When we make investment and financial planning decisions for clients, most often we are not able to predict with any certainty how markets will behave, how or when personal or business situations will change, or the timing and impact of the variety of life events that change considerations.
Though we cannot predict, we can at least prepare.*
We prepare with financial plans that accommodate “What if?” scenarios. We prepare with investment strategies that target specific objectives but have the flexibility to correct course if need be. We prepare by seeking insight from analysts and experts from a wide variety of sources. Often, a forecast or opinion from one source is in direct conflict with that of another. Whether or not there is consensus on the most attractive investment opportunities at any given time, we strive to position our clients for a balance of risks and reward that is consistent with their goals. We prefer not to be outliers at either end of the spectrum of outcomes—with significant reward but similarly elevated risk or with no reward for too little risk.
With this perspective in mind, here are a few themes we think are worth noting as we manage clients’ accounts.
Improving sentiment drives pent up demand
While many analysts and investors think that the global bull market for stocks will continue, others continue to be worried about a market correction.
Fidelity market strategist Jurrien Timmer commented in a conference call April 15 that “fundamentals are good and getting better.” He’s referring to the underlying characteristics of evaluating companies, such as their earnings, free cash flow, etc.
As fundamentals improve, market sentiment climbs and the herd of unsophisticated investors moves in. When comfort with risk increases, the risk of returns not meeting expectations also increases.
Timmer said that there is moderate risk of a correction but “the market is running on pent up demand.” Therefore, the confluence of price, confidence and sentiment could easily push S&P 500 beyond what is considered fair value today.
We have seen many market analysts raise their forecast for the S&P 500 from the 1,200 range that was passed last week to 1,500 and beyond.
It’s all about corporate earnings
If global stocks are to continue their march back toward peak values of October 2007—requiring approximately another 20% of gains—company earnings will have to grow beyond expectation, beyond what is already priced into the market. Expected earnings growth is very strong—in fact, record earnings for S&P 500 companies are predicted for 2011 but these earnings may already be fully factored into prices.
Most analysts base their projections for stock prices on the value of a company and its projected earnings levels. Stock prices are anticipatory more than reactionary. If there is too much good news already priced in, even moderately good news will be disappointing.
This is more of a problem in growth stocks where earnings growth is expected to generate higher future profits and escalating price. Because of the uncertainty of earnings and the extent to which expectations are already priced into stocks, we currently favor high-quality, dividend-paying companies.
Wisdom from Warren
As Warren Buffett noted in the Berkshire Hathaway annual report, times when confidence is growing are not the most rewarding for investors. He was happy to put money to work when the investment environment was far more bleak than it is today.
“A climate of fear is their (investors) best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business—through the purchase of a small piece of it in the stock market—and what that business earns in the succeeding decade or two.”
* This thought comes from a Morningstar Q&A with Chris Davis, a money manager for Selected Funds and Davis Advisors.