Weekly Compass from Hutchens Investment Management

CONCORD, N.H. - July 30, 2013 - PRLog -- “The stock market is nonetheless a barometer of business, but it must be read in causes rather than effects.” -- Bernard M. Baruch

This is the fourth year that the Compass has been written and with only brief periods of caution during the European sovereign debt problems, our investment strategy has been an unswerving fully invested position in equities. We remain bullish on corporate America despite the global slowdown and domestic structural unemployment. The consumer returned sooner and stronger than most economists anticipated but, there remains sufficient pessimism to enable the market to continue to climb a “Wall of Worry.” Housing is rebounding, the wealth effect has returned, and 2Q2013 earnings are coming in better than expected.

Earnings season is at its half-way point. According to the Bespoke Investment Group, “of the 815 companies that have reported earnings so far this season, 65.2% have beaten earnings estimates.” Bears hold to the belief that companies under promise so they can over deliver and analysts are pawns in estimating quarterly earnings. But we believe stocks follow earnings and at this stage of the earnings cycle stocks are up. Of more importance is the significance of the earnings beat-rate by sector. Reporting higher relative earnings performance are Information Technology (+71.3%), Industrials (+68.7%), Financials (+67.9%), and Consumer Discretionary (+65.3%). These are the economy driven sectors. Also with about half of the S&P 500 companies reporting 2Q2013 earnings, 56% have beaten consensus revenue estimates. It is the forward earnings estimate that determines an expanding or declining market P/E. The 4Q forward growth rate of 6.54% remains near to its 2013 high and tracking $116.14 compared to the forward 4Q estimate a year ago, leaving room for multiple expansion.

According to Black Swan logic, it is what you do not know which is more important than what you do know. Black Swans can occur on a micro and macro level. Our concern is macro, specifically stock market risk. China has the potential to create disruption of the global economy. While having the advantage of a centrally controlled economy that can make decisions quickly and effectively, there is no insurance of the right decision. This is the unraveling taking place today. The main assumption is that a Central Committee of astute planners make better decisions than the free market. The rigid control of its troubled banking system is just one example of how the system is flawed.

But longer term the demographic consequences of the Central Committee on population and family planning’s rule of one child, implemented in 1979, preventing an estimated 400 million births, negatively impacts China’s economic growth. The results are an aging population and negative population growth in the strictly enforced urban areas. There is sufficient evidence that the elderly population could exceed the size of the labor force as early as early as 2020. Compounding the demographic problem to China is an evaporating cost advantage. China is following in the footsteps of Japan, but Japan got rich before it got old. Like Japan, they will have to eventually compete on quality, something that the Central Committee cannot create or mandate. There are few Chinese recognizable branded products and the questionable intellectual property practices limits exposure. China will eventually make the transition, but it will take substantial capital investment and time, during which it could get old before it gets rich.

Our investment policy continues to maintain a full position in equities. Any increased volatility is indicative of market uncertainty, not of a chaotic outcome of Fed policy. The market is moving away from the summer doldrums and approaching the seasonally more favorable fall and winter months.

Authors:

David Minor

Rebecca Goyette


Editor:


William Hutchens