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Investment Committee Discussion

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Investment Policy Committee Meeting
7/26/10

Discussion

The market reacted favorably last week to the positive results announced by the roughly 1/3 of S&P 500 companies that reported their 2nd qtr earnings.  This holds with our view that a good earnings season would help reduce some of the uncertainty and anxiety that had been holding valuations below historical levels.   (By valuation, we mean the price/earnings ratio, or P/E, which is calculated by dividing a company’s stock price by its earnings per share.)

The market continued to move higher in the first half of today’s trading (when these minutes were written) in response to more positive earnings news and June new home sales that were higher than expected.  This also continues to support our view that strong corporate earnings will eventually result in higher stock prices, and that despite the pessimistic economic news often heard in the popular media, companies could not have turned in 5 consecutive quarters of better than expected earnings unless the economy was strengthening.

More data has come in indicating that individual investors continue to keep their money either in cash or bonds, staying away from stocks.   Institutional, or professional, investors however are increasing their holdings of common stocks.  Clearly, one group is much more uncertain than the other.  We wonder how much of this anxiety among individual investors (also called “retail investors”) is due to excessive influence from popular media.  

This quarter’s DCM client letter tries to reduce that influence a bit by pointing out that partly out of necessity and partly by choice, the popular media can only tell a superficial story about something as huge and complex as the economy.   Also, in order to gain viewers and sell advertising, whatever story they do tell is often written to be “newsworthy”, and unfortunately, bad news is often considered more newsworthy than good.  As old newspapermen say: “If it bleeds, it leads”.

What retail investors may be missing is that they are not investing in the economy.   They are investing in companies.   And, some - even many - companies can do quite well even during weak economies.   We do study the economies of the major countries here at DCM, but more to get a broad feel for general direction and to identify which economic sectors might have more or less favorable conditions for companies in those sectors.  Choosing which companies to actually invest in, however, is about 95% the company’s individual potential for growth and 5% overall economic conditions.

On the fixed income side of the ledger, specific increasing or decreasing uncertainties are being felt lately.

The uncertainty relates to future tax rates.   The yields of 30-year, tax-exempt bonds have been steadily dropping over the past month.   They are now about 0.4% lower than they were in May (~ 4.125% vs. 4.505%).  This drop we believe is almost entirely due to concerns in the bond market that tax rates will move up in 2011.   Higher tax rates mean that tax-exempt bonds don’t have to pay as much interest to compete with taxable bonds.  We hope this “bet” by the bond market is wrong.   But, of course, no one will know until Congress takes action – or doesn’t - on the expiring Bush tax cuts.

For preferred stocks, less uncertainty about the health of European banks has moved prices of their preferred stocks higher.  The European bank stress tests themselves and their results released last Friday were far from perfect.   They did, however make some additional data public and did reduce concerns about bank stability.   This benefited European banks the most, but also U.S. and other banks since all would suffer from a major shock to European credit stability.

This increased confidence reduced the credit risk discounts that had been applied to the prices of many financial industry preferred stocks, pushing their prices higher and yields lower.  This is a good sign and a development we can use to our clients’ advantage.

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