Houston, We Have Liftoff!

Since the March lows, the market has shot off the pad in a manner reminiscent of Apollo 11 and confused the so-called experts by rising more than 50%. Why? And where do we go from here?

Back in late February, strategists were cutting their 2009 year-end targets for the markets only a couple of weeks before the market began to turn and climb that "wall of worry." Maybe the selling had been exhausted. Maybe investors could smell a recovery six months out. Whatever the reason, though, the turnaround has been dramatic.

Will the March lows end up being the final lows? We won't know that for another year or so, from a technical viewpoint. But from a fundamental viewpoint, there is evidence that might be the case. Usually the market trades at about 15 to 18 times earnings, but when the market reached 6600 on the downside, it was selling at only 12 times forecasted earnings – and those were very low earnings.

Where do we go from here? Well, we are starting to see light at the end of the tunnel -- and it's not a train. There are signs that the recovery might be real and sustainable. Importantly, corporations have done so much cost cutting that any revenue gains will fall right to the bottom line. And, although many investors dismissed second-quarter results by claiming companies only beat results by cost cutting, we are starting to see revenue increases as well. Second-quarter earnings per share were up 22% over first-quarter EPS, driven by a 4% sequential rise (2Q vs.1Q) in revenues. In other words, it was the top-line gain of 4% that enabled S&P 500 companies to grow earnings 22% sequentially.

In addition, with the strong performance of the equity and fixed-income markets over the past six months, we are seeing several corporate investment banking deals. Abbott Laboratories is purchasing Solvay’s pharmaceutical business for about $7 billion, and Xerox is buying Affiliated Computer Services for $6.4 billion. With these acquisitions, Abbott and Xerox are focusing on growing their businesses not for "financial" reasons, but strategically. Also, the secondary offering by corporations to raise cash and repair their balance sheets is strong, not only in the equity market but also in the fixed-income market.

As I look at third-quarter Wall Street expectations, I believe companies are likely to beat top-line expectations. We have more than $3.5 trillion in money market funds potentially looking for a new home, and we have a global synchronization by countries to keep their monetary and fiscal policy spigots wide open.

One of the fundamental bedrocks of our economy, the housing market, is still improving and should continue to improve. However, I am watching carefully to see what happens when the $8,000 tax credit for first-time home buyers expires at the end of November.

There are other things that temper my optimism slightly. For example, although there definitely is a recovery going on throughout the United States, Europe and Asia, there is a question as to how much of that growth is being driven by the policy and actions of the governments and the central banks. What happens by the middle of next year, when this intrusion of the public sector into the private sector begins to diminish and interest rates start moving a little higher? This could cause some hiccups, especially in China and other growth areas.

And longer-term, we are facing a trillion-dollar deficit on average for the next 10 years. In the last eight months we have seen a massive expansion of spending by the federal government in the form of a trillion-dollar budget expansion program. We now have a potentially $1.5 trillion health care plan on the table. Americans have cut back their spending habits to adapt to our "new" economy, but our government keeps spending our money.

Overall, though, I believe there is growing cause for at least cautious optimism. And I believe that the same investing fundamentals apply to this recovering market. I continue to look for established, quality companies that pay a quarterly dividend and earn a good return on capital. Well-run, solid companies are the best option, no matter what the market is doing.

Garry K Schaefer
Atlanta, Georgia
October 7, 2009

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