The Calm Before the Storm

 | Oct 08, 2012 | 2:30 PM EDT  | Comments
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The most dangerous thing an investor can do is become complacent during a rising market -- and complacency has ruled the day for a number of months now. The U.S. markets are experiencing low volatility, and stocks have been rising, as many expect they should do. It almost seems as if the "good old days" are upon us again.

The concern I have is that there are too many signals that could perhaps lead to some stormy days ahead. Let me be clear and affirm that I'm not one of those folks who has lost faith in the stock market since 2008. The market itself did nothing to me; rather, the storm that hit land in fall 2008 was caused by the irrational behavior of many people over the course of many years. Those types of irrational behaviors -- ignited by characteristics should as greed, over-confidence and loss aversion -- always exist in the human psyche. That's why we have bull markets, bear markets, expansion and recession.

I am bullish on America, U.S. capitalism and the free markets -- yet, all the while, I am concerned about today's economic state of affairs and the risk that poses to equities today. According to estimates from S&P Captial IQ, overall earnings for the companies tracked by the S&P 500 are expected to decline by 1.3% in the third quarter. This would mark the first decline in 11 quarters. Moreover, the Schiller price-to-earnings ratio for the S&P -- a P/E ratio that uses average earnings per share over a 10-year period -- is nearing 30x. That's significantly higher than the trailing and forward P/E ratios that are often in the headlines. For 2012, earnings for the S&P 500 are forecast to be around $100 per share, thus suggesting a very modest trailing P/E ratio of 15x. I would be very cautious about using such a multiple in assessing the attractiveness of equities.

I would also pay close attention to any further upcoming earnings warnings -- which, so far, are outpacing upbeat pre-earnings announcements. I understand that some companies like to set low expectations in order to impress Wall Street. But already we have seen companies like FedEx (FDX), which serves as a good economic pulse, warn of slowing growth. For another good gauge of overall economic activity, Caterpillar (CAT) CEO Douglas Oberhelman is now anticipating years of modest growth.

I certainly don't anchor my investment decisions on any forecast, be it from an analyst or from a CEO. But I think it's time for investors to pay really close attention to what is happening now -- and, at the moment, attention is being focused on the Fed's third round of quantitative easing, and not on fundamentals. As far as that's concerned, I think the fundamentals are actually much better than what the pessimists will have you believe. Banks are a lot less leveraged today, labor productivity has improved (although that improvement doesn't aid job creation) and most consumers are taking on less debt. But the best time to be on your guard is when things appear to be most calm, as they are today.

Going forward, I would put a premium on earnings quality and management quality over a shot at earnings growth. High-quality management will deliver on growth, but not in a way that harms the business in the long run. A company's business decisions today will affect its performance tomorrow. I was glancing over AutoZone (AZO) last night, and the company is the definition of quality earnings and highly capable management. As expected, it has created enormous value for investors during the economic recession and beyond.

As the market heads into earnings season, to be followed by the presidential election, there will be short- and long-term hurdles to overcome. Instead of trying to guess what will happen, focus on what you can control: making disciplined investment decisions.

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