Buoyant But Cautious

Investing Daily Article of the Week

by Roger Conrad, Investing Daily

The markets are in good spirits and we share this optimism. However, we still live in an era of uncertainty. Investors should curb their enthusiasm, because it wouldn’t take much of a shock for stocks to head south.

The market has largely rebounded from the dive that began on February 21. All eyes are riveted on the persistent fiscal follies in Washington, which culminated with the dreaded budget “sequester” that automatically went into effect March 1.

Different stocks have reacted differently to the market’s gyrations. Happily, our philosophy of focusing on inherent business strengths and not political vicissitudes continues to bear fruit, as the latest round of earnings reports from our PF portfolio holdings makes resoundingly clear.

The numbers don’t lie and our recommendations are posting solid results, which in turn are buoying their share prices. With the stock market now hovering around nominal record highs, we’re more than holding our own.

Economic indicators are sanguine across the board. New home construction and home prices are rebounding, as the Federal Reserve keeps interest rates at extremely low levels.

Consumers are opening their wallets, while corporate debt is low and profits are high. Orders for machinery and other durable goods are showing new signs of health. Meanwhile, corporate profits reached 14.2 percent of national income in the third quarter of 2012, their largest share since 1950.

Robust fourth quarter and full-year corporate earnings are being rewarded by optimistic investors, who seem unconcerned with sequestration. Our portfolio holdings are likewise following this happy dynamic.

Unlike the dour and waning days of 2012, when financial prognosticators wrung their hands about the forthcoming fiscal cliff, sentiment is more blasé over the risks stemming from drastic spending cuts that kicked in this month, as part of a previous budget agreement hammered out between the White House and Congress.

If no deal is reached, this so-called sequester could inhibit US gross domestic product growth, by what extent remains unknown. Roughly $85 billion in automatic cuts are slated to take effect between now and Sept. 30. The US Bureau of Economic Analysis projects that these cuts could eliminate up to 700,000 jobs in the country.

While those layoffs translate into real human pain, they’re not expected to seriously affect corporate profits—nor the recent market rally. That’s in large part because companies are learning to make do with fewer workers, and when they do hire, it tends to be overseas.

The Fed’s aggressive policy of quantitative easing has done an excellent job of stimulating market conditions, albeit less so in sparking job creation.

What’s more, chances remain good—even in dysfunctional Washington—that some sort of 11th-hour deal will mitigate the damage, especially to defense spending.

That’s why we continue to remain bullish on certain aerospace and defense stocks, even though they’ve been punished by the doom-and-gloom over Pentagon cuts. We think these concerns are overblown and they ignore the lessons of political history.

However, not everything is wine and roses. Unemployment in the US has fallen but remains stubbornly high, as corporations fail to translate their higher earnings into new job generation.

And while Europe seems to have a grip on its debt woes, the political farce now playing out in Italian elections should give investors pause. It wouldn’t take much for the shaky Continent to hit the skids again and knock the globe’s nascent recovery off kilter.

Wall Street these days is exhibiting more confidence in the nation’s economic future than Washington. Nonetheless, caution—and strict adherence to actual growth potential, as demonstrated by earnings performance—continues to be our watchword.