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Is It Just the Weather - Fundamental Forces

April 05, 2012 | Comments: 0 | Views: 127

Given current valuations, we think it is time to say a "long goodbye" to bonds, and embrace the "long good buy" for equities as we expect them to embark on an upward trend over the next few years.

-Peter Oppenheimer, chief global equity strategist, Goldman Sachs, London.

A bold statement, but one that is close to our own view. However, our vision is not farseeing enough to take us out over the next few years. Let's just say that over the intermediate-term, or the rest of this year, Mr. Oppenheimer's position is one that gets thumbs up from us.

The title we give to this article is our way of asking whether there are fundamental forces that are driving the rally or is the market just in a temporary phase that will shortly give way to another phase? A random walk, if you will. Obviously, we think there is more going on than just an extended, but temporary, mood shift by investors.

Some fundamentals

The first thing we have to say is that we see the market returning to normal. By that we mean that the wide swings we saw last year-swings that drove the average investor out of the market-are highly likely to be behind us. Europe, with fears about the euro, was the source of the problem. We are by no means implying that Europe's problems have been solved, far from it. But the major fear, namely fear of the dissolution of the eurozone, now seems extremely unlikely to occur.

Without that fear the markets can return to doing their thing: assigning value to the prospects of regions and individual companies. Fund selection will once again make a difference. A much less violent and "rational" market will go a long way to reverse investor flows.

Another fundamental is the growth prospect of the American economy. We know that growth in the quarter just ended was undoubtedly low. The expectation is that growth will pick up as the year goes on. Even so, the numbers coming from Wall Street forecasters are modest indeed. Given the slack in the economy-essentially labor-our economy has the potential to grow faster, and for some time. Very little, if any, of this potential is reflected in the market right now.

Of course, the political stalemate in Washington has made it impossible to tap more than a sliver of this potential. Maybe the upcoming elections will help, maybe they won't. There is unanimous agreement that we all want faster growth.

A further support for the stock market comes from valuation. U.S. stocks are not as cheap as they were last autumn, but they are still attractively valued. The average forward price-earnings ratio for the S&P 500 is 16. ("Forward" means using estimated earnings for the year ahead.) Right now the forward price-earnings ratio for the S&P 500 is 13.3. A 23% gain for the S&P would get it to 16.

Finally, we come to the Federal Reserve. In recent speeches Mr. Bernanke has made it clear that the improvement in the unemployment rate has not changed his view that the economy's growth rate is too slow. He says, "further significant improvement in unemployment will likely require faster economic growth than we experienced last year."

At the very least, Mr. Bernanke is strengthening the case for a continuation of low-for-long interest rates.

None of this is to suggest that all is serene for the American economy. For example, consumer spending has been doing well. Unfortunately, consumer incomes have not been keeping up. Spending is bound to slow down unless income growth is boosted.

Then there is the issue of profit growth. James Montier of the GMO family of funds has written a compelling paper arguing that profit margins, now at post-war highs, will be coming down over the years ahead. As they do, earnings growth will suffer.

This is not today's problem but it does raise the issue of valuation for long-term institutional investors who make up the bulk of the market. They buy now on the basis of expectations of earnings some years out.

Relative performance

We have been struck by the difference in performance between the domestic and international funds. If you look at the six-month column for each, you will see that many top domestic funds returned in the mid-thirty percents. The international funds returned in the mid-twenty percents.

It is easy to explain the difference. First, there are Europe's problems. Then there is Asia, with China restraining growth and Japan suffering from earthquake and tsunami. We do not think the performance gap will close in the very near-term, but we do look for it to narrow. Among other things, the latest manufacturing numbers from China suggest that some of China's slowing can be attributed to their New Year holiday break.

Walter S. Frank has been the Chief Economist and Chief Investment Officer for Moneyletter for the past 25 years. He has had a long and distinguished career as an economist, financial advisor, and money manager. Mr. Frank is a regular contributor to Barron's and The Economist magazine.

For more information on the Moneyletter, visit our website

Source: EzineArticles
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