Mid-Year Letter To Clients {Part II}

Today is Part II of our mid-year letter to clients which was originally published on July 23, 2012.  We will conclude this series tomorrow.

As mentioned {Yesterday} these record earnings along side static stock prices over the past year have lead to price/multiple compression. Consensus earnings forecasts for the S&P 500 for 2012 and 2013 are currently around $105.00 and $116 per share. Our analysis all year has been for $103.75 and $111.00 respectively. In our analysis using our more conservative estimates, stocks are trading around 13 times our 2012 estimate and carry an earnings yield of about 7.5%.  They trade a bit over 12 times our 2013 estimate and an earnings yield of 8.2%.  The earnings yield is simply the inverse of the price/earnings multiple and is used to compare the aggregate total yield to different fixed rates of return.  Currently the US 2 year treasury yields 0.23% and the US 10 year bond yields 1.44%.  The German 10 year Bund yields 1.32% and for comparisons sake the Greek 10 year yields 26.34%.  The market’s historic price multiple range has generally been a range of 14-16 times the current estimates.  If stocks would trade back to that historic range then stocks have valuation potential between 1450 and 1660.  This valuation potential is based on earnings estimates at the end of 2012.  Taking those estimates out until mid-year 2013 show a much significantly higher valuation potential for the markets should our earnings analysis prove to be correct. I know what our valuation markers tell us and I have been sounding variations of this same theme over the past three years. While I can weigh the market’s evidence for clues as to future price movements, I have no idea whether this analysis will pan out starting tomorrow or in the next six months. However longer term, in the time period where as Warren Buffett likes to say Mr. Market gets a vote, stocks valuation will come out.  It is in that frame that for the most part we invest client monies and it is in that time frame that we frame our investment analysis.

Every investor should have a long-term investment strategy. For our clients, this strategy comes from our understanding of their unique risk/reward criteria and then incorporating that into our investment disciplines. All of our strategies are based on our playbook. The playbook is situational analysis based on historical market results. We study money flows along with the disciplines of fundamental and valuation analysis to see how markets have responded to similar historical events. It gives us different scenarios regarding market activity. We use it to formulate our game plan. The game plan is a tactical and a strategic allocation of assets based on what the playbook tells us has historically occurred. It is then further refined to the specific risk/reward parameters of our clients.  Currently the playbook is telling us that stocks are discounting concerns regarding the global economy, discount a potentially disruptive event such as a war or natural disaster or act as if the US has the potential to enter a recession in the next year.  What our analysis cannot tell us is how much of these concerns are baked into current prices. Thus while we are mindful of the potential for equity appreciation in the course of the next year, we also recognize the fact that any advance could start from lower price levels  than where we currently trade.  That is why we have the defensive pages of the game plan open just in case we take a turn for the worse.

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