A relatively weak first quarter earnings season is winding down, while major stock market indices are reaching all-time highs. This doesn't quite add up, does it? Overall, corporate profits advanced at an anemic 2.5% in the first quarter, well below the long-term average of 7%. Worse over, revenues were actually flat in the first quarter, below expectations in most cases. On top of that, most companies that have reported earnings have also lowered estimates for the remainder of the year. Clearly, the economy is struggling, and is likely to do so as it digests the numerous tax increases, burdensome compliance, and regulatory changes in this great wave of governmental overreach.
How, in this slow growth environment, can stocks continue to grind higher? Valuations are largely driven by three variables, and two of the three remain quite positive.
First, interest rates are at historic lows and are likely to remain so for the next couple years.
Second, inflation remains benign, with few signs that it will become a problem any time soon.
Third, earnings, although weak, are still growing.
In other words, while an accelerating economy is unlikely near term, the probability of a recession is just as remote. Combined, these three pivotal drivers of stock prices allow for a volatile, grinding-higher scenario for stock prices.
Is this the best we can expect? Stocks can continue to grind higher as long as interest rates and inflation remain low. While this trend can persist, it can't go on forever. Our economy will either sink from the weight of an uncontrollable government behemoth, or it will find a way to live within its means, reduce the federal deficit, and rekindle the entrepreneurial spirit. Ultimately, we will travel one of these paths.
Balancing portfolio strategies... In the meantime, while this far-reaching, debate of our times plays out, there are portfolio strategies that can leverage the low interest rate environment, while also taking advantage of pockets of growth in the overall economy. Outperforming stocks are likely to include companies that pay above average dividends as well as companies that produce above average earnings growth. A flexible, barbell approach, with an emphasis on higher yield on one end and above trend earnings growth on the other end, makes increasing sense in our view.
Our research efforts are focused on both of these strategies in order to identify attractive yield plays as well as companies that can outgrow their peer group through product innovation and superior strategic decision making. This is a painstakingly difficult process, but the path to investment success, greatness if you will, demands flexibility and balance. Even if it makes one uncomfortable.