Summer Client Letter {Part II}

Here is the 2nd installment of our recent client letter, originally dated July 25, 2014:

While most of the economic indicators we review have remained positive, we must acknowledge that revised 1^st quarter GDP statistics were worrisome.  Investors have currently been willing to look beyond these, likely using the horrific winter as an excuse.  So far the economic data coming out from the spring suggests that weather was indeed the largest factor in the slowdown.  The beginning of earnings season has also been supportive of a growing economic environment.  However, economic data needs to continue on its positive trajectory and earnings need to at least match expectations or probability suggests stocks may be in a tougher spot in the short run.  That’s particularly true given that valuations seem to be a bit elevated right now.  

At current levels the S&P 500 is trading closer to the high end of our “Cone of Probability” for stock prices in 2014.  That current range is 1,700-2,100. The Cone of Probability is a concept developed by us and is our current assessment of the price range within which we think stocks have the potential to trade during a described period, in this case calendar year 2014.  It is a probabilistic assessment based on many inputs.  Some of these inputs are: earnings estimates, and whether those estimates are rising or falling, dividend yield, earnings yield and the current yield on the US 10 year treasury.   We use the Cone of Probability solely for analytical purposes.  It will fluctuate with market conditions and changes to the data inputs.  Index prices can and have traded in the past outside of its range.  It is possible that our estimates are conservative, particularly if corporate earnings continue to adjust higher.  However based on 2014 estimates, stocks are now trading with a 16 PE, a 1.89% dividend yield and a 5.7% earnings yield.  There is likely less room for error now than there was a year ago.  Also given where stock prices are today, anything that even hints that interest rates could potentially begin to move higher over a sustained period of time could also have the potential to impact both the stock and bond markets. 

*Long ETFs related to the S&P 500 in client and personal accounts although these positions can change at any time.