We held our second quarter investment strategy meeting on March 28, 2013. Despite the market achieving record levels recently, the outlook for stocks remains fairly constructive, in our view — particularly relating to the economy, corporate earnings, and investor sentiment. We expect the economy to continue to grow in 2013 with the potential for some acceleration later in the year and in 2014. Continued economic growth should support further growth in corporate profits and cash flows, which are key underpinnings for stocks. We expect inflation to remain relatively low, particularly near term, and with a continued accommodative Federal Reserve policy, we also expect interest rates to remain relatively low. Valuations, while increased, are not yet at levels that would cause us to be overly concerned. We also believe investor sentiment, reflected in continued apathy and disbelief, remains constructive.
We now view the stock market as reasonably valued but not overvalued. We believe the enormous amounts of cash sitting in corporate coffers provides considerable “fuel” to ramp up M&A activity, which would be positive for stock valuations. We see similarities in the current market with that of the late 1970s and early 1980s period. During that period, towards the end of that secular bear market, corporate cash flows became grossly undervalued. This eventually resulted in a wave of mergers and LBOs that preceded the secular bull market of 1982-2000. We think many of the same conditions exist now: lots of corporate cash, many businesses still undervalued relative to sustainable cash flow.
With regard to fixed income, we believe there is increasing possibility that interest rates could begin to rise more sharply later in the year. Interest rates, as reflected in the 10-year Treasury, actually bottomed in late July and have risen modestly since then, perhaps presaging an improving economy or an end to Fed easing. Given the rather modest growth of the economy, as of now, we suspect any increase in rates will continue to be moderate and not of a jarring or rapid increase that could greatly upset the financial markets. A rise in interest rates has been expected and well-heralded for a couple of years now, so it would not come as a big “surprise”; however, a rapid rise in rates would have potentially negative ramifications for both stocks and bonds. As a result of these conditions, we believe it is prudent to reduce exposure toward longer and intermediate-term fixed income investments. With respect to equities, we continue to favor large-cap value and dividend-paying stocks, small and mid-cap growth, natural resources, particularly energy and basic materials, and health care-related stocks.
Bob Toomey is Vice President, Research, for S.R. Schill & Associates, a registered investment advisor located on Mercer Island.