Peachtree Quarterly

Houston, We Have Liftoff!

Since the March lows, the market has shot off the pad in a manner reminiscent of Apollo 11 and confused the so-called experts by rising more than 50%. Why? And where do we go from here?

Back in late February, strategists were cutting their 2009 year-end targets for the markets only a couple of weeks before the market began to turn and climb that “wall of worry.” Maybe the selling had been exhausted. Maybe investors could smell a recovery six months out. Whatever the reason, though, the turnaround has been dramatic.

Will the March lows end up being the final lows? We won’t know that for another year or so, from a technical viewpoint. But from a fundamental viewpoint, there is evidence that might be the case. Usually the market trades at about 15 to 18 times earnings, but when the market reached 6600 on the downside, it was selling at only 12 times forecasted earnings – and those were very low earnings.

Where do we go from here? Well, we are starting to see light at the end of the tunnel — and it’s not a train. There are signs that the recovery might be real and sustainable. Importantly, corporations have done so much cost cutting that any revenue gains will fall right to the bottom line. And, although many investors dismissed second-quarter results by claiming companies only beat results by cost cutting, we are starting to see revenue increases as well. Second-quarter earnings per share were up 22% over first-quarter EPS, driven by a 4% sequential rise (2Q vs.1Q) in revenues. In other words, it was the top-line gain of 4% that enabled S&P 500 companies to grow earnings 22% sequentially.

In addition, with the strong performance of the equity and fixed-income markets over the past six months, we are seeing several corporate investment banking deals. Abbott Laboratories is purchasing Solvay’s pharmaceutical business for about $7 billion, and Xerox is buying Affiliated Computer Services for $6.4 billion. With these acquisitions, Abbott and Xerox are focusing on growing their businesses not for “financial” reasons, but strategically. Also, the secondary offering by corporations to raise cash and repair their balance sheets is strong, not only in the equity market but also in the fixed-income market.

As I look at third-quarter Wall Street expectations, I believe companies are likely to beat top-line expectations. We have more than $3.5 trillion in money market funds potentially looking for a new home, and we have a global synchronization by countries to keep their monetary and fiscal policy spigots wide open.

One of the fundamental bedrocks of our economy, the housing market, is still improving and should continue to improve. However, I am watching carefully to see what happens when the $8,000 tax credit for first-time home buyers expires at the end of November.

There are other things that temper my optimism slightly. For example, although there definitely is a recovery going on throughout the United States, Europe and Asia, there is a question as to how much of that growth is being driven by the policy and actions of the governments and the central banks. What happens by the middle of next year, when this intrusion of the public sector into the private sector begins to diminish and interest rates start moving a little higher? This could cause some hiccups, especially in China and other growth areas.

And longer-term, we are facing a trillion-dollar deficit on average for the next 10 years. In the last eight months we have seen a massive expansion of spending by the federal government in the form of a trillion-dollar budget expansion program. We now have a potentially $1.5 trillion health care plan on the table. Americans have cut back their spending habits to adapt to our “new” economy, but our government keeps spending our money.

Overall, though, I believe there is growing cause for at least cautious optimism. And I believe that the same investing fundamentals apply to this recovering market. I continue to look for established, quality companies that pay a quarterly dividend and earn a good return on capital. Well-run, solid companies are the best option, no matter what the market is doing.

Garry K Schaefer
Atlanta, Georgia
October 6, 2009

Peachtree Investment Quarterly may offer general financial, insurance, tax and business ideas. However, due to the ever-changing tax laws as well as the complexity of the financial industry, you should seek professional advice before implementing any of the ideas contained in this newsletter. Peachtree Investment Partners, LLC(TM), and Osmosis Digital Marketing, Inc. assume no liability whatsoever in connection with the use of this newsletter.

Last summer my Peachtree Quarterly message was inspired by “Gimme Shelter” by the Rolling Stones. The market in the spring of 2008 was becoming more volatile as a precursor to calamitous events to come. Later in the summer, corporate earnings started to collapse, and then the market went into free fall.

These times are, I believe, more appropriate for the Beatles. We have been getting by “with a little help from our friends” in government. Since taking office in January 2009, the Obama administration has been throwing a lot of money at our economy trying to revive it. They have implemented one giant stimulus package and may be considering another. They are working to reform health care, improve education and create a new category of “green” jobs, all as a means of putting people back to work and easing the economic pressure, especially on the middle class. It remains to be seen whether these efforts will provide enough return on the investment of all of us who pay taxes.

Unfortunately, the government efforts are hampered by the current contraction among consumers. For the first time in decades, the U.S. savings rate is going up. That is good news in the long term because much of the current financial crisis was caused by people spending beyond their means. Americans are realizing that they no longer can afford to spend money they don’t have, and they appear to be making an effort to put their financial houses in order.

That is bad news in the short term, though. Consumer spending is the major driver of the U.S. economy. The reluctance of the consumer to go shopping has hampered the recovery effort, just as consumer spending created much of the boom that preceded this recession. Shoppers hit the malls armed with credit cards. Home buyers used ridiculously easy mortgages to buy houses they could not really afford. And many people started to live off their home equity. Then the housing market collapsed, and home equity disappeared. Credit for mortgages and other loans also dried up. Credit card companies raised interest rates and tightened standards. And the American consumer pulled back in a big way. To make matters even worse, the credit crisis and market collapse spread around the world, largely because of foreign involvement in the U.S. credit markets.

The good news is that, with a little help from our friends in Washington, credit markets are beginning to thaw. The bad news is that we are only lending to the best risks. In order for a recovery to be meaningful, the middle class needs to be able to buy houses and cars, and to go shopping again. And that will not happen overnight.

We are in uncharted waters as investors. The government is in uncharted waters as well. The $64,000 question is: Can the Fed supply enough money to keep us afloat? And can they do that while at the same time keeping inflation at bay down the road?

On the corporate earnings side, the surprise so far this year has been an improvement on margins caused by cost cutting and inventory sell-off. Below the surface, however, corporations reported weak revenue growth. Given this situation, the bulls suggest that any kind of revenue growth will fall to the bottom line. The bears counter that investors should not hold their breath until consumer spending, which represents 70% of the economy, comes back.

Since the market lows on March 6, stock indexes have posted three consecutive months of gains. U.S. corporate profits increased $42.6 billion in the first quarter to $1.307 trillion, so the economy contracted less. The question is whether this is a short-term result of cost-cutting or the sign of a longer-term recovery.

So what should investors do? I believe that, now more than ever, is the time to look for high-quality companies with strong fundamentals. That is no guarantee against a drop in stock prices, of course; stocks seem to have been especially capricious in recent weeks. But, in the end, I believe that strong, high-quality companies will survive the current crisis and thrive once the recovery begins. I especially like companies that pay investors a dividend and have a good return on capital. I also like investment grade bonds where you can identify with the company and feel comfortable with their fundamentals.

Meanwhile, we can watch as the government, companies and the markets work to return stability and ease the transition to the next economic cycle. At the moment, we are in a post-credit-bubble cycle. I am confident that we will recover from this and move into a cycle of economic expansion. However, I think there will still be ups and downs before we get there.

Garry K. Schaefer
Atlanta, Georgia
July 22, 2009

Peachtree Investment Quarterly may offer general financial, insurance, tax and business ideas. However, due to the ever-changing tax laws as well as the complexity of the financial industry, you should seek professional advice before implementing any of the ideas contained in this newsletter. Peachtree Investment Partners, LLC(TM), and Osmosis Digital Marketing, Inc. assume no liability whatsoever in connection with the use of this newsletter.