Market Comment Q3 2012



Despite the world’s woes, stock markets have performed well so far this year. For the moment, a combination of strong corporate earnings, reasonable valuations and increased confidence has somewhat dispelled the fog of economic and political uncertainties. Can it endure?


To form a view, let’s look at each of these factors in turn. Corporate earnings are one of the prime determinants of stock valuations. Our core valuation model, in fact, is driven by three factors: the level of earnings, the expected growth in those earnings and the discount rate applied to future earnings. Of these, incidentally, the only one we know for certain is the current level of earnings.

Since the depths of the recession in 2009, the rebound in corporate earnings has been stellar. In the second quarter of 2012, quarterly earnings of companies in the S&P 500 stock index were $25.43, an all-time high and nearly three times higher than the lowest level of positive earnings in the recession.

Given the disappointing level of economic growth, and therefore corporate revenues, much of the increase in earnings is attributable to higher profit margins. In fact, corporate profit margins are the highest in at least 60 years. The chart at right illustrates the burst in profitability that followed the recent recession.

An armchair explanation for the rise in profitability is that corporations drastically trimmed investment spending and payrolls during the recession and kept them low during the subsequent recovery. There is substantial evidence that this is, in fact, the case.

Unfortunately, at this stage of the recovery, unemployment remains stubbornly high. Given the boost to profits from minimizing employment, we can legitimately wonder whether it is still true that, as Charles Wilson famously remarked, “What is good for General Motors is good for the country.”

The question is can profitability remain this high? A corollary to the profitability phenomenon is that corporate profits as a share of GDP are also at an all-time high, while wages are at an all-time low. The political pressure to re-allocate the economic spoils is one reason to doubt it. Whether this pressure is brought to bear in terms of higher taxes, reduced corporate “welfare”, mandatory healthcare insurance, or good, old-fashioned wage-bargaining remains to be seen. We have already seen banking profits tamped down by new regulations in response to the financial crisis.

A more immediate reason to be concerned is that cyclical pressure on earnings seems to be increasing. For the third quarter of 2012, earnings expectations for companies in the S&P 500 index are currently expected to decline by 2% or so, the first decline since the fourth quarter of 2009. With Europe in recession and the U.S. dollar high against many foreign currencies, many multinational companies based in the U.S. have guided earnings lower for the coming quarter. Much of this decline is expected in the energy and materials sectors, reflecting lower commodity prices than a year ago. While consensus earnings expectations point to a strong rebound in the fourth quarter, it is unclear just why that should be so. Should the European recession deepen or China not regain its mojo, expectations may well turn out to have been too high.



Stock valuations appear neither too high nor too low, but reasonable in light of the current economic environment. As shown in the chart at right, the S&P 500 stock index is now trading at about 13 times trailing 12-month earnings, just a hair below the average of the past 60 years. Prior to the past two market corrections, the market’s price was significantly higher relative to earnings. In 2000, it was priced at nearly 30 times earnings; in 2007, it was at 17-18 times. Today’s lower multiple probably insulates the market from the extreme sell-offs experienced in those years.

Given the concern we have expressed about the sustainability of the recent earnings trend, however, it is prudent to look deeper into valuation. Those measures that attempt to normalize earnings for cyclical factors, as well as those that look at multiples of market value to book value, suggest that stock prices are well above historical averages. Even though our valuation model suggests that many company stocks are priced well below their intrinsic values, we continue to tread cautiously in the market.

A source of significant support to valuations does come from low interest rates and bond yields. Given the alternative, many investors would prefer to take the risk of owning stocks, which currently provide a higher dividend yield than most bonds. Since central banks throughout the world are determined to keep interest rates low, we expect that stocks will continue to benefit from the comparison with bonds.


Confidence is the most difficult factor to measure and the most ephemeral. While the price/earnings ratio discussed above contains much information about investor confidence, there is much more that comes into play. To our minds, the sense of mistrust and unease that pervades the market discourse today reflects three uncertainties: economic (especially regarding housing and employment), public policy, and geopolitical. Perhaps these are the same three factors that always come to bear, but, at any rate, none are convincingly positive today. Still, there has been recent improvement in some of these areas that parallels the progress of the stock market.


