The verdict is in. The message to Washington is crystal clear.  If we as individuals have to live within our means, then our government has to as well.  That is the crystal clear message from this historic, mid-term election.

Realistically, what are the chances that a divided congress will work together to make meaningful and lasting progress toward reducing our trillion dollar federal deficit?  As Congressman Willard Duncan Vandiver purportedly stated in 1899, “I am from Missouri. You have got to show me."  But let’s imagine that they do come together to solve this seemingly insurmountable challenge.  The explosion of entrepreneurial energy would be astounding.  Moreover, the $2 trillion in corporate cash sitting unproductively in the bank would be invested in capital and labor, unleashing more economic growth and productivity.  Predicting these exciting scenarios might be premature, but it is far from wishful thinking.  I do believe meaningful deficit reduction initiatives will grind their way through congress at some point over the not too distant future.

In the meantime, the global economy continues to face a long list of economic and political challenges, including: sovereign debt, stubbornly weak housing, escalating tensions between North and South Korea, and the crisis du jour, Wikileaks.  According to their website, Wikileaks “publishes and comments on leaked documents alleging government and corporate misconduct.”  How wonderful.

Back to things we can actually analyze… The pressure on corporations to productively redeploy their mountain of cash is intensifying.  Already we are seeing aggressive share buy-backs and higher dividends, as well as more activity on the Mergers & Acquisition front.  All these uses of cash are positive for stock prices.

Meanwhile, the October jobs data was surprisingly strong, but here too, we need to see more of a trend before concluding that the economy is growing fast enough to reduce the stubbornly high unemployment rate.   Nonetheless, it’s a positive development.

Is the market’s recent rally a sign of better times ahead?… Yes, I believe so, particularly in the context of how bad the economy and markets have been over the past ten years.  Markets tend to bottom well before the recovery is officially confirmed by economic statistics.

Which brings us to the fundamentals of the market... Corporate earnings and cash flow are strong, interest rates and inflation are low, typically a very positive environment for stock prices to rally.

Despite this positive backdrop, skepticism and anxiety remain high… What if gridlock paralyzes Congress preventing meaningful deficit reduction?  What if the latest quantitative easing by the Fed fails to stimulate the economy?  Or what if Wikileaks exposes and discredits the entire capitalist system?  It doesn’t take much effort to compile a list of dire predictions for the future of our economy.  Nevertheless, my sense is the reality of what will transpire over the next couple of years is somewhere in between the best and worst case scenarios.  I know that isn’t much of a statement, but the Grand Canyon could fit comfortably between the upside potential resulting from economic and political progress, and the dire predictions of attention-grabbing doomsayers.  While investor sentiment may very well gyrate between these emotional extremes throughout the coming year, the underlying fundamentals: earnings, cash flow, interest rates, and inflation, are typically much more forecastable and vary within a much tighter range.  This relationship between relatively predictable fundamentals and wildly volatile investor sentiment is what creates tremendous opportunity for the disciplined investor.

One of the cornerstone philosophies within our process is to continually look for opportunities to upgrade quality of our holdings whenever possible.  An ideal scenario is to buy a leading company when its stock price is “on sale” due to a short-term over reaction or change in investor sentiment.  It takes patience to spot these infrequent bargains, but they can be found.

So, while we roll up our sleeves, and work the process to uncover value in this volatile market, we wish you all a very Merry Christmas and Happy New Year!

Michael Kayes, CFA