My dad was a wonderful golfer in his prime, sporting a +2 handicap during his undefeated college career at Le Moyne College in Syracuse, NY. He showed me an old scorecard once from a 36-hole match in which he was up by nine after the first round, then proceeded to birdie the first five holes of the second round to win 14 up with 13 to play. There were no scores beyond the 5th hole, so I asked him why he stopped, why he did not at least play the 6th hole to see if he could extend his birdie streak. He shrugged and said, “The match was over, it was time to celebrate.” Then he chuckled and added, “It was, one heck of a start.”
Which, I think, is an accurate assessment of where we are regarding the stock market thus far in 2012. With the overall market up 12%, the best first quarter since 1998, it was, most definitely, one heck of a start. Before we get too carried away, here is a list of the reasons why the bears contend the end of the first quarter will prove to be the high point for stocks this year:
- The Fed is keeping interest rates too low for too long, which will eventually cause hyper-inflation.
- There remains too much debt in Europe which will prevent any meaningful economic recovery in that region.
- Government spending in the US is out of control and much needed reform is unlikely in an election year.
- High gasoline prices will crimp consumer spending and depress economic growth the rest of the year.
- Potential geo-political disruptions in the Mid East pose a risk to global economic growth.
This is, surely, a formidable list of concerns. But none of these issues are new, which means the market has had time to discount them. Moreover, all five are complicated, and making specific predictions about how they might impact the economy and market is a dubious exercise at best.
Meanwhile, the list of positive factors is equally impressive. Corporate profits and cash flow remain strong, while dividends and share buy-backs continue to enhance shareholder returns. From a macro perspective, interest rates and inflation remain relatively low, and in this context stocks remain undervalued.
It is interesting to note that despite the powerful advance in stock prices in the first quarter, money flows continue to pour into bonds and out of stocks, generally speaking.
Collectively, investors remain skeptical about the sustainability of this recent advance in stock prices, most likely for the aforementioned reasons. While this might seem counter-intuitive, stock prices are likely to continue to move higher only as long as there remains a healthy level of skepticism. As the saying goes, the market climbs a wall of worry. As long as the underlying fundamentals are strong, the market is likely to work its way higher over time.
If this bullish move persists, eventually money will flow increasingly into stocks, and the list of reasons why the bull market will go on forever will grow. Whenever skepticism wanes, it is time to get more cautious. My sense is we have a ways to go before excessive optimism emerges.
As the table below illustrates, history suggests the rest of the year should be a positive one for stocks (S&P 500 total return) –
In 6 out of 8 years when the market was up double digits in the first quarter, stocks ended the year up significantly higher.
Going forward, stock selection within the major market sectors will remain a critical driver of overall return. We continue to search for companies that are winning the competitive battles within their respective peer groups. Potential buy candidates will include companies that market innovative products and services, while enhancing internal productivity. We also favor companies with low debt who have the propensity to return cash flow to shareholders through increasing dividends and share repurchases.
Michael Kayes, CFA