Col. Jessup & Rufus T. Firefly

In the classic movie, “A Few Good Men,” Col. Nathan R. Jessup, played by Jack Nicholson, delivers one of my favourite lines…

“I run my unit how I run my unit. You want to investigate me, roll the dice and take your chances. I eat breakfast 300 yards from 4000 Cubans who are trained to kill me, so don’t think for one second that you can come down here, flash a badge, and make me nervous.”

The best portfolio managers are a little bit like Col. Jessup. They don’t get nervous when you might expect them to. Instead, they get nervous when others are complacent.

After a powerful rally in June, the stock market is close to an all-time high, and that makes me a little bit nervous. Admittedly, on the surface, there are several reasons for optimism. First, interest rates remain low supporting higher equity valuations as investors take on more risk in search of higher returns. Second, the most recent jobs data was welcomed as a sign of an improving labor market, so vital to future economic growth. Third, corporations continue to increase dividends and repurchase shares, both of which serve as a tailwind for the recent rally in stock prices. What’s not to like?

Ask what can go wrong, not what can go right… A critical aspect of portfolio management is to identify and then quantify risk. Especially during periods when the overall market is rallying, it is essential to dig deeper, below the bullish headlines, and identify what could go wrong. In this regard here are a few disconcerting trends…

While the unemployment rate has fallen to a six-year low, the overall labor market remains sluggish. Income growth, a much more important factor in terms of consumer spending and future economic growth, remains well below average for this stage of an economic recovery. Moreover, the overall economy is growing about 2%, too slow to generate wage gains and income growth to benefit the bulk of the country. Burdened by higher taxes and government regulation, the economy appears to be stuck in this low growth environment.

Stretching valuations… At the beginning of 2013, the Price/Earnings ratio (P/E) of the S&P 500 was 14x. Currently it is nearly 18x. Clearly, earnings growth has not kept pace with the increase in stock prices. With interest rates and inflation low, an overall P/E of 18 is not excessive, but it isn’t a table pounding bargain, either. Here again, the critical question is what could go wrong. There are three primary risks to stock prices. First, higher inflation and/or higher interest rates would likely alter the valuation equation, causing a devaluation in stock prices. While, food and energy prices have risen, labor represents nearly 2/3 of consumer inflation. Although wages have not increased, should this trend reverse, inflation could spike, driving up interest rates.

Second, to support a further expansion in P/E ratios, earnings growth will have to accelerate. And again, burdensome government regulation and higher taxes are holding back corporate earnings. Third, geopolitical risk is increasing, and an unanticipated event could cause a short-term market correction.

So, what comes first?… Do higher stock prices pull the economy out of the doldrums? Or does the struggling economy or a geopolitical event cause a market pull-back?

As long as interest rates remain low, stock prices can move gradually higher. But the higher stock prices go, driven by low interest rates instead of accelerating earnings, the greater the eventual correction is likely to be. Moreover, I do not feel that a continued rally in stocks will lead to an improvement in the overall economy, as long as the current political environment prevails. Admittedly, this environment could change dramatically in November.

A tried and true remedy for nervousness is to focus on in-depth valuation analysis. Not only does this provide a means to quantify risk within a portfolio, it also serves as a guide to determine relative exposure across the various economic sectors. In our portfolio analysis, we employ several valuation techniques including: Price/Earnings, Price/Sales, Price/Book, and Price/Cash Flow. We also incorporate a Price/Earnings Growth ratio in certain higher growth industries. Our goal is to own a portfolio of stocks that have significantly more upside potential than downside risk.

Which brings me to one of my favourite lines from another classic military movie, “Duck Soup,” starring Grouch Marx as Rufus T. Firefly

Rufus T. Firefly: Oh, I’m sick of messages from the front. Don’t we ever get a message from the side? – What is it?
Bob Roland: General Smith reports a gas attack. He wants to know what to do.
Rufus T. Firefly: Tell him to take a teaspoonful of bicarbonate of soda and a half a glass of water.

When the markets make us nervous we know what to take—a teaspoonful of valuation analysis. Or better yet, a bucket full…