Ramblings of a Portfolio Manager 10-26-2009

Ramblings of a Portfolio Manager

Nouriel Roubini, perpetual bear a.k.a. Dr. Doom, was on CNBC early this morning doing a fair amount backpedaling and sounding (for him) positively bullish. His thesis: things somehow changed in government policy back in March (huh?) and so the market rally is justified. As he sees it, the market is now at fair value! Sharp-eyed contrarians instantly brought the early Dow futures down 30 basis points. We note that a broken clock is only correct twice a day as long as no-one fiddles with the hands or mechanism. Clearly, the negative feedback loop of rising stock prices fiddled with Dr. Roubini’s inner workings so we no longer trust this clock and decline to take the contrarian bet just now.

Third quarter earnings season is about two-thirds over and the results have been fairly good, despite the market’s apparent lack of interest. Experienced portfolio managers, however, are already looking at 2010 and have been doing so since at least July, which explains much of the market’s rise since then. The media has made much hullabaloo about Dow 10,000 since we crossed that psychological barrier and the “too far too fast” crowd has used the milestone to bolster their case. In their view, the market is expensive and the earnings don’t justify the levels. In our view, they have missed two very important points: First, consolidated Dow Jones constituent earnings are now projected to be 22% higher in 2010 than in 2009, which represents only an 8% decline from 2007 earnings, when the index was 40% higher. Doing the math, assuming we get to the same trailing multiple as we had in 2007 (and remember the housing crisis started in that year) we get, roughly, Dow 12,700 by year-end 2010 (that’s a 27% return!). Secondly, in the same vein, looking at 1999 when the Dow last crossed 10,000 on the way up, actual constituent company earnings were 24% lower than actual 2008 earnings (viewed another way, earnings are 31% higher now!) and 26% lower than 2010 expectations (which represent 36% growth from 1999). So much for the valuation argument!

Of course all of this is a simplistic analysis involving just the Dow Jones index and we remind investors that, back in 1999, we were in a different world—one in which that new-fangled thingy called the internet, coupled with Y2K spending, were going to drive US earnings growth at double digit rates well into the next millennium. Clearly, that bullish outlook on our economy had a big influence on the multiple investors were willing to place on forward-looking earnings at the time. By the same token, however, we now have that not-so-new-fangled thingy called a global economy in which very large (China, India) population centers are growing rapidly in wealth and, thus, consumer demand. If we need to remind you which country is king at developing and delivering products for consumers, first go to your local supermarket and count the varieties of potato chips available, then move up the value-added chain and browse the Apple Store. And that’s just consumer products. Where else does one find the likes of Caterpillar, IBM, Boeing, etc., all of whom produce things growing economies need? Rising global demand for the diversified base of US products, we believe, is a much more robust and sustainable underpinning to future domestic earnings growth than a new distribution and information system. That underpinning will give us higher US company earnings over the next decade and for multiple expansion on those earnings, all we need is for folks like Dr. Roubini to recognize it.