The stock market rallied late in the quarter to help narrow losses. The S&P 500 ended the quarter with a modest 0.1% gain while the Russell 2000 fell by -1.61%.  Emerging markets were hit the hardest dropping by a little more than 2%.  Defensive stocks were in favor most of the quarter and did well.  That trend combined with a healthy short-term bond and cash position allowed our portfolios to nicely beat their benchmarks.

 

Most of the economic data during the quarter was surprisingly weak. If this is due to temporary factors like the Japanese earthquake and tsunami and high energy prices, the soft patch should end in the second half of 2011.  However, even if this rosy scenario plays out, longer term headwinds remain in place. What has become clear two years after the Great Recession is that we are in a period of suboptimal economic activity, despite aggressive fiscal and monetary policy. Almost all rich countries are still stuck with a toxic mix of modest growth, depressed housing markets, negative real interest rates, even more asset concentration at our financial institutions, and uncomfortably high unemployment and government deficits. 

 

Deleveraging from our debt-financed spending spree has just started for the consumer and will need to be followed up by western governments. This adjustment will take a long time. Europe is currently dealing with a debt crisis in the periphery countries which is capable of causing more financial turmoil since banks own most of this shaky debt.  America ’s debt is rising unsustainably. By 2016 our overall government deficit will be 6% of GDP, the IMF estimates, well above the comfort level for debt stability. Alarmingly, almost none of that deficit will be the product of the economic cycle. 

 

Stock prices are determined by earnings and the multiple that investors apply to those earnings.  From our perspective these negative structural issues suggest earnings multiples will continue to decline, or at least stay low, until our debt overhang is worked off.

 

On the positive side corporate earnings continue to impress, overall balance sheets are in terrific shape (cash represents the biggest proportion of total assets in the US than at any time in the past half century),the yield curve is positively sloped, and valuations are not excessive (social media stocks being the clear exception).

 

It is well documented that companies play games with stock analysts, by lowering earnings guidance in order to consistently beat the consensus earnings expectations. Last quarter fewer than 8% of companies guided analyst consensus higher, the least in the current bull market according to Bespoke Investment Group.  We anticipate more of the same this quarter. Caution is also warranted when looking at the empirical data on margins which are at historic highs at over 9%, especially considering that profit margins reliably revert to the mean.  Hussman Econometrics reported that the highest quintile periods for profit margins were followed by three year annualized market returns of -1% versus 15% when margins were lowest.

 

Despite our macro concerns there are opportunities in the stock market.  We are in a unique period of time where an investor can own very high-quality stocks and generate a sustainable and growing income stream well above money markets and even on par with medium term U.S. Treasury securities.  Our current portfolio of stocks is yielding over 3% despite having several companies with no or very low yields.  Valuations are attractive with the average Price to Earnings ratio of only 12x.  Best of all, we are not taking balance sheet risk to achieve this yield as our companies sport very high credit ratings.

 

High-quality stocks have been largely ignored by investors who have chased the momentum in small capitalization stocks over the past decade.  We believe this asset class is underrepresented in institutional portfolios and will benefit as this group rediscovers the value in this area.

 

 

(c) Tillar-Wenstrup Advisors

www.twadvisors.com