Ramblings of a Portfolio Manager

The Cake is Baked. So What’s the Icing?

We’ve been postulating for weeks now that the mid-term elections have already been discounted by the equity markets. That is, the equity markets’ 12+% rise from their late August bottom has been due, in part, to expectations of a Republican retake of the majority vote in the House of Representatives. But election euphoria alone hasn’t done all the work--the other factor contributing to the markets’ rise, we have been proposing, has been the expectation of the initiation of QE2 in November and that, therefore, is also discounted to some degree. In fact, these two “events” have been the principal drivers of this market now for almost two months, all in the face of continued weak economic data. Expectations for the mid-terms probably got it all started and QE2, which has brought the US Dollar to a 15 year low versus most major currencies, has been doing the heavy lifting, acting as the support and continuing driver to equities. In fact, the US market indices now slavishly move in reverse lockstep to the dollar’s strength or weakness, ignoring economic data, earnings reports, or any other fundamental data related to their constituent companies. So, with the two big catalysts already baked into the cake, so to speak, what’s left to drive the equity markets to the end of the year?

According to our research, gleaned from multiple sources, since 1922 the average fourth quarter rise in the Dow in a mid-term election year is 8.5%. In fact, there were only two times when the equity markets were not higher in the 90 days following a mid-term election and in both situations the Fed was actively raising rates in an attempt to reign in the economy. Given October’s performance to date, we’re already half way to the average. But this has been a year of historic swings—worst May since the 50’s, best September since the 30’s, etc. etc. Have we already gotten half the expected gains for Q4? We don’t think so. There are several drivers still remaining, which have not been fully discounted by the markets. The first is a Republican retake of the Senate as well. Polls are notoriously inaccurate but many show this as a possibility. Would it drive stocks higher? We think so. In fact, we are beginning to believe that political “gridlock,” usually so good for the markets, may be a detriment this time around. Much of what has been suppressing the economy, and thus the markets, over the last year-and-a-half have been the onerous bills passed by the current Congress—Health Care and Financial Reform. With gridlock, these two items will most likely persist, unmodified. With a Republican mandate in both the House and Senate, there is a fair chance that they will be lightened up to the benefit of business or, better yet, go away altogether.

Another driver we see is the size of QE2. Right now it is difficult to find a portfolio manager appearing on TV who doesn’t believe that QE2 will be anything less than $1Trillion but there are still some skeptics. We think the Fed is listening and doesn’t wish to rock the equity markets, which it is attempting to lift to spur the wealth effect. Therefore, we believe that the minimum amount of the easing will be $1trillion. Anything more and the dollar will plummet further, with the markets off to the races.

Finally, there is—gasp--fundamentals and valuation. Does anyone pay attention to those anymore? We think investors will start doing so again, particularly if the “government overhang” is eliminated in the mid-terms. Right now First Call is looking for $92+ in S&P500 earnings for 2011—that’s a 14% rise from this year’s estimates, ¾ of which are “in the bag” with the remaining quarters inching higher as this earnings season progresses. That puts the S&P at 12.8x forward earnings, a decade low. And with those earnings estimates poised to rise with renewed confidence and guidance from Company Management (again, post elections), we may well see a market that not only grows along with earnings (just like the good old days) but gets some long awaited multiple expansion. Given this and the “icings’ mentioned above, we believe Q4 and 2011 will be sweet for equity investors indeed.