Look at the spike in earnings expectations over the past two weeks.   Based on this chart, we would have expected the market to rebound sharply based on the great earnings news.  Yet it has done the opposite.

Third quarter earnings are expected to increase 25.2% over last year (up from our baseline 21.5% two weeks ago) with another boost from the Energy sector.

Of the 240 companies in the S&P 500 that have reported earnings for the third quarter, 78.3% have reported earnings above analyst expectations.  This is still well above the long-term average of 64% and even above the average over the past four quarters of 77%.  In aggregate, companies are reporting earnings that are 6.6% above estimates which is strongly above the 3.2% long-term average surprise factor and even above the 5.3% surprise factor recorded over the past four quarters.

57.9% of companies have reported revenues above expectations. In aggregate, companies are reporting revenues that are 0.9% above estimates.

As we stand today, eight of the 11 market sectors are still expected to see double-digit earnings growth and six of them – Energy, Financials, Industrials, Materials, Information Technology and Communications Services – are expected to see growth over 20%.  Real Estate (+3.9%), Utilities (+6.6%) and Consumer Staples (+9.0%) are the laggards seeing the least amount of growth.  No sector is expected to contract this quarter.

Equation 2

Higher Earnings + Lower Market Price = Cheaper Valuation. 

The market valuation from a forward p/e standpoint is now trading below its 25-year average and earnings are growing.

Story 1

Ralph Wanger was born in 1933, almost to the day of the bottom of the Great Depression. He went on to be not only a great investor but a great investment writer, sharing wit and wisdom in his quarterly shareholder letters. 
 
Wanger once analogized the stock market to a man walking his dog in New York. The man has done the same walk for years, starting at Columbus Circle, strolling through Central Park, and ending at the Metropolitan Museum of Art.
 
The dog has boundless energy and never walks in a straight line. He leaps randomly from one direction to the next, stops to smell every leaf, barks at other dogs, and jumps on you for no reason.

At any moment, there is no predicting what the dog will do or which way he’ll leap. His movements are totally unpredictable. But you know he’s heading northeast at about three miles per hour, toward the museum, where he’ll eventually end up — because that’s where the owner is taking him.

“What is astonishing,” Wanger said, “is that almost all investors, big and small, seem to have their eye on the dog, and not the owner.” As you navigate your life as an investor, pay more attention to the owner (businesses) and less to the dog (markets).
 
CP Take – There is an increasing amount of noise and confusion in the capital markets.    To be successful as an investor, it is critically important to focus on the businesses you own in your portfolio because they are generating higher levels of earnings and dividends.  These businesses will generate significant growth in wealth over time, in our opinion.   Being a long-term business owner is something we can control. 
 
The P/E ratio will adjust up and down over time and it is beyond our control so don’t focus on it.  We will look opportunistically to try and take advantage of the volatility in the P/E ratio.

Story 