Pullback? More Gains Are More Likely

The following commentary is from Jeff Westmont, who is the founder of Westwoods Investment Capital, a hedge fund focused primarily on consumer companies. He was formerly a Managing Director in investment banking for a bulge bracket investment bank where he focused on consumer companies.

While many analysts and investors continue to expect a substantial pullback in the stock market, there are a number of indicators that suggest the current levels are at, or near, fair value. Although the economy is still facing many headwinds, the following points provide support for current market levels and offer the tantalizing possibility of continued gains:

• Third- and fourth-quarter earnings should largely beat expectations, which means the current 2009 S&P 500 earnings multiple will appear more reasonable. True, many companies will achieve these results largely by cost cutting, but what is critically important is that companies have demonstrated the ability to operate profitably at lower revenue levels. This puts an earnings floor under the stock market even if revenues don't pick up materially (as long as revenues continue to stabilize). If revenues do begin to rise, there will be a substantial flow through to earnings.
• Through the morning of October 13, 30 S&P 500 companies had reported third-quarter earnings. While more than 70% of these companies reported revenue declines, nearly 60% actually reported higher operating EPS than last year. In fact, of the approximately 65 companies that have reported in the past three weeks, more than 80% have met or beaten expectations and more than half of these companies reported the same or higher EPS than the prior year.
• Coming out of an economic downturn, what is important is sequential revenue improvement. Retail sales over the last few months have demonstrated a slow, steady improvement -- as has the performance of many industrial and technology companies.
• Consumer debt levels have come down from peak 2007 levels and net worth is once again rising. In fact, the household debt service ratio has returned to 2001 levels and has risen from 12% of disposable personal income in 1990 to 13.1% today. Equally important, despite the large rise in mortgage debt over the last seven years, consumer net worth, while down 20% from the peak in 2007, is still 30% higher than in 2002 (an increase of $12.5 trillion).
• Consumers have significantly benefited from lower interest rates, commodity and food prices, thereby boosting real disposable income. For instance, lower oil prices are currently saving the U.S. (which consumes approximately 20 million barrels a day) approximately $140 billion annually (assuming an average price of $92 barrel last year). This effective rise in real consumer disposable income helps offset the income decline impact of higher unemployment.