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More Sideways Movement or a Breakout?

Posted by RAA on Apr 6, 2016 10:30:00 AM


Market_Matters_Icon_medium.jpgOne of the many decisions that our Investment Policy Committee must make is not just which fund managers to hire, but how much stock and bond market exposure we should have for the portfolios.

The bond side of that question is usually easier to determine as bonds are normally less volatile than stocks, but do not have the ability to give you the kind of returns that help sustain your withdrawal rate OVER TIME. As a result, when we find ourselves where we are today with respect to market valuations, we need to dig deeper and try and discern earnings as to whether they are “good” earnings or “funny” earnings (read: are games being played by companies to “gin up” earnings for market purposes?) 

This is important because it can give us a clearer picture of the overall valuation of the market and how we should be invested. More about this later…

The Bigger Picture

Before we drill down to earnings, let’s take a look at the bigger picture for the market. The Fed bank officials seem to be talking out of both sides of their mouths. They still believe that interest rates are too low and will condition the markets for a June rate hike unless, as they have said, “something changes.” In other words, they are only sure of one thing: rates need to go higher but they also realize that if they do it too quickly it would hurt our economy and not be kind to the markets.

As a result, last December they telegraphed four rate increases to the markets for 2016. They are now probably down to two, and depending on how the economic data comes out it could be one. Stay tuned...

So, with the Fed not sure what to do (remember, they are data dependent), and a presidential election later this year, which is usually good for the stock market in normal times (2016 is not normal), how do we invest for the remainder of the year? This is a challenging question which has our Investment Committee constantly talking and reviewing all kinds of economic data.

Profit Margins

At this juncture of the economic cycle, profit margins are starting to come down (profit margins, simplistically speaking, are a company’s bottom line earnings divided by their gross revenues). This tells shareholders how much a company makes on each dollar of revenue. These numbers are declining a bit due to depressed oil prices and a very strong dollar, which hurts multi-national companies’ gross revenues, which negatively impacts their earnings.

We know that margins are coming down and that the headwinds facing corporate America (depressed oil prices, a strong dollar and a consumer that while still spending is also trying to pay down debt and save a little) represent a challenge to market valuations. Let us say a word about the strong dollar or “King Dollar”  as Larry Kudlow of CNBC would say. Accelerating domestic growth would allow the Fed to step up the pace of raising the Fed funds rate (and rates in general), which would give support and more strength to the dollar.

Earnings

The corollary is that domestic earnings cannot accelerate too much without negatively impacting profits from our multi-national companies because of the strengthening dollar. Hmmm… so which is better - stronger earnings which would result in higher interest rates or less strong earnings which most likely would result in lower interest rates? This is a real balancing act, to be sure.

As a result of the macro picture being challenging, we must drill down and look at corporate earnings and see if there is some “light at the end of the tunnel.” An issue we now face on the earnings front is the disturbing deterioration in earnings quality.

A recent study in the Financial Analysts Journal (the trade publication for all CFAs) suggested that approximately one in five companies intentionally distort earnings, even when adhering to the accepted GAAP accounting standards. The average magnitude is 10% of reported profits. Declining earnings quality means that the valuations are pricier than they appear because the earnings backed by cash flows are overstated. This is consistent with our view that while this equity rally is welcomed, the risk/reward of using some of the 10-12% that is in your money market fund is not warranted at this time.

Tepid global growth, weak pricing power and declining margins create a strong incentive for companies to “massage” earnings. While earnings expectations are probably bottoming, profit growth will most likely remain lackluster. Until we see more evidence of earnings growth bottoming and valuation multiples becoming more reasonable, we are content with our overweight cash position, but may make some slight adjustments.

Please contact us at (972) 684-5923 if you have any questions.

 

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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security. 

Topics: Investment Updates