Foremost is the boost to confidence provided by global central banks’ determination to give support to the economy. The European Central Bank this summer unveiled the “bazooka” designed to give pause to speculators hounding the sovereign debt of Spain and Italy. Under the plan forwarded by ECB President Mario Draghi, the ECB will engage in unlimited purchases of the sovereign debt of these countries. Meanwhile, the U.S. Federal Reserve has pledged to keep rates extraordinarily low through 2015, with the explicit goal of encouraging investors to bid stocks up. The actions of central banks—though designed to counteract weakness—have had the effect of simulating strength.

Housing prices were reported by Case Shiller to have risen in July for the third month in a row. In 2008, we wrote that things would not return to “normal” until housing prices stopped falling. If that is indeed what is happening now, and it may be too early to tell, then we expect the confidence this instills in homeowners to increasingly benefit the economy and markets.

Finally, consumer confidence, despite a downgrade to the estimates of second quarter GDP, reached a four-month high in September. Though it is probably an effect of the market’s rise, it could foretell further strength.

On balance, we remain positive towards the stock market despite the risks from known uncertainties. Over the long term, we believe it very likely that stocks will outperform bonds, so it becomes a matter of positioning the portfolio to withstand the likely volatility.



As an investor, you can probably classify yourself in one of two categories: accumulator or decumulator. These awkward terms differentiate those who are trying to build a nest egg from those who are spending from it. As the baby boomer generation retires, investors who have focused for a lifetime on accumulating enough money to retire are now looking for ways to generate retirement income from their portfolios.

One need only look at the plethora of financial advertisements in major media outlets to discern this trend. It seems like every financial supermarket on earth has a “retirement solution.” Because the issues are complex and often unfamiliar, many advertisers seek to simplify the issues. One firm’s “Turn Here” television campaign asked investors to “follow the green line” for help in matching their investment strategy to their position in the lifecycle. This tagline attempts to simplify matters that befuddle many investors, according to their research.

The transition to retirement does give rise to a need for education and guidance on a wide range of investment alternatives and related products and services. But there is no one-size-fits-all solution. A retirement income strategy need not be complex, but it can vary considerably from one individual to another. In an era of increasing longevity and, perhaps, increasing uncertainty, the value of a sound strategy has never been so high.

The past twenty years has seen the erosion of one of the most valuable employee benefits ever invented, the defined benefit plan. In such a plan, employees were guaranteed a known retirement benefit backed by employers who had access to the best professional investment advice. There was little worry that a retiree would outlive his or her assets, at least not for those with significant pensions. And retirees did not bear the risk that investments would not perform, the employer did. In the new era of defined contribution plans (i.e., 401(k) or 403(b) plans) investors must fend for themselves without guarantees and, in many cases, without professional advice. What’s an investor to do?

A “decumulation strategy” is a roadmap for financing retirement. When it comes to retirement income, the principal building blocks are social security, retirement savings, pensions (for an increasingly lucky few), personal property and any anticipated legacies. The core question is “How much can I spend to be relatively certain I will not outlive my assets?” Other important questions are also addressed, such as “When should I begin to collect social security?” and “What accounts should I spend down first?”

A relationship with a financial advisor, someone who understands your objectives and knows your resources, can be of invaluable assistance when navigating any of life’s stages, including retirement. At HeadInvest, we value the opportunity to get to know our clients “holistically” and strive to apply our expertise in a customized solution to meet your needs.



On November 8, HeadInvest will present its updated Economic and Investment Outlook. Among the topics for discussion are the investment implications of the U.S. elections and the Chinese leadership transition. The presentation will also include a brief overview of factors to consider when preparing for retirement. The presentation is open to all clients and selected invitees. If you would like to attend and do not receive an invitation, please call our office at (207) 773-5333 for more information.


By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.

The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts [sic] and even beyond their expectations or desires, become “profiteers,” who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat.

As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

John Maynard Keynes, The Economic Consequences of the Peace (1919)

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