The Shooting Star

I grew up in Cincinnati, Ohio, home of the Big Red Machine, Skyline Chili and Graeter’s Ice Cream. But what I remember most about being a kid in Cincinnati is the Shooting Star roller coaster ride at Coney Island amusement park.

The Shooting Star was one of the fastest, tallest, scariest roller coasters in the Midwest. I can remember getting into a car, the bar coming down on my lap to secure me in the compartment, and then hearing the clanky sounds as we moved to the top of the world. As we approached the top of the platform, our car stopped, and an eerie silence descended on us right before we plunged to the ground. Then the car jerked us back up a long hill at horrific speed before making a sharp right turn and then a left turn…

As I watched the markets during the second quarter, I thought a lot about the Shooting Star. And about the headwinds and tailwinds that were the subject of my last issue of the Peachtree Quarterly. It seems that as the second quarter came to a close, there were a lot more headwinds than tailwinds, especially when compared to the previous few quarters.

In short, the second quarter was virtually the opposite of the first quarter of 2010. The broad equity market had been climbing more or less steadily upward since March 9, 2009, on stronger corporate profits and expectations of future growth. Then we were hit with the fallout from economic issues facing Greece, Portugal, Spain and some of the other European countries, an intraday 10% correction, the end of the housing tax credits, and continued high unemployment. As a result, in the second quarter the market gave up its gains from the first four months of the year and closed down more than 11%. No sector or company escaped the battering.

So what happens now? Certainly we know there are still strong headwinds. We read about them in the business periodicals and hear about them on cable TV. And they are real. The government continues to run up debt and seems unable to make any meaningful changes. And as both parties gear up for the midterm elections, the likelihood that they will work together grows even more remote-at least until the fall. The public lacks confidence, in the government and in the economy. Banks are hoarding cash, worried about what the economy will do, and that makes less money available for companies looking to grow.

But let’s not forget that there are still some tailwinds out there. For example, unlike the government, the private sector has lots of cash. In fact, corporate balance sheets are showing $1.8 trillion in cash. In addition, carload volume growth on rail trains continues to be solid. The International Monetary Fund raised its global growth forecast and now expects the world economy to expand 4.6%, compared to April’s 4.2% projection.

But I believe the most important tailwind is valuation. With S&P 500 corporate profits estimated by Wall Street analysts at $78 per share on a composite basis for 2010 and around $90 for 2011, the market is not overvalued. In fact, the companies in the S&P composite are now selling at around 13 times this year’s earnings and only 11 times next year’s earnings, according to Wall Street analysts. Some very large and very well-known companies are selling at close to single-digit price-earnings ratios on next year’s projected earnings. These include companies like ATT, Alcoa, Bank of America, Chevron Corp, Exxon Mobil, Hewlett Packard, IBM, Intel, Merck, JP Morgan, Pfizer and Travelers. These are much more attractive valuations than we saw a decade ago, when investors could not seem to buy stocks fast enough.

Of course, part of the reason for the difficulties of the last year can be traced to that rush to buy overvalued stocks, but the fact remains that when you look at the financial realities of companies, there is plenty of reason to be optimistic and own their stock.

And don’t forget the ability to make money on dividends, which have comprised approximately 50% of the stock market’s total return since 1930.

So what’s the takeaway from all this? The situation remains serious. Consumers are still struggling, and long-term growth depends on consumers having money to spend and the confidence to spend it. Problems in Europe and elsewhere continue to be a drag on the world economy. The U.S. government seems alternately unable to do anything, then willing to tackle huge reforms that, even if they are needed, will have an unknown impact long-term.

But things are not as dire as the talking heads on TV would have us believe-they rarely are. Especially in challenging times, the best approach continues to be to invest in strong companies that pay a dividend, and to think long-term. In the end, the poor performance in the second quarter is no more important than the strong performance in the first. What matters is what the economy does over many, many quarters.

Just like when I rode the Shooting Star all those years ago in Cincinnati, the ride can be terrifying. But what really matters is getting safely back to where you want to be.

Garry K. Schaefer
Atlanta, Georgia
July 14, 2010

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