Stocks Could Keep On Rollin'

Regular readers (and clients) know that we are underweight to equities at the moment. Meaning that, if a family has a long-term objective of 60% stocks, we only have about half that exposure to stocks and stock-like assets. We made this tactical change in late 2009 when stocks moved into mildly over-valued territory.

Our view is that a collection of stocks (say, the S&P500) is inherently worth some multiple of the ability of those companies to produce earnings. In the short run, earnings are affected by all sorts of things and will spike up and down. In the longer run, the earnings of a large group of companies grows on a relatively stable path, as all the short-term fluctuations (charge-offs, one-time gains, etc.) are smoothed out. If we further adjust for inflation, we find that real earnings growth moves like a battleship -- nice and steady and relatively predictable.

Using data available on Standard & Poor's website, we find that the trailing one-year earnings of the S&P500 companies peaked in June 2007 at $85 per share. As I write, the current trailing one-year earnings are reported at about $60 per share. This is up from the bottoming-out figure of only $7 per share a year ago, and reflects the ongoing and robust recovery. A key question for us now is whether earnings are headed back to their earlier level of $85, or if they will instead now oscillate around a different level. If earnings are headed back to a steady $85, then the S&P500 is worth about 20% more than today's price. If earnings are instead going to settle in the $60 range, then the index is overvalued by about 20%. This is a critical question that can't be answered with certainty, but can be analyzed a bit to understand the probabilities.

In the chart below, the red line shows the short-term variability of earnings (click on it for a bigger view). The blue line is the 10-year trailing average; the dotted line is the trendline of the blue line. As you can see, short-term earnings have recovered right back above the 10-year average.

So, again, our question is whether "it's different this time" and earnings will escalate back to their earlier highs -- and stay there. Or, will they settle nearer to their long-term potential, as shown by the blue and dotted lines? We cannot know for sure, but we need to make a decision about portfolios. To make that decision, we look to the individual investment policies and mandates of our actual clients. Unlike institutional managers and hedge funds, who typically deal with a small slice of a client's overall wealth, we manage most of the life savings of our clients. Our mandate is not, "just go make money," it is a mandate to balance opportunities with the very real fact that this is all the money our clients have, and we cannot risk losing it.

With that mandate in mind, we choose not to make a big bet that "it's different this time" -- even though it might be. After all, earnings moved above trend for most of the 1990's, and stocks went to the moon. As we know, they then fell back to earth. Rather than make that painful and disruptive round trip, we are placing our bets conservatively. We will have to be patient if and when earnings accelerate past a sustainable level, which will surely pull stocks up with them.

Read our quarterly newsletter here for some further commentary on our current positioning.