Winter Investment Letter {Conclusion}

Below is the conclusion to our winter investment letter sent to clients in early February.

Basic economic numbers also point towards growth.  Existing home inventories are at levels last seen in the early 2000s in spite of population growth and increased family formation.  Housing is a huge economic multiplier as people that purchase homes need to buy all the things that go with them.  New home construction increased 28% in 2012 to 780,000 units 6. which is still below the estimated one million new homes needed on an annualized basis just to keep up with population growth.   Auto sales are approaching a three-year high while energy costs keep declining.  In regard to energy, North America has become the fastest growing oil and natural gas producing region in the world.  This is leading to jobs in these related fields and lower energy makes US manufacturing more competitive.  Finally while still too high, unemployment has edged down over the past year.  Take home pay for individuals has been rising slightly and consumer balance sheets are in a much better condition than they were a few years ago.  All of this can form the basis for favorable equity conditions over the next few years. 

While we earlier poked fun at the ‘gloom and doom” crowd, we do acknowledge that many of their concerns are valid.  Any of these concerns, as well as a few we have not thought of, has the potential to come back to the forefront. The potential for an exogenous shock out of the Middle cannot be discounted, as Syria seems to become more destabilized every day.  Recent rumblings out of Europe also remind us that all is not fixed there yet.  Here at home, markets are navigating confusion about corporate profits, largely owing to uncertainty over fiscal and tax policies out of Washington. However this last point should also be balanced against US corporations that are collectively in their best position in years with strong cash flows and record earnings.  Estimates on the S&P 500 range between $98 and $112. I am using an earnings range this year of $104-108 and a midpoint of $106.50.  That gives us a cone of probability for this year of between $1,490-1,700 on the S&P 500.  We will use as a mid-point 1,625, which is the same number that we introduced in our winter letter last year.  As always we will revise that number during the year as conditions warrant.  A market that could potentially trade at the mid-point of our estimates would trade with a mid 15 PE and an earnings yield of 6.5%, still attractive in a world of subpar interest rates.  We will introduce a rough 2014 estimate of $112-115 on the S&P 500 and a cone of probability between $1,575 and $1,810 on the S&P 500 for next year.  Please note that there is no guarantee that any of these estimates will be met.

We also note that markets have rallied about 5% in January and are up about around 11% since mid-November. Stocks are overbought and are now vulnerable to a correction of some sort.  It is unlikely that stocks will move to higher levels this year without experiencing a pullback.  Markets have now gone 16 months without experiencing a correction larger than 10%.  Normal volatility is for markets to pullback between 5-20% so events could shake us out a bit at some point this year.  To these events are the markets the final arbitrators and we’ll have the defensive pages of our playbook handy in case markets take a turn for the worse.  Given all of that however, in a world where interest rates hover around the 2% level, and stocks trade at reasonable valuations, a pullback absent a market changing event is likely a better buy.

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