The Four Key Fundamental Questions

Early May is beset by a “Flight to Safety” trade. That may be hard to see from the modest losses of the S&P 500 the past couple days. However, as I write this article the riskier/smaller cap stocks of the Russell 2000 are down 3% since Monday morning. So quite likely your more aggressive positions that outperformed the market over the last 4 months are now getting brutalized.

This brings us back to a topic that I have discussed in the past. What do you do when the market goes through periods of pullbacks or where the money swirls around looking for a new home? What was in…is now out. And what was out…is now in. Round and round it goes.

When that happens it is best not trying to read the tea leaves through share price movement, as that can change at any moment and go 180 degrees in the other direction. Rather it is best looking at the top-down fundamental picture with the following 4 questions:

1) Is the economy expanding? Yes, but the latest quarter at +1.8% has some investors worried that the engines of growth have stopped. I am not in that camp because most aspects of the slowdown are likely transitory and we will get back to 2-3% growth in subsequent quarters. Most other top investment strategists are on board with this outlook.

2) Are US corporate earnings beating expectations? Yes. During the first quarter earnings season the average S&P 500 firm has beaten estimates by 4.6%. Plus 4 companies are topping estimates for every 1 that misses. Most importantly, 50% more companies are receiving increased estimates for the future than lowered estimates. That is the clearest sign of earnings strength for stock investors to notice.

3) Are stocks reasonably priced? Yes. The 2011 EPS estimates for the S&P 500 currently stand at $97 per share and rising. Divide that into the level of the index, 1352, means the market is trading at a PE of just 13.9. That is not dirt cheap, but far from overpriced. At this stage of the bull rally we should be seeing PE’s of around 15+.

4) Is there cash on the sidelines? Yes. Even after this two-year run-up in the market there are still tons of investors sleeping on a mattresses stuffed with cash. And given a recent Flight to Safety trade, more money has moved out of stocks into bonds and cash. So yes, there is plenty of cash on the sidelines to fuel the market higher when more investors come around to seeing the viability of all the good fundamentals discussed above.

Now it is just a waiting game. And during that time the market may indeed go lower. Then at some unspecified time, it will head higher once again.

So if you are the sidelines when that next bull run takes place, then you miss out. For myself, I can suffer the “slings and arrows of outrageous fortune” in the short run if the fundamentals point to more gains in the long run. So I will sit tight. You need to make your own call. We’ll compare notes of who did better down the road.

By: Steve Reitmeister

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