after a comparable revised increase of 22% the previous quarter,” reported the Financial Times.

 

Further good news on the global economic front came from Eurozone industrial production that expanded for the fourth month in a row.

 

Dollar Decline – The declining dollar tends to help the U.S. economy as it makes exports cheaper. It also benefits U.S. investors in foreign investments. As long as the decline is controlled and gradual it is not a major issue.  If the U.S. has to act to defend the dollar the usual mechanism is to increase interest rates which results in a loss in bond values.  I discuss this more in our Bond Update.

 

Positive U.S. Economic Signs - The October Philly Fed report was positive for the third straight month. According to Bespoke, “the last time this indicator was positive for three straight months was from September through November 2007”.

 

Dissecting the September retail sales data shows that trends improved all over, with the exception of auto-related sales due to the ending of “Cash for Clunkers”.

 

Industrial production increased 0.7% in September, following an upwardly revised 1.2% gain in the prior month. The industrial production index hit the cycle low in June and has since risen every month. In the third quarter, industrial production rose at an annual rate of 5.2%, the first increase since the first quarter of 2008.

 

Short Interest back to pre crash levels – Bespoke reports that as of the end of September short interest in the S&P1500 was at the lowest level since the start of 2007 long before the market plunge. Short Interest is the measure of those betting the market will decline so they sell a stock “short” expecting it to decline so they can “cover” the short position at a lower cost.

 

New Highs Expand – Bespoke reports “This is a bull market that’s lifting all boats. With today’s run above 10,000 in the DJIA, and another new high in the S&P 500, the number of stocks in the S&P 500 hitting 52-week highs rose to 22%. As long as this figure can expand as the market rises, the ball is in the bulls’ court.”

 

Gold driven by thin traded speculation – With inflation a long ways off with so much excess capacity and increased productively the argument for buying gold at all time highs of over $1000/oz doesn’t make any sense to me. Gold had previously peaked at $888(Intraday) in 1980 - not a good long-term return.

 

 

¹Investors cannot directly invest in indices. Past performance does not guarantee future results.

²Additional risks are associated with international investing, such as currency fluctuations, political and economic stability, and differences in accounting standards

The views and opinions expressed by Dave Hutchison, CFP are as of the date of the report, and are subject to change at any time based upon market or other conditions.  The material contained herein is for informational purposes only and should not be construed as investment advice, since recommendations will vary based on a client’s goals and objectives. Information is believed to be from reliable sources; however, no representation is made as to its accuracy.  All economic and performance information is historical and not indicative of future results.  Please consult one of our financial advisors for more information. Hutchison Investment Advisors, Inc. is an Arizona registered investment advisor. Part II of Form ADV (Disclosure Statement) has been given advisory clients and is available upon request and is at www.davecfp.com