What Lay Beneath?

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As I was sitting in my office looking out the window deciding what topic to write about, I watched the last leaves fall from the trees and I realized how similar this annual occurrence was to what was happening in the equity markets. In the spring, you will be witness to the sprouting of the branches’ leaves, which once were desolate.

However, just weeks prior to this annual re-awakening of nature, those same trees looked as if they were ready to die. Conversely, to those who are not familiar with the changing of seasons … they could be easily convinced that the tree is at its end. Its best days are behind it. For instance, someone could report that there are clearly no leaves, it doesn’t look very healthy, or the branches are drooping. And because of these visually apparent issues — the tree will eventually die. Taken at face value, this seems pretty logical. Doesn’t it? However, they are unaware of one vital area (or fact); what lay beneath.

The facts missing, or better stated, what they are not evaluating correctly is what determines the long-term life of the tree is the strength of the root system. No matter what is happening temporarily with the branches, leaves, or flowers in the short-term … the focus should remain on the root system. Understandably, most will focus on what they can observe — the branches’ leaves or flowers — and others who appear to know what they are talking about then reinforce it. All of a sudden, that consensus view becomes a certainty (the herd mentality) … the tree will die.

Stick with me here because I do have a point.

Let me now make a correlation between the above scenario and the financial markets. The tree’s branches and leaves are corporations’ stock prices as reflected in the stock market. The root system is corporate earnings, cash flow, and balance sheets. Of course, the financial media (the convincing voices) only focuses on the stock market because that is what is visible to them, just like we focus on the visible leaves and branches of a tree.

The market (as viewed by the S&P 500) bottomed out around the spring of 2009 — in other words it lost its leaves and flowers. Since that time, the financial media have tried to convince the investing public that the market is dead, or getting ready to die soon. Well, they have had some pretty compelling reasons to point out just why; the entire global system was ready to shut down, Greece’s debt crisis would infect Italy, and then, Spain. The U.S debt level and high unemployment would push us into another long recession (oh sorry, The Great Recession II), and the dollar would become worthless and we would all be chewing on gold bars for our currency. I could continue for another few pages because the financial media has, and historically always finds, another crisis to convince us of — there are a lot of leaves on the branches dying and that keeps them in business.

But what lay beneath? The earnings, cash flow, and balance sheet strength of the companies that make up the S & P 500 are strong … and growing. Actually, they are at an all-time high (can you remember the financial media pointing this out … of course not because they haven’t). The estimate for the full year earnings on the S & P 500 in 2011 is $98, and with the price of the S & P 500 around 1,250, that provides investors with an earnings yield of around eight. Now compare this to the 10- year Treasury with a yield of around two (remember, a high price equals lower yield and vice versa). Said another way, Corporate America’s root system, lying beneath the view of most investors and financial media, has the potential strength of a Northern Red Oak to grow strong and wide for hundreds of years. However, most investors would never realize this unless they knew what lay beneath. Start digging.

Past performance is no guarantee of future results.  An investor cannot directly purchase an index.
Bonds are subject to yield/price change and availability.
This article was written by Lou Melone, Managing Partner, with Budd, Melone & Company in Auburn Hills, MI.  Lou Melone can be reached at 248.499.8704.
Posted date on Dbusiness.com- Article XIIII, Issue II
Dated 12.2011
Wells Fargo Advisors Financial Network did not assist in the preparation of this article, and its accuracy and completeness are not guaranteed.  The opinions expressed in this article are those of the author and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates.  The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.
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