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Cadinha Blog



Since the Federal Reserve started raising interest rates just over two years ago, investing in quality stocks and bonds just hasn’t been very exciting; it definitely hasn’t been very profitable.

Risk is temporarily elevated. After 17 consecutive rate increases over the last two years, fears of Fed overkill may be justified. However, we believe that the longest Fed tightening cycle in history is likely near an end and investors should begin coming back to equities and fixed-income securities, especially U.S. large-cap stocks that currently represent the cheapest asset class in the world.

Thus, the key question is: Will the Fed break the U.S. consumer, the growth driver of the world? The answer lies in future inflation expectations. Fears of inflation seem overblown. Breaking up current inflation into its components reveals core inflation is being driven by a rise in housing costs…likely a short-term phenomenon as real estate prices are decidedly softening. Additionally, inflation (excluding energy and housing) has been quite stable at just below 2 percent, suggesting higher energy and commodity prices are not translating much into higher prices for consumer goods and services.

Assuming no Fed overkill, large cap equities should soon be the asset of choice as a combination of extreme bearish sentiment among investors and the stocks’ strong fundamentals lures back the billions of dollars hiding out in cash or chasing returns in real estate and foreign markets.

The strength of equity fundamentals is astonishing. Revenue and earnings growth among U.S. companies continue to be robust, due, in part, to global growth and trade. (Large companies derive some 40 percent of their business from abroad while lowering costs using cheaper foreign labor.) The attached chart illustrates that while earnings continue to grow, large caps continue to get cheaper with P/E multiples at 10-year lows. The S&P 500 currently trades at 15x forward earnings.

Earnings and dividend yields are also on the rise. We expect dividends to continue rising as strong earnings’ growth are generating large cash positions for companies and federal tax rates of 15 percent on dividends and capital gains have been extended through 2010. In addition, companies are also buying back stock in record amounts…a smart and tax-free way to benefit shareholders as fewer shares in the marketplace increase the value of the remaining stock held by investors.

Since inflation is a fixed-income killer, dissipating fears of inflation should also mean better bond returns. Bond yields, from Treasury Bills to 30-year maturities, are all yielding over 5 percent and should prove to be a bargain once investors realize the Fed will be successful in keeping inflation low and stable into the future.

We believe the prospects are good for the long-term investor, and time should prove once again that best investing results lie in owning core equities of good fundamental value…that is, buying companies with a combination of strong current and future growth and income, and buying them on the cheap. While this approach hasn’t panned out as well for us lately (or for other quality and fundamentally-driven investors like Warren Buffett who have had weaker performance over the past several years), we have great confidence going forward.

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The Cadinha Team




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