Over the past several months the stock market has maintained the momentum that
started from the depths of despair last March.While we have all enjoyed the recovery, I find myself wondering if we
have come too far, too fast.
Based on current
earnings estimates for 2010, the market trades at just over the historical
average of about 15x earnings.On one
hand, one can certainly make the argument that earnings are still "below
trend," meaning that we are due for strong earnings growth as the economy
rebounds.On the other hand, analyst
estimates are notoriously optimistic, suggesting that the market's real P/E
multiple is well above the historical average.
My approach is not to
worry so much about the market's overall valuation but rather to look for
individual stocks that are attractive.Quite frankly, with each passing month (and each uptick in stock prices)
it gets harder to find really attractive stocks.But consider the alternatives.Government bonds yield little, and the spread
over Treasurys for riskier bonds (including junk bonds) has fallen
significantly over the past 10 months.Money market returns are paltry.As
long as inflation remains low, I doubt we will see great fixed income
opportunities.
So what does it all mean
for stocks?It probably means we should
ratchet down our expectations somewhat.The market has fallen in only one month since the lows in March, and
that kind of steady move higher can't continue indefinitely.Even as the economy gets better and companies
start to report better results, I doubt the stock market will push higher with
each piece of good news.We are starting
to see that with the early 4th quarter earnings.Companies like IBM, JP Morgan and Intel (none
of which I have bought for clients) have reported strong results, but the
market has not rewarded the stocks.
Even as we expect lower
returns for stocks, those returns should still be considerably better than the
fixed income alternatives over time.And
with low inflation, even the lower returns I anticipate are still quite
attractive on a real basis (i.e. once we adjust for inflation).
So have we come too far,
too fast?I don't think so.The market fell a long way, so we had a long
way to recover.The best of that
recovery may be over, but what is left should still help us build real long-term
wealth.
Having complained about
the difficulty of finding attractive stocks, I do want to mention a stock I
purchased for many of you late last year.UnitedHealth Group is the nation's largest health insurer, which puts it
right in the middle of the health care reform debate.
As the health care bill
gained momentum, fears of a public health insurance option and various taxes knocked
the stock down.My approach to valuing
the stock was first to consider the business ignoring the consequences of the
potential new law.What I found was a
well-positioned insurer with both local scale (hugely important in health care)
and national scale (pivotal for keeping costs down in this competitive business).In addition, the poor economy and the H1N1
virus had led to weak margins in the industry.But in insurance, weak margins usually lead to better results as underperforming
capital leaves the industry.So my view
was that we had a financially strong company earning good returns in a
difficult environment.And the stock was
trading at 8-9x EPS.
Of course, then I had to
go back to adjust my valuation for health care reform.I considered a range of outcomes based on
what could reasonably be passed by Congress, fully understanding that I
couldn't predict which outcome would win.The worst outcome I could see for United (a public insurance option with
a weak mandate that would encourage only the sick to get insurance) was bad,
but it wouldn't bankrupt the company.In
fact, given its scale and operational strengths, United could ultimately do
quite nicely in such an environment.And
that was the worst outcome.Much better
outcomes (for the industry, anyway) could include the whole thing falling
apart.Again, I don't want to predict
political outcomes.But it was a case of
heads-we-win, tails-we-do-OK.Put
another way, I believe the risk-reward tradeoff was tilted in the stock's
favor.The stock has enjoyed mostly good
political news since then, but things are far from settled.Still, I am optimistic about the company's
long-term prospects.
I have updated my Form ADV, which describes the business of Jacobs
Investment Management in more detail.I
am obligated by law to offer annually to send it to you, and I would be happy
to do so if you reply that you would like a copy.
For those of you with
taxable accounts, a capital gains report for 2009 will be coming shortly.Please call or email if you have any
questions.