Musical Chairs

Do you remember when you were a kid and played musical chairs? We walked (or ran) around a set of chairs, waiting for the music to stop. When it did, we pounced on the closest chair. After a terrific year in the stock market, investors are now asking: Is the music over?

I always have believed that markets and stocks go up or down based on earnings and the expectation of those earnings. Back in mid-2008, Wall Street analysts were forecasting record profits for the 500 largest companies (Standard & Poor’s 500) for 2008 and a continuation into 2009. Instead, we started seeing profits start to evaporate in the summer of 2008 and then go into a total collapse in the fall of 2008. Beginning in August 2009, I started noticing that analysts were actually increasing their earnings estimates. First, it was on a monthly basis. Then, beginning this fall, analysts started nudging their estimates higher on a weekly basis, even as the market climbed higher and continued to confound the skeptics.

So where are we now? As I have discussed in earlier issues of this newsletter, analysts slowly have been raising their profit outlook for companies, and they presently stand at $77.79 for 2010 and $94.51 for 2011. As of this writing, the S&P was selling at 1136, meaning the market is valued at 14.6 times 2010 estimates and around 12 times 2011 estimates. This is good news; I like to see stocks trading at 12 to 15 times earnings.

A recent report from the 12 Federal Reserve Districts also held some glimmers of good news. In most districts, consumer holiday spending was up slightly, auto sales were steady or slightly better, and home sales were up, especially for lower-end homes.

On the flip side, there are still many uncertainties. First, employment is still very weak, although there are signs that it is starting to stabilize. Also, according to the Federal Reserve Board October 2009 Senior Loan Officer Opinion Survey, domestic banks have indicated “that they continue to tighten standards and terms on all major types of loans to businesses and households.” We have the potential risk of a policy mistake by our relatively new administration. We still are awash in excess capacity in all different types of industries, and commercial rents are still falling in the face of huge oversupply. Finally, the Obama fiscal stimulus plan is expected to have its peak effect on GDP and jobs around the middle of the year.

So where do we really stand? Are we going to be left without a chair when the music stops?

One thing that is certain is that the financial services business has become much more complex since I got into it in 1985. For one thing, finances are global now. For example, when Dubai, a remote city-state in the Middle East, announced it had run out of money this fall, the shock waves were felt around the world. Secondly, the federal government has chosen to or has been forced to, depending on your point of view, inject itself aggressively into the economy. This probably means more regulation, and definitely means that politics has become an economic factor. Finally, the industry itself has become more complicated. There are lots more financial advisers working with lots more platforms and offering lots more options.

Perhaps the best way to deal with the complexity is to focus on the simple. In the end, good companies are going to make more money for their investors than bad companies will. I have always believed in finding strong, quality companies that pay a dividend. I continue to think that this is the approach that is most likely to succeed, no matter what economic and political environment prevails.

There are no guarantees, of course—the last few years have reminded us of that. But by focusing on the stocks of successful, innovative, well-capitalized companies, we increase our chances of finding a seat in our game of musical chairs.

Garry K Schaefer
Atlanta, Georgia
October 7, 2009

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