Saturday, August 14, 2010

Are we there yet?

Human beings are not known for being patient. According to the internet Wikipedia article on Patience, we “are inclined to discount future rewards—the present value of delayed rewards is viewed as less than the value of immediate rewards.” On a long trip, our children want to know, “Are we there yet?” and “How much longer?” will it be until the destination is reached.

Our economy is clearly “recovering” from a financial crisis, but we have not yet “recovered”. The trip is not over, and we are not there yet. During the initial stage of the recovery, it appeared that we were making rapid progress and we hoped that our destination was in site. Over the past few months, it has become clear we are moving slower than we thought and that the journey back to “recovered” will be longer than we hoped.

Data indicates that we have now had 15 straight months of unemployment at 9 percent or higher, 12 months at the current 9.5 percent level or higher. Of the more than 10 million currently unemployed, almost half have been unemployed for more than 6 months. To some, the most impatient and the most pessimistic, it seems that we are moving so slow, that it will take forever to reach our destination of being “recovered” and comfortable. These folks are not only worried about the present headwinds of unemployment and a weak housing market—they are also worried about future headwinds, like higher taxes and bigger government.

It seems that we are in a bubble of pessimism. We can be so focused on the fact that the trip is longer than we hoped, that we fail to recognize that we are still moving toward the destination. As I have written, markets value stocks based on future earnings. Future earnings are unknown, so they are estimated based on present earnings (E) and investor sentiment regarding the future, sometimes measured by the price/earnings ratio (P/E).

Many still estimate that earnings for the S&P500 will reach 79 for 2010. With a P/E of 15, this would result in an S&P500 of 1185 or almost a 10% increase above the 8/13/2010 close. (The estimates for S&P500 earnings vary from 70 to 87 and estimated P/E ratios range from 12 to 18, for a range for the S&P500 from 840 to 1500—now that’s uncertainty!)

In addition, when we finally reach “recovery” and return to the S&P500 level reached nearly three years ago in 2007, the market will have risen by 45% from it’s present level !

Corporate profits are clearly recovering. Earnings reported in July have indicated that corporate earnings continue to exceed expectations. Our excessive pessimism tends to discount the importance of these higher earnings with an attitude that the improvement is only temporary.

My prediction is: corporate profits are on the road to recovery. This road may not be straight and it may be uphill, but it’s general direction is toward improvement. We may be slowing but it is very unlikely that we are making a U turn. Corporate profits may fail to meet analyst’s expectations, but the trend is still likely to be UP. The best assets to own during a time when corporate profits improve are stocks.

While we are clearly not there yet, and may be moving slower than hoped, as corporations hoard cash and consumers pay off debts, we are clearly also increasing our potential for growth. Be patient, those delayed rewards may be better than we expect.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.