“Sign, sign
everywhere a sign,

Blocking out the
scenery, breaking my mind,

Do this, don’t do
that,

Can’t you read the
sign?”

–The Five Man Electrical Band, 1971

A big drop on Friday wiped out earlier gains in the
week and left the Dow Jones Industrials down 1%. The Dow is lower by 3.2% since
January 1. The S&P 500 pulled back 1.2%, its third weekly loss in the past
four. NASDAQ showed a loss of 0.8%.

Corporations reported
quarterly earnings in earnest last week and the news has largely been good. So
far, three out of four companies have beaten Wall Street profit forecasts while
82% topped estimates for revenues. This quarter is nearly certain to mark the
S&P 500’s sixth straight positive quarterly earnings surprise following six
negative revelations in a row mid-2007 through 2008.

The good times should
continue to roll for at least the next year. Based on the Wall Street outlook,
analysts are predicting 25% earnings growth for the third quarter, 33% in the
fourth and 13% and 20% for the first two quarters of 2011. If these predictions
come to pass, S&P earnings should be $82 for 2010 and $96 the following
year. That would propel corporate profits above the previous all-time record of
$88 achieved in 2007. S&P shares now trade for 11 times the 2011
projections versus an historical average of about 15 times.

Some argue that the
financial mess in European economies will cause a double-dip recession.
However, this conclusion is not supported by recent data. May industrial
production in France was up 1.7% and +1% in Italy, both better than expected.
Germany also showed industry output accelerating, up 2.6% month-to-month. Debt
issues in some smaller European countries pale in comparison to the economic
strength in larger ones.

Even though stocks are
cheap and the economic recovery continues, investors don’t seem to believe it.
They continue to sell rather than buy. Why? In good part, the selling is due to
political uncertainties, particularly future tax policies. Neither business nor
individuals can plan when tax ambiguity clouds their future. Corporations are
sitting on a record $1.6 trillion in cash equivalents instead of spending and
hiring because they can not make reliable forecasts. Many individuals are
sellers of stocks because the capital gains rate will almost certainly rise
from 15% currently to at least 20% next year.

While negative in the
short-term, the current uncertainties will likely prove to be a positive for
today’s investors. We know that corporations will begin to spend their cash
hoard some day, probably soon after November. We can also be certain that
individual selling to capture current low capital gains taxes will finish, at
least by yearend. Most of the selling may already be over.

Investor beliefs run
in irregular cycles of pessimism and optimism. Currently, skepticism exists
toward stocks. The Investors Intelligence Bull/Bear ration is 0.94, the lowest
level since the time of Armageddon mentality of March 2009. People are always
most skeptical of stocks when they are on sale. Yet high returns on any asset
are most likely when you buy cheaply.

Opposite pessimism,
investors can believe in impossibly positive things from their investments.
Such was the case a decade ago when dotcom stocks with zero profits were valued
for more than flourishing multinationals. The S&P 500 was trading 44 times
earnings in 1999 and the general public was motivated to pour money into
stocks. Something similar happened in the housing market around 2005. Now, gold
is popular after doubling and tripling in price over the past decade. People
often wait to purchase assets at such high price levels that good future
returns are almost impossible.

Can you read the
signs?

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About Richard Leader

Richard Leader is President and Chief Investment Officer of First Houston Capital, and has more than 30 years of experience making solid investments for clients. He is actively involved in all aspects of stock selection and portfolio design for clients of the firm. Richard began his career in 1976 with Citibank’s Investment Management Group in New York City. He was transferred to Houston in 1980, and through a succession of increasingly responsible positions, Richard has developed a thorough knowledge of economics, securities analysis and portfolio management. Richard received his undergraduate degree from Wake Forest University, followed by an MBA from Vanderbilt University. He also earned his Chartered Financial Analyst (CFA) in 1981 following a three-year program of study and testing.Richard, his wife Carrie Leader and their four children are active in St. Luke’s United Methodist Church, Memorial West Swim Club, BraeBurn Country Club and the Houston Safari Club. Richard has also been on the Board of the Woodland Hollow Civic Association and is currently the President of the Wake Forest Alumni Association/Houston Chapter.Each week, Richard provides his perspective on the financial markets and the economy in his Leader Market Letter and on the firm’s Leader Market Letter blog.

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