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See the forest AND the trees.



The narrative for positive equity returns remains intact. The U.S. economy continues to strengthen and should expand for at least a couple more years. We wrote last August,

…factors are in place that have positive impacts on equities, including an accommodating Fed, low interest rates, rising profits, a growing economy, recovering housing prices and construction, increasing auto sales…

That is still largely the case.

This environment of mild inflation, low interest rates, loose monetary policy, improving economic prospects, and record corporate profits (due largely to low tax rates and low interest costs as discussed in our October 2013 Letter) has done wonders for risk assets.

Interest rates of the bottom rung of investment grade debt haven’t been this low since the 1960s. The high yield (junk) corporate bond market, the riskiest sort of business debt, is yielding just 5.50%, a rate you could earn with negligible risk on AAA-rated money markets prior to the last recession. Risk aversion is mostly absent and we suspect it will become more so.

The Standard and Poor’s 500 Index is now trading for 1.67 times sales, a level higher than any other period in history except for the peak years of the technology bubble. From this data point alone, one can expect low-single-digit average annual future returns:


The mathematics of the above table is straightforward. S&P 500 revenues have historically grown 4% per year. Dividends have grown by 6% per year. Since 1992, the price-to-sales ratio has averaged 1.38 times. If valuations normalize over the next seven years (even while sales and dividends continue to grow), broad equity market returns will barely cover the historical rate of inflation. Index investors should take note.

The benefit of utilizing price-to-sales to review potential future returns is the fact that it isn’t influenced by prevailing profit margins. This benefit is also its main fault, at least in the short-term. If margins are abnormally high, as they are today, price-to-sales would logically be higher than normal (as it is). But over longer periods, margins do mean-revert and thus using price-to-sales to estimate future returns makes economic sense. While broad markets will likely generate poor average returns over the next seven years due to elevated valuations, our portfolio, it reasonably seems, is not bound by the same dire impediments.

Our portfolio is, in our opinion, priced to deliver double-digit annual returns. Unlike the broad market or index investors, we own a small collection of world-class businesses with fair valuations, a higher aggregate yield, and better return prospects. Importantly, our approach carries a process designed to limit our downside risks when the economic, monetary, and investment landscapes cease to be so favorable to risk assets.

As we have expressed in other letters, we do not think peril is imminent, only inevitable. The above seven-year forecast of 3.4% returns does not factor in the likelihood of an economic recession. If returns are subpar assuming an expanding economy, what then will the likely return set be in the event the business cycle actually cycles? As they say in Australia, “rooster today, feather duster tomorrow.”

Portfolios rose 2.8% for the quarter.

This material contains the current opinions of the author but not necessarily those of Black Cypress and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without proper reference. Past performance is not a guarantee and may not be a reliable indicator of future results. ©2012, Black Cypress Captial Management