Second Quarter 2010 Market Report

Tuesday, August 17th, 2010

Late Summer Update

As the summer season winds down, investors are once again sounding a note of caution over prospects for the economy, prompting a retreat in stock prices from their highs reached in late Spring. Presently, most major market averages rest modestly in negative territory across the US, Europe, and the developing world. The Japanese and Chinese stock markets have been notable laggards, posting double-digit declines. Global interest rates remain very low in most of the developed world, as central banks continue to provide monetary stimulus to their client economies.

Corporate earnings performance has proved firm through the second quarter reporting season, with a majority of companies announcing earnings that bested analysts' forecasts. However, market averages have been generally non-responsive to these positive earnings trends, as concerns over macroeconomic conditions, and their future direction, have held stock prices in check. Instead, against an improving earnings backdrop, investors have been dealt flat stock prices, and P/E multiples have come down.

What Can Go Right (Yes, Right) in the Market

An old investing saw goes "if it's in the news, it's in the price," meaning that stock market levels already impound much of the lower-growth scenario dominating investors' concerns. Thus, a surprise from expectations, should one unfold, could well be to the upside.

The structural economic conditions in many of the mature, developed economies are wanting at the moment. This list includes the US, Japan, the UK, and several minor nations within the Eurozone. All are beset, to varying degrees, by too much household and public sector debt. The US and Japan - in the latter's case, for two decades - are trying to stimulate growth with deficit spending and low interest rates. Other countries, notably Greece, late of the headlines, and the UK, have embarked on austere programs of spending cuts and tax hikes to close yawning budget gaps.

Despite the different policy prescriptions, it is a fair bet that those nations struggling with indebtedness and sluggish growth will continue to do so, as their economies only gradually adjust to corrective policy actions. Post-crisis, the bulk of residual systemic risk comes from the accumulation of policy decisions, taken over decades and facilitated by both political parties, that leave us with too much debt, too many financial promises (e.g., entitlement spending) to keep, and a domestic economy that will remain challenged to keep those promises.

Amidst this less-than-stellar backdrop, though, corporations can continue to thrive. A multinational company, in particular, has ample flexibility to deploy capital toward growth initiatives, to optimize monetary and tax regimes to its advantage, and to generate earnings gains despite modest revenue growth. Global companies that can reach higher-growth markets in the developing world are prime beneficiaries of such scale and adaptability. Due to presently low stock multiples, the risk of owning most equities has been lowered, as companies have focused themselves so intently, both internally (cost cuts, and balance sheet improvement) and externally (end market development), after the financial crisis.

Another potential catalyst for investors actually derives from a sluggish-growth scenario, namely increased merger and acquisition (M&A) activity. Companies finding insufficient organic growth opportunities can "buy" their growth through M&A. Over a virtuous M&A cycle, industries can rationalize capacity, protect margins, and reward investors with higher stock prices. Present conditions are quite favorable: deal financing is cheap and available, corporate balance sheets have ample cash, and capacity to borrow, and target company valuations are reasonable, due to the low multiple environment. In short, multiples that are too low, relative to growth prospects, will be corrected upward through M&A activity. While we are not about to predict a wide-scale M&A boom, the conditions are favorable for the formation of one. And we like the fact that scant investor attention is being paid to the M&A discussion at present.

So, Then, Why the Gloom?

In a normalized market environment, multiples at their current and projected levels would be quite attractive to investors. The market wouldn't remain for long at a baker's dozen multiple; in the post-war world, a mid-teens multiple would be the norm, implying market averages 15% higher on the same earnings base. Yet instead of multiple expansion, or at least stability, we have witnessed pressure on multiples throughout the current recovery.

Numerous factors are at work here to depress the market multiple, some not terribly difficult to fathom. Worries include the following: next year's hoped-for earnings will not be realized, as the economy slows; due to our debt burdens, the longer-term trajectory for growth in the US is diminished; the unemployment problem is severe, and will take years to cure; and last, there remains an elevated sense of risk aversion from the 2007-08 financial panic, which has forced a discounting of the stock market multiple.

We are well-versed with these concerns, and others, and do not mean to diminish them. We endeavor to prepare for a multitude of risks in charting an investment course. Occasionally, though, we need to remind ourselves of the opportunities, and of what can go right. At present, we believe, assuming stable-enough earnings, that stock multiples have a fair chance to expand, as news and event flow prove to be better than expected (or feared) by investors.

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Memo: A Fast Primer on Multiples

At an elementary level, the current price of a stock can be decomposed into its per-share earnings and its multiple, commonly referred to as the price-earnings (P/E) ratio. Take, for example, Johnson & Johnson, which currently trades at $59 per share, and earned $4.84 per share in the last year. Dividing JNJ's stock price by its earnings reveals the stock's P/E ratio, in this case about 12.

Stated differently, for every $1 of per-share earnings that JNJ generates, a new investor is paying $12. And stated even more differently, the inverse of the P/E multiple (that is, the E/P multiple) is called a stock's earnings yield. In the case of JNJ, this value is about 8.2%. In theory, for every $1 of share price, JNJ is generating a return of some 8.2%, which managers are both reinvesting in the business, and returning to shareholders via quarterly dividends.

The logic of prices, earnings, and multiples can be readily extended to a market index. Consider the Standard & Poor's 500 index, comprised of larger US companies and considered a proxy for the US stock market. For 2010, S&P 500 earnings are expected to be about $81, expanding to about $92 in 2011. The current S&P index level is about 1,080, so on this basis, "the market" is trading at about 13 times current-year earnings, and less than 12 times next year's expected earnings.

[As a broad disclaimer, most security analysis is performed utilizing cash flow measurements, and not measurements of accrual-based accounting earnings such as P/E ratios. Nonetheless, accounting earnings, and their trends, remain important indicators of a stock's, or a market's, condition.]

Strategic's Equity Market Strategy

We were net sellers of equities through the summer frame, in an effort to manage downside risk through the market's pullback.

Within our Quality Core strategy, we adjusted our portfolio, and reduced our exposure somewhat to economically sensitive equities. We maintain an overall bias toward economic expansion, however, particularly among companies with global reach. Notable recent purchases were of a blue-chip industrial company, a luxury goods manufacturer, and a manufacturer of "smart" meters serving the electric, gas and water industries. We sold or trimmed several industrial names, and also reduced our holdings among health care stocks.

We sold more than we bought in our dividend-focused Equity Income stock strategy as well, and raised some cash in the process. We added new companies within the utility and health care sectors, and were net sellers of industrials and technology companies. The strategy maintains a tilt toward traditionally defensive sectors of the market.

Of late, coincident and leading economic reports are signaling a softening in economic conditions. However, further to the discussion at the top of this letter, we take some comfort in the undemanding market multiples possessed by many of the stocks that our clients own. As always, of course, investment performance can never be assured.

Strategic's Fixed Income Strategy

The Fed continues to draw a tight noose around interest rates and it shows. We continue to believe that investors are not being compensated appropriately for risk in the fixed income market.

Short rates remain near zero. Reflecting investor concerns about further slowing in the economy, and of the possibility of disinflation, longer rates have declined sharply this year. At present, the 10-year US Treasury yields 2.6%.

Amid ample market liquidity and intense investor demand, investment-grade corporate spreads have tightened as the year has progressed. We also observe that other income-oriented instruments of several stripes (including preferreds, junk bonds, real estate investment trusts, and pipeline master-limited partnerships) have found eager buyers amid tightening spreads.

We expect the current low-yield environment to persist, but not indefinitely. We have continued to maintain short average maturities for our client portfolios. In addition, to prepare for an eventual rate reset, we have increased our purchase of callable securities with step-up coupons, and of variable rate notes that set their payment on changes in a benchmark such as the Consumer Price Index or LIBOR (a short-term rate benchmark).

Our otherwise hallmark requirement for insisting on high-grade credit for client investments remains unchanged.



Scott C. McCartney, CFA
President and Chief Investment Officer
Strategic Financial Services, LLC


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