Can Stocks Move Beyond Their Current Peaks?

Can Stocks Move Beyond Their Current Peaks?

The beginning of May marked a clear shift in the financial markets. The Russell 2000 Index lost 1.9% during the month and is off 1.9% from its recent high on April 29, 2011. Over the past few weeks, investors have reduced risk, clearly concerned about mixed economic data.  Some have attributed this shift in market performance to the upcoming end of "QE2," as investors position themselves for what they believe will be the inevitable economic and market slowdown following the program's completion in June. For others it is Europe's latest debt restructuring and the U.S. debt ceiling debate. Finally, to some it is simply the old adage to "sell in May" and position for a possible seasonal repeat.

In 2010, for example, the Russell 2000 rose 19.0% through April 23 before dropping 20.3% through July 6. From that small-cap low, it rallied 33.6% through the end of 2010. Whatever the reason for the change in the market's direction, we are struck by the consistently constructive tone we are hearing from corporate managements following first-quarter earnings. From our perspective, while many are questioning the sustainability of earnings and fear peak margins are at hand in the face of renewed economic concerns, we think there is a long way to go.

It should come as no surprise that cost cutting for many companies has been and continues to be a powerful story coming out of the Great Recession. As Furey Research Partners pointed out in a recent research report, "With most companies having reported first quarter 2011 numbers, the Russell 2000's median 1Q 2011 +24% year over year earnings growth was among the highest growth figures posted since 1985, nearly matching growth posted in both 1996 and 1997. Current next twelve months estimated earnings growth is expected to decelerate but remain strong at +18%."

And what about profit margins? In many of our recent conversations with corporate management teams, we hear about continued productivity gains and expanding profit margins. To put that into perspective, we turn again to Furey Research Partners, who recently noted, "Currently 56% of Russell 2000 ex Financials constituents are posting net margins below their long-term median level. This compares to the 34% average rate posted between 1993‐2006 and suggests margin expansion potential still exists for a large number of Russell 2000 constituents." Margins in general have been solid, but we suspect they have room to run.

We spend very little time, if any, looking at the world from a macro point of view. From our perspective, taking advantage of opportunities that the market is providing on any given day and building our portfolios from the bottom up are more meaningful for our work. That being said, we do not know what will bring about an end to the current disconnect between the macro and the micro worlds. However, it seems clear that this disjunct is helping to create new and interesting opportunities for us.

To us, the reality of earnings results and improved corporate guidance trump fears of the economy slowing down. This theme has been present through much of the economy's slow recovery, with macro headlines dwelling on negative news or feeding fatalistic perceptions while the people running the companies that make up our economy were telling a very different, and far more optimistic, story, one that was usually reflected in bottom-line results.

Stay tuned…
FDG