Avoiding the noise

This exchange is indicative of many that we might have on a monthly basis with clients from all walks of life. Whether coming from a professional or a retiree, it seems to matter little. There is still this impending sense of dread, and it seems to be directed at the equity markets. Maybe it is residual effects from “The Great Recession,” or maybe just the byproduct of the 24/7 financial news cycle. I wish I knew, however. But just like you’re taught when first learning golf, you need to keep your head down, focus and drive the ball. Other than that, everything else is a distraction in that one moment in time.

Let’s look at some of the current economic data. I always like to start with revenue and earnings, then put it in perspective. You can’t have profits without revenue, and profits are what conceptually drive a market higher.

Operating earnings for the Standard & Poor’s 500 was $116.12 per share as of June 30, 2013. This is an increase of approximately 16 percent from the previous stock market highs in 2007. All this translates into a price/earnings ratio (stock value relative to stock price) that moved from approximately 15 times earnings to a valuation of 13.9 times earnings. Yes, even with the S&P 500 Index hitting fresh highs, we are still trading almost 7 percent below 2007’s peak earnings valuation, as well as approximately 7 percent below a 30-year price/earnings average. Furthermore, corporate profits are near 10 percent of the country’s GDP, compared to the 50-year average of 6.2 percent.

Let’s put this in perspective. Corporate revenues are strong, profits are at record levels, corporate debt is at 20-year lows, employment is recovering and the ratio of earnings to stock price is signaling a discounted stock market valuation. Granted, “corrections” are a normal part of any market environment, but from this point of view I’m not seeing “crash.” Maybe it’s just hyperbole, and we understand that many people feel nervous. The question is, where does this heightened sensitivity to volatility come from?

Taking into consideration the economy as a whole might help further develop the picture. Seventy percent is the often-quoted statistic of what consumer spending represents in our economy. It is important when reviewing corporate revenue and profits to look at the health of the consumer, since so much profit is a result of consumer spending that trickles through the economy.

In looking at the consumer balance sheet in the aggregate, we see assets increasing from $82.1 trillion in the third quarter of 2007 to a current $83.7 trillion. This 2 percent, although not enormous, is significant in light of the $16 trillion worth of wealth destruction that took place between the third quarter of 2007 and the first quarter of 2009. Furthermore, the portion of the consumer’s income needed for debt-service has fallen from 14 percent to slightly over 10 percent (a 28 percent decline), thus giving consumers more purchasing power. In a consumer-driven economy, this fact, combined with slowly falling unemployment, should be further catalyst for increased corporate revenue and profits.

So where is the downside? It is our belief that the average investor has more to fear from the fixed income side of the market than the equity side of the market. The Federal Reserve Board is still being accommodative, and this has artificially inflated the price of government bonds and has had a similar effect on all fixed income investments, by extension. Although the yields are still near historic lows, the Federal Reserve’s comments hinting at the easing of stimulus has caused bond yield to rise and, therefore, prices to fall. We are seeing this more pronounced at the longer end of the yield curve, with a change in the Barclays Long-term index of -6.47 percent through July 2013 vs. the Barclays Intermediate index of -1.10 percent for the same period.

So what are the next steps? Do you have an investment plan? Have you figured out your “risk profile” and adjusted your investments accordingly? Do you have a “bunker”? If the market drops by 10 to 20 percent, do you have enough cash and liquid investments as a reserve so that you can avoid selling “under-valued” assets to meet emergency or even day-to-day needs? Are you properly diversified?

We advocate that investors work with financial professionals who understand both historic market patterns as well as how markets react in a rising interest rate environment. There is little substitute for education, investment product knowledge, experience and a strong understanding of helping people reach long-term goals.

It is painful to see CDs and short-term Treasuries paying less than 1 percent. If it is part of your “bunker,” you have to stay disciplined. If your investment time frame is short, you must be very careful of volatility. With a longer time frame, you could possibly take advantage of high-quality stocks with dividend potential or short-term corporate bonds. Remember, we are in a global economy, so do not overlook investment opportunities throughout the world. These are all issues that investors should be seeking help with through a qualified professional.

We believe that one of the safest ways to invest is with a long-term horizon. We don’t see the “crash” that many fear, but we do see volatility in the equity side of the market, and we flash caution on the fixed income side of the market. With care and the proper maintenance, we see the dull thud of the corporate bottom line continuing to resonate for future growth.

Remember: Head down, focus, drive the ball.

This article was provided by David Keator, a Partner with Keator Group, LLC in Lenox, MA. For more information, please call The Keator Group at (877) 532-8671. Investment products and services are offered through Wells Fargo Advisors Financial Network, LLC (WFAFN), member SIPC, a registered broker-dealer and separate non-bank affiliate of Wells Fargo Corporation. Keator Group, LLC is a separate entity from WFAFN. Data provided by JP Morgan Asset Management, Market Insights 3Q/2013, as of June 30, 2013.
The accuracy and completeness of this material are not guaranteed. The opinions expressed in this article are those of the author and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material have been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity.
U.S. Treasury securities are guaranteed by the full faith and credit of the U.S. Government for the timely payment of interest and principal if held to maturity.
Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock’s weight in the Index proportionate to its market value.
Barclays Capital U.S. Intermediate Aggregate Bond Index: The Barclays Capital Intermediate U.S. Aggregate Bond Index represents securities in the intermediate maturity range of the Barclays Capital Aggregate Index. The Aggregate Index represents securities that are U.S. domestic, taxable, and dollar denominated. The Index covers the U.S. investment-grade, fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Securities in this Index must have a maturity from one up to (but not including) ten years.
Barclays Capital U.S. Long Government/Credit Index: The Barclays Capital U.S. Long Government/Credit Index is the Long component of the U.S. Government/Credit index. It consists of securities in the long maturity range of the Government/Credit Index that must have a maturity of 10 years or more.
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