Don’t be surprised by surprises

Corporate earnings experienced quite a resurgence in the second quarter, surprising investors and market pundits. Overall profits advanced around 9% while revenues grew at the fastest rate in over a year, at 4%. Meanwhile, merger and acquisition activity continues to gain momentum, adding further fuel to the relatively strong stock market.

But can this bull market, now in its 5th year, continue? … That depends on several factors. Over the past five years, the price earnings ratio (P/E) on the overall stock market has risen from 14x to 19x, which means that stocks are not quite as undervalued as they were at the start of the bull market. At the same time, as long as interest rates and inflation don’t move appreciably higher, the overall market P/E could continue to climb. In addition, M&A activity, higher dividends, and share repurchases all bode well for higher stock prices.

What could change this positive picture?… Any number of things. We live in a complicated world where geopolitical events and domestic political changes can have profound impact on our economy and markets. And since most of these lingering issues are difficult to predict, it creates a heightened sense of investor anxiety. But that is a good thing, as it relates to the future direction of stock prices. Let me try to explain.

Back in the heyday of the boom in technology stocks, one of the leading companies, Cisco Systems, became the largest stock by market capitalization in the S&P 500. Shortly after achieving that milestone, someone remarked to me that, “One should NEVER sell Cisco Systems stock.” When I heard that remark, I wrote down the price of the stock – $82/share. That price turned out to be the all-time high for the stock. What is my point?

Stock prices are driven by the ever-changing balance between expectations and reality. When expectations are high, it becomes harder for reality to measure up. Conversely, when expectations are low, it becomes easier for actual events to bring positive surprises.

Today, we seem to be permanently stuck in an environment where there are countless things to worry about. Rationally, we all know that worst case scenarios rarely happen, but we also know that disasters occasionally strike and that few things in life are certain. So, with this ever-nervous mind set, we are often, strange as it may seem, pleasantly surprised by the absence of cataclysmic events.

But if something bad does happen, then what do we do?… Going back over the past 75 years, virtually every major event that led to a sharp drop in stock prices turned out to be an auspicious long-term buying opportunity. And that will be the case the next time as well. The investment team at Willingdon is constantly going over “what if” scenarios to develop plans to take advantage of long-term buying opportunities resulting from unforeseen events.

This proactive approach also helps us remove emotional volatility from the decision process. By preparing for various potential events, we hope to take advantage of opportunities while the majority of investors are paralyzed by fear and uncertainty. As I have stated many times in previous editions of Willingdon Views, emotional decisions almost always have a negative impact on portfolio values.

Looking at the various sectors of the market, it is interesting to note that three are leading by a relatively wide margin this year – Health Care, Technology, and Utilities. The first two are driven largely by innovation. Within Health Care, new product successes, particularly in the Biotech area, have led to outstanding performance in this industry. Within Technology, pent-up corporate demand, after a period of reluctant capital investment, is resulting in strong earnings growth. Moreover, corporations continue to be focused on improving productivity and earnings growth without adding appreciably to payroll expenses. This substitution of capital equipment for labor, bodes well for technology spending going forward. Utility stocks have done relatively well so far this year due to abnormally low interest rates, as many offer dividend yields over 4%.

In about a month we will get another wave of corporate earnings reports. The mid-term elections are a month after that. In between, there are all kinds of possibilities for geopolitical disruptions around the world. Stay tuned, and don’t be surprised by surprises.