The Tails that Wag the Dog

Right now in the financial markets, the tail is wagging the dog. Actually, there are several tails that are driving markets now, including:

– Rampant pessimism among investors worn down by the country’s continuing financial difficulties and spooked by the volatility of the last few months.

– The appearance that Europe – i.e., the European banks – can’t find a way out of their mess. The problem is rooted in the fact that while the members of the European Union share a single currency, they have very different fiscal policies.

– Technology, which continually needs to feed itself. There was a day when you found out about the performance of your investments when you got your monthly statement. Now you can check the status of your investments on your iPhone, and you can watch the financial news networks 24/7. This constant stream of information and commentary can spur anxiety and undermine a long-term approach to investing.

– The market gains that were propelled partly by QE2 are gone. QE2 started on November 16, 2010, with the S&P at 1178.34. When the program ended on June 30, 2011, the S&P closed at 1339.67 – an increase of about 14%. Now the S&P has given up those gains.

– A dysfunctional government in Washington continues to leave businesses and investors uncertain about the future. And markets do not like uncertainty. Our elected officials, from the president through the Congress, need to learn to work together to govern from the center.

All these factors have combined to make investors jumpy. And who can blame them? We are two years into a period of deleveraging, as individuals and corporations work to get rid of their debt, and the process could take several years more. People need jobs, and individuals and businesses need the financial system to work its way back to health. Instead, the Treasury market is showing us that we could be following in the footsteps of Japan and headed for an even more prolonged recession.

But if we forget about those tails for a moment and focus on the dog, there are many positive things:

– Corporate profits are good. Markets go up and down on profits and expectations of profits, and despite some problems recently, profits are still headed for a record year.

– Overall, we are selling at about 11 times earnings, which means that many stocks are still a good value. Expectations are that we will be selling at about 10 times earnings in 2012.

– There are companies that are adapting well to our “new normal” with creativity and strong, astute management.

– Many companies are increasing their dividends. Dividends are critical to investors; since 1930, stock dividends have comprised approximately 50% of the stock market’s total return. Currently the dividend yield for S&P 500 stocks is higher than the yield on 10-year Treasury notes. This also happened in December 2008. However, prior to that, it had not happened in more than 50 years.

– Companies are buying back their own stock, meaning they are confident in the underlying value of their own companies. As of June 28, 30 companies had announced a total of $168 billion in share buy-backs, according to The Wall Street Journal.

As frequent readers know, I focus on earnings. Since the middle of 2009, S&P 500 earnings estimates by Wall Street analysts had been going up. In the May-June timeframe, earnings estimates started going sideways, and over the last few months, they have started trickling down. Earnings season for the third quarter is now upon us. The numbers for that quarter and companies’ outlooks for 2012 will be very, very significant. My hope is that companies will deliver up to Wall Street expectations.

These are difficult times, there is no question about that. But there are still opportunities in the market. Particularly in times like these, it is important to focus at least as much on the health of the dog as on the tails that are doing the wagging.

On a personal note, I would like to note the passing of Steve Jobs. Like other visionaries such as John F. Kennedy and Martin Luther King, Steve Jobs changed the way we live. He was the creative genius of a generation. He inspired us all to strive for excellence, and his legacy can be an inspiration for future generations. The world is a better place because he was in it.

Garry K. Schaefer
Atlanta, Georgia
October 11, 2011

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