Cumberland Advisers.
Here’s why we believe that the lean years are over and that a big bull move is now directly in front of us.
Various value oriented measures suggest that the S&P500 has another 30% to 40% of upward potential in the next few years. We can reach this conclusion a number of ways. We will examine just one of them.
We initially expected the S&P500 to earn $93 in 2007. The first quarter numbers are now mostly known. 2 out of 3 of the S&P500 companies are exceeding consensus earnings estimates. With about 80% having reported we can now draw some powerful inferences for the entire year of 2007. One of them is that our $93 number is likely to end up on the low side.
The upward market movement has been driven by the large cap stocks. These big guys comprise the heavy weighting of the US stock markets. They are benefiting from the weaker dollar. They have substantial cash. They are able to borrow cheaply. Their cost of funds is under 6% before taxation or under 4% after taxes. Using derivatives (swaps) they can lock in these costs of funds for several years and they are doing so.
That is why they are using cash or borrowing to buy back their own stock. It is a bargain for them. The same applies to the private equity folks. So we have a diminishing supply of publicly-traded equity which is being financed with cheap debt. About $600 billion in stock value has been retired or retrenched to private hands from the public markets. Shrinking stock supply and growing demand from rising earnings is a recipe for higher prices.
The macro stage supports our view.
In our slowly growing low inflation US economy, we can expect the nominal GDP to increase about 5% per year. That takes the US economy to about $17 trillion in output by the end of 2010. The largest part of the non-government sector is in services and is relatively stable. Healthcare, for example, will be nearly 18% of GDP by then.
In such an economy, we will see about 2%-to-2 ½% inflation. We expect 2 ½% to 3 ½% real growth. In that climate, the S&P500 earnings can easily increase about 7%-to-8% per year. Remember: earnings grow faster than the economic growth because of the leverage in corporate balance sheets. For US big cap stocks, this earnings growth is assisted by the international addition to the US reported earnings. They come from the foreign subsidiaries of these US companies. And the earnings per share are enhanced by the continuing stock buybacks.
Simple math gets the S&P500 earnings to a $115-to-$120 range by 2010. A 17 price/earnings ratio easily gets you to 1950-to-2000 on the S&P500 index. That would still be within an environment of moderate economic growth and moderate inflation. And we would still be seeing reasonably low interest rates centered on a 10-year Treasury note yield of around 5%.
No dream here. We are not attempting to make the case for stocks by excessively valuing the stock market. Sure, a frothy and exuberant time will come just as it has in the past. And by then it will suck in the uninitiated as it did 8 and 9 years ago. We believe that is out in the future and possibly many years away. That is why Cumberland’s stock portfolios are fully invested, worldwide.
There are some assumptions and readers may, of course, disagree. Here are ours. We are basing our strategy on them.
We believe that the world’s financial systemic risk is well contained by the global consortium of central banks and institutions. Inflation is a risk but it is also high on the policy maker’s radar screens. It seems manageable through skilled application of monetary policy. The housing price adjustment is certainly under way. But it has not turned into a recession and it is not causing contagion. The US labor force is more than 95% employed. Worker’s incomes are rising. The unemployment rate is decidedly skewed by education. It is under 2% for college graduates and around 4% for high school grads with some college. Only those who do not complete high school face a 7% unemployment rate. Is this a problem? Yes. Does it derail our picture? No.
In sum, the situation is neither bleak nor excessively frothy. We believe that an investment policy should be centrist. Simply put, diversify broadly and worldwide. Own some bonds now that real yields are positive. Keep the bond duration close to neutral. Maintain what cash reserves are needed for comfort but otherwise a fully invested strategy will serve best.
Lastly, be aware that it is the shocks, the extraordinary events, which can sink the positive outlook. Those shocks can be natural events like bird flu or hurricanes. Or they can be politically driven like war, terrorism or protectionism. Those risks always exist. One doesn’t reposition a portfolio in anticipation. Acting BEFORE they occur is a mistake like waiting for Godot. Life and investing should not be done in a cave.
One can and should react swiftly if any of the shock scenarios unfold.
