Monday, May 2, 2011

Don’t be Fooled by the Financial Headlines -- Corporate Profits are the Story!

From the Desk of Joe Rollins

As you may have noticed, I took an extended leave of absence from posting to the Rollins Financial Blog. Due to tax season, the months of February through April are an intense time for our office. We work extended hours and have little time to post regularly to the Blog. This isn’t to say that nothing has happened in the financial world that warrants a post.

From the fallout from the March 11th earthquake in Japan to the near government shutdown due to the budget battle between Democrats and Republicans in April – along with the weak economic recovery – there was certainly enough negative news to make one believe that investing is a waste of time. However, nothing could be further from the truth, and I will explain why in this post.

As I’ve written before, corporate profits are what drive stock market performance, not geopolitical events. Contrary to several forecasts, April was a good month for the financial markets. During April, the S&P 500 had a total return of 3%, and it’s up an impressive 9.1% for the first four months of 2011. The Dow Industrial Average was up 4.1% for April and has an even higher rate of return for the year through April 30, 2011 of 11.5%. The NASDAQ Composite notched a 3.4% gain for the month of April and stands at 8.6% for the year through April 30, 2011. What is even more surprising to the stock market bears is that all the major financial indices stand near double-digit gains for 2011 as I write this post.

We’ve witnessed an amazing comeback in the financial markets with double-digit gains in 2009, 2010, and for the first four months of 2011. I am one of the few people who believed that the markets would make a roaring comeback from the bear market lows of 2008, and thankfully, that’s exactly what happened.

For the year to date, the U.S. stock market has been the outstanding performer. If you have diversified your portfolio to international funds and to some bond positions, you have more than likely had a rate of return somewhat less than the S&P 500 year-to-date.

The tragic effects of the earthquake and tsunami in Japan have dragged down the Asian markets for the quarter, but the long-term financial effect should be minimal. Furthermore, the unrest sweeping through much of the Arab world erupted in Libya in February, causing American and European forces to begin a broad campaign of strikes against Colonel Qaddafi and his government on March 19th. This has forced up the cost of oil prices even though the oil supply in the United States will be largely unaffected. Interestingly, however, these history-making geopolitical events have not prevented the stock market from continuing to move higher.

There are specific reasons why the markets continue making gains despite such harrowing world events, which investors should keep in mind when making portfolio decisions. Almost 80% of the Fortune 500 companies that have announced earnings for the 1st quarter of 2011 have exceeded their expectations. Corporate profits for the 1st quarter of 2011 are now projected to exceed the highest corporate profits level ever in the history of the U.S. financial markets. Additionally, corporate profits are anticipated to be even higher for the second half of 2011, and will continue to grow in 2012. Since corporate profits are the most important indicator of future stock prices, stock market investors can’t ask for a more favorable financial environment.

It’s been projected that the S&P 500 corporate profits for 2012 will exceed $100 per share. Applying a modest multiple of 15 times earnings, the S&P 500 will potentially have a value of $1,500 per share. A multiple of 15 for the S&P 500 would be an average multiple, but multiples of 18 to 19 in an economic environment where corporate profits are accelerating are certainly not unusual. Given the current S&P 500 level of $1,363 per share, this $1,500 value provides an implicit future gain based on earnings alone in excess of 10%.

I continue receiving questions from clients regarding the issue of the falling U.S. dollar. I reiterate that the downward adjustment of the U.S. dollar is a positive for the U.S. economy, not a negative. I previously explained that the lower revisions to the dollar is nothing but a positive for the U.S. economy, as it makes U.S. manufacturers more competitive in international markets and puts more Americans to work by creating manufacturing jobs in this country. A verification of the positive effects of a lowered dollar is the balance of payments with foreign countries over the last years of the trending lower dollar. During that same timeframe, the trade gap is half of what it was three years ago. Today there are more manufacturing jobs in the United States than there have been in decades. Contrary to the promoters of doom, the lowering of the dollar has been a net positive for the U.S. economy.

Another amusing prediction of doom relates to the international holders of our debt. It’s not unusual to hear that the U.S. is destined for financial disaster because the holders of our debt will refuse to buy and will ultimately sell our debt, making it impossible for us to continue to borrow. This logic is nothing short of absurd.

First and foremost, the Chinese must buy our debt; it’s not optional. If China all of a sudden decided to dump all of its U.S. denominated debt on the open market, they would probably be doing us a tremendous favor. They need us a lot more than we need them. By selling U.S. denominated securities and repatriating the money back to China, the value of their own currency would immediately be forced significantly higher and the U.S. dollar value would be forced down.

This is strictly the economics of supply and demand: lowering the U.S. dollar and forcing the Chinese yuan higher would devastate China’s economy by making products produced in China no longer competitive in the international markets. Conversely, U.S. manufactured goods would be more competitive, reducing jobs in China and increasing jobs in the United States. Surely the Chinese would not make such self-destructive financial moves.

The favorite doom and gloom prediction in the current environment concerns the U.S. government deficits. While our deficits are undoubtedly staggering and depressing, the media’s assumption that these deficits will be ongoing and will never trend lower is preposterous.

It’s true that U.S. deficits can’t continue for the next decade without an adverse impact to our country, but I haven’t seen any evidence that this is what we’re facing. For the first time since the Obama Administration took office, there’s finally some recognition of the incredible financial mismanagement that has occurred. Massive governmental spending didn’t stimulate the economy and a new financial projection was required.

The GDP’s growth at 1.8% for the 1st quarter of 2011 after three years of federal expenditures of close to $4 trillion (when the federal government only receives approximately $2 trillion in revenue) is further proof that Keynesian economics simply do not work. I recall President Obama campaigning that he would end the federal deficit by the end of his first term. As we approach that date, more deficits have been run up in the last three years than in every preceding president’s term combined. But the good news is that change is on the horizon.

The following graph doesn’t need much explanation, but it should be encouraging.

The Obama Administration submitted a budget for 2011 on February 14th, which is represented by the higher line on the graph. As you can tell from the line, this budget would essentially make the current deficits permanent for the next 20 years.

On April 5th, the House of Representatives submitted their budget (represented by the lower line on the graph). While this budget would not close the deficit, it does bring federal spending to pre-Obama levels where revenue has the potential to close the gap.

The middle line represents the Obama Administration’s revised budget. It appears that they finally figured out that the American people did not want to continue subsidizing gigantic governmental spending forever. Even though the revised budget is still way too high, it’s better than their first budget. It should also be remembered that no budget was ever submitted for the federal expenditures for 2010. The good news is that everyone in Washington wants decreased spending; the bad news is that no one can seem to agree on what items to cut (but they are finally talking about it.

Washington finally appears to be focused on reducing the deficits. Politicians who aren’t offering leadership in that goal will likely be replaced. I predict that within the next decade, the federal budget will be brought to more manageable levels, and therefore, the debt will be lower rather than higher. Once economic activity picks up, the increase in tax receipts due to this higher level of activity will do the heavy lifting in bringing the deficit back under control.

In summary, most of the headlines forecasting disaster in the U.S. economy are unsupported by the facts. The Federal Reserve has done an excellent job in stimulating the economy while slowly withdrawing the stimulus to help create a soft landing from a difficult time. However, for the purpose of investing, the proof of the pudding is strictly corporate profits.

For the 1st quarter of 2011, corporate profits reached the highest level ever in the history of the financial markets and are forecasted to trend even higher going forward. If you need any other evidence reflecting that long-term investing is the best way for you to realize profits, just review the slope of higher corporate profits instead of the predictions of gloom and doom.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

No comments: