A relatively weak first quarter earnings season is winding down, while major stock market indices are reaching all-time highs. This doesn't quite add up, does it? Overall, corporate profits advanced at an anemic 2.5% in the first quarter, well below the long-term average of 7%. Worse over, revenues were actually flat in the first quarter, below expectations in most cases. On top of that, most companies that have reported earnings have also lowered estimates for the remainder of the year. Clearly, the economy is struggling, and is likely to do so as it digests the numerous tax increases, burdensome compliance, and regulatory changes in this great wave of governmental overreach.
How, in this slow growth environment, can stocks continue to grind higher? Valuations are largely driven by three variables, and two of the three remain quite positive.
First, interest rates are at historic lows and are likely to remain so for the next couple years.
Second, inflation remains benign, with few signs that it will become a problem any time soon.
Third, earnings, although weak, are still growing.
In other words, while an accelerating economy is unlikely near term, the probability of a recession is just as remote. Combined, these three pivotal drivers of stock prices allow for a volatile, grinding-higher scenario for stock prices.
Is this the best we can expect?… I spent a delightful evening last night at the 10th Annual Davidson College Men's Basketball Awards Dinner. This event was highlighted by the speeches given by the graduating seniors. One closing quote delivered by a remarkable young man, JP Kuhlman, resonated with me. "The ways of the Lord are not comfortable, but we were not created for comfort, but for greatness, for good." Pope Benedict XVI.
Our country was not created to be comfortable either, but to pursue and achieve great things, to be a shining light in an increasingly dark world. But just as the economy is struggling, our country itself is struggling to fulfil this calling. Our inherent entrepreneurial spirit is under attack from an ever growing government bureaucracy. A recent example of this frustrating trend was documented in the May 6th edition of the Wall Street Journal article, "Backroom Internet Tax Ambush." Essentially, the Senate recently passed legislation to give state and local governments the power to collect taxes on Internet sales. Within this bill, Senate Majority Leader Harry Reid altered the wording of the bill to include "any tribal organization" as an entity that has the power to audit any business with Internet sales. According to the House Natural Resources Committee there are several hundred federally recognized tribes, which means instead of a
manageable 50 state auditors, small businesses may have to wrestle with approximately 600 audits related to Internet sales.
While large companies like Amazon can handle the additional cost and complexity involved in the hundreds of potential audits related to Internet sales, this legislation could be the death knell for many small businesses. And it is small businesses that create the vast majority of new jobs in our country. Tax increases, burdensome compliance regulations, and regulatory controls are crippling small businesses and therefore our economy's ability to break out from this frustrating slow-growth environment.
Stocks can continue to grind higher as long as interest rates and inflation remain low. While this trend can persist, it can't go on forever. Our economy will either sink from the weight of an uncontrollable government behemoth, or it will find a way to live within its means, reduce the federal deficit, and rekindle the entrepreneurial spirit. Ultimately, we will travel one of these paths.
Balancing portfolio strategies… In the meantime, while this far-reaching, debate of our times plays out, there are portfolio strategies that can leverage the low interest rate environment, while also taking advantage of pockets of growth in the overall economy. Outperforming stocks are likely to include companies that pay above average dividends as well as companies that produce above average earnings growth. A flexible, barbell approach, with an emphasis on higher yield on one end and above trend earnings growth on the other end, makes increasing sense in our view. Our research efforts are focused on both of these strategies in order to identify attractive yield plays as well as companies that can outgrow their peer group through product innovation and superior strategic decision making. This is a painstakingly difficult process, but the path to investment success, greatness if you will, demands flexibility and balance. Even if it makes one uncomfortable.
Michael Kayes, CFA
© Willingdon Wealth Management
