My first visit to the circus was a big disappointment. I can't remember when or where it was, but I remember that it was a three-ring circus in a small town in Southern Indiana. I remember to this day the anticipation as I walked toward the huge tent and heard the sounds of hundreds of circus-goers pouring out into the steamy summer night.
Everything about the night was great until the actual circus began and I tried to watch the acts in each of the three rings. After about thirty minutes, I was exhausted and frustrated because I found that, at least for me, it was impossible to see any of the acts when I tried to see them all. I decided that I would need to watch only one act at a time if I was to enjoy it. The frustrating thing about this approach was that my attention was constantly being drawn from the act that I was watching by the ooohs and aaaahs that I heard coming from other people watching the other rings. I remember the distinct feeling that what I needed was a one-ring circus.
I've revisited that old desire for a one-ring circus in recent weeks relative to the economy and the markets. It seems as though we have been forced to endure a three-ringed economic circus since the first of the year as three major events have been playing themselves out: 1. the health-care debate and its effect on the economy, 2. the debt crisis in Greece and other European countries; 3. the almost fantastic fourth-quarter earnings results of US companies.
I admit that I have spent many hours trying to analyze the true effects of the government take over of health-care. I believe there is no question that the government takeover of health-care will slow economic growth in the US. Nobody really knows by how much, or when its full effect will be felt, but no economist I follow believes that economic growth will benefit as a result of the new health-care plan, should it become law. Yet, while the healthcare plan might not be good for the economy and jobs, its effect on corporate profits is less clear. Nearly 50% of S&P 500 earnings come from outside the US.
I have thought from the very beginning that France and Germany would bail out Greece. These two countries are dedicated to a Greater Europe strategy for political and economic power and they are not going to let a small country like Greece derail their agendas.
These two rings of the circus both may be moving toward closure, but their ultimate effects will come to bear years in the future. Therefore, I have begun to focus more of my attention on the final ring of the current three-ring circus: corporate earnings. Corporate sales and earnings in the fourth quarter rose for the first time on a year over year basis since mid 2007. Eighty percent of companies beat their earnings estimates. This was not a case of less bad; this was a case of genuinely better earnings. Thus, I have to conclude that in the face of a very slow economy US companies are doing an extraordinary job of generating free cash flows.
This uptick in earnings has largely been ignored by the market, which is about where it was at year end. That means that the S&P 500 is now trading at about 13.5 times projected 2010 earnings. In the current low interest rate environment, the appropriate PE should be at least 15 times, if not higher.
If investors can get their minds off of the two rings of the economic circus that will take years to evaluate, and focus on the good news of corporate earnings in the here and now; I believe a significant rally would result, perhaps as much as 15%-20%.