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The Sandy Spring Way

March Observations

March 1st, 2012 | By Beau Mercer

Let me start the March Observations with an Irish toast. “May you have the hindsight to know where you have been, the foresight to know where you are going, and the insight to know when you are going too far.”

At times the Irish seem to have an exclusive hold on truisms. An Irishman may have reacted to the cover story of the February 13, 2012 issue of Barron’s entitled “Enter the Bull” with an off-hand insight that everything you have said can and will be used against you. The Barron’s story observed that cyclical patterns of market history indicate  that the odds are better than two chances in three that the Dow Jones Industrial Average will reach 15,000 or higher over the next two years. Based on the same cyclical patterns, there’s about a 50-50 chance that the Dow could hit 17,000 or more. Is Barron’s providing a recommendation that betting men should consider buying stocks? Apparently non-betting men do not like the odds and are tired of losing money. Data from the mutual fund industry indicates that over $76 billion has flowed out of domestic mutual funds since September 2011 and much of that has been transferred to bond funds. T. Rowe Price mutual funds spokesman Brian Rogers thinks investors are showing “irrational pessimism.”

Attitudes change quickly when influenced by certain emotions. The stock market is perhaps the only place where shoppers/investors rush in after prices go up. Behavioral finance has evidence that investors will continue investing in the stock market because they like their odds that a rising stock market will solve their financial problems.  The consummate behavioralist, Thomas Jefferson wrote that all citizens are entitled to life, liberty and the pursuit of happiness and he anticipated that we would work hard, buy a house, and invest in stocks in the pursuit of happiness. The politicians have created some confusion about the meaning of life and liberty but they understand how to pursue happiness. My suspicion is that President Jefferson did not think Europe would be a continuing problem nor did he envision the role of the media in interpreting how citizens pursue happiness.

The Dow is trading around 13,000 which is quite a change from its 2009 low of 6,547. Dow earnings are at an all time high. If Apple had been a Dow component the Dow would be near 14,000. Nevertheless, the Dow average is just arithmetic. Stocks are valued on their present and expected future growth, earnings, and ability to generate free cash flow.  The companies that constitute the Dow are selling at 13.9 times last year’s earnings which are near historic averages. At the Dow’s low in 2009, the shares were selling at 8.2 times earnings. All investors need to project how of economic policy (take into account the role of the government) and corporate profit growth will prospectively influence broad market movement. The Dow consists of 30 well managed companies that adjust to higher cost and grow profit margins. The odds of generating real investment returns are distinctly in favor of certain Dow stocks.

The U.S. Treasury yields remain at near fifty-year lows (not going lower does not mean rates are going higher). The Fed has advised investors that it will likely keep nominal rates low until 2014. Inflation, both the government reported kind and the real one we live with, is higher than the nominal Treasury yield. Many high-quality dividend paying companies have dividend yields exceeding both Treasury yields and inflation and yet trepidation persists. We are entering a world in which “baby boomers” are beginning to enter a stage in life in which they will be shifting their focus from growing a nest egg to spending a nest egg. Spending the nest egg without a real contribution from the stock market will reshape the pursuit of happiness which many of us anticipated. Maybe we will learn if B.J. Thomas was right when he sang: “Raindrops keep fallin’ on my head, but that doesn’t mean my eyes will soon be turnin’ red. Cryin’s not for me ’cause I’m never gonna stop the rain by complainin’ Because I’m free. Nothin’s worryin’ me.”

Happy Saint Patrick’s Day.

– Fred