Current Fundamentals and Valuation

Fall may bring a renewed focus on the headwinds that we discussed yesterday but these must be balanced against certain other factors that have the potential to affect markets in a positive manner.  One of the first things to note is that all of the factors we listed yesterday are widely known to investors and therefore have probably largely been discounted by the markets unless they become appreciably worse in the next few months.  

Let us first take note that above everything else the economy is growing.  It may be growing in fits and spurts.  Its growth may be anemic and below historic norms, but it is growing.  GDP for the 2nd quarter was revised up today from 1.5 to 1.7% today.  Now again this upward revision is nothing that should make us want to throw a party.  However it beats economic contraction and may point the way for continued expansion in the months ahead.

Second while investors will increasingly focus on the election {which we noted yesterday has the potential to be a short term negative influence} from a practical aspect market participants on an economic basis probably don't care whether President Obama or Mitt Romney wins in November.  That's because regardless of who wins neither will completely control the either the House or the Senate.  Therefore expect either compromise next winter on some of our economic issues or more gridlock.  Either way markets will adjust accordingly regardless of who the occupant is at 1600 Pennsylvania Avenue.

Corporate balance sheets remain in excellent condition.  Profit margins remain high.  Interest rates are still near historic lows.  Under the hood economic innovation has continued albeit often in industries or products that don't necessarily show up every morning on the news.  Consumers continue to repair their own personal balance sheets and housing is starting to show just the faintest hint of a recovery.

On a valuation basis stocks are not as cheap today as they were back on June 19th, 2012 when I noted "NEVER IN MY INVESTMENT CAREER {now spanning over a quarter of a century} HAVE I SEEN STOCK VALUATIONS THIS CHEAP BASED ON HISTORIC PE LEVELS  AND ABSENT A RECESSION OR A SIGNIFICANT ECONOMIC CONTRACTION!!!!  Either we are going to have an event that provides a significant hit to growth or stocks are presenting a buying opportunity of a generation for longer term investors."  

Stocks have advanced about 6% since then and are nearly 10% higher since their early June lows.  The yield on the S&P 500 is still just a bit under 2% compared to a two year treasury yielding 1.65%.  Based on our 103.75 end of year S&P 500 earnings estimate {an estimate that is much closer to consensus today than it was about three months ago}, stocks carry a 13.6 PE and an earnings yield of 7.3%.  These are still attractive valuation principles based on what we currently know. 

Having said that, stocks are nearing the lower end of what I think is a likely valuation cone between 1450 and 1525 for the rest of 2012.  We'll talk a bit more about that and what we have been doing for clients tomorrow.

*Long ETFs related to the S&P 500 in client and personal accounts.