Patience Here

Stocks prices, measured by the S&P 500 fell 2.9% in August. The S&P 500, trading at 1632.97, is just below the upper boundary of a trading range it’s been in for the last several years. It’s exhibiting good relative strength, for now. While down months always seem to raise doubts in the back of investors’ minds, the evidence is mixed regarding whether we should be “buying on the dip” or “taking some chips off the table.” At a point in time like this, the best course of action is to be patient, and attentive.

The primary concern most investors are wrestling with today is the possibility of military action in Syria. This could be the latest chapter in the Arab Spring saga. It raises the question whether, and to what extent, the U.S. needs to take an active role. While not an ostrich, I prefer we use any resources we have to improve our schools, jobs and environment here at home. And, if we simply feel compelled to spend some money and do a good deed, we don’t have to look further than Detroit to find a place to flex our muscles.

While any action in Syria may be politically charged, it will not likely have any affect on the stock market or the fixed-income markets here in the U.S. There may be some agitation for a short period, but no longer- term effect.

A parallel concern, one that began back in May, is the upward shift in interest rates across the yield curve. The change in rates is a result of the market’s anticipation of the taper Ñ the reduction in the monthly purchases of mortgage bonds by the Federal Reserve. The rise in rates is causing downward pressure on bond prices. The Barclays US Treasury Bellwethers (10Y) is -6.79% ytd, and the BofA Merrill Lynch Municipals Master is -5.46% ytd.

The rise in rates has also led to a general flight from many investments that behave in sympathy with fixed income. This includes high dividend- paying stocks, REITs, and many closed-end mutual funds. Some fixed income investors now extrapolate continued rising rates, but in my opinion, while this could of course be the case, it is not likely.

Markets cycle up and down in relation to short-term news flow. It is clearly impossible to trade in front of these events. While there are some seasonal tendencies in front of us, and while this fall looks as though it will be unusually “noisy,” my suspicion is that the underpinnings of the stock market are still secure. I also think that longer term, the fear of rising interest rates, wreaking havoc in fixed income-related markets, will temper, and these securities will begin to see price stability tied to fundamentals.

From a portfolio management perspective, it is not helpful when fixed income balks, but the growth and wealth creation does not come from this segment of the portfolio Ñ it comes from the stocks. Stock prices are highly correlated with earnings, making earnings a critical market measure. 2Q2013 saw modest 2.1% earnings growth. 3Q2013 is expected to be slightly higher, and hockey stick growth is forecast for 4Q2013. The 12-months forward consensus earnings forecast for the S&P 500 is $117.88. At today’s price level, that means the market is trading at a PE multiple of 13.8x earnings, a reasonable level by historic measures.

There are many variables that will dictate whether or not these earnings estimates become real. Concerns are structural shifts in our economy, some as a result of the “great recession” that we may not fully understand yet. There are well known difficulties in Washington DC. Fiscal policy is non-existent and the market’s strobe light is pointed at the Federal Reserve. There are also changes taking place around the globe (Europe on the upswing, China on the downswing) that impact our economy and make effective forecasting difficult.

At the same time, profit margins are at all-time highs and forecasted higher. Corporate leverage is low and forecasted lower. Based on current FactSet data there is ample room for stock prices to move higher without becoming overheated. So, from a longer-term perspective, I see continued value in holding stocks.

We’ve come to the unofficial end of summer, Labor Day and all things related to back-to-school. For many this marks the unofficial start of the New Year. As I said last month, one of these days, things will change, we should expect that. If September lives up to its billing as the worst month to own stocks, then we may want to reallocate. At the moment, patience is key. As always, please do not hesitate to call if you have any questions or would like to schedule a meeting.

Bruce Hotaling, CFA

Managing Partner

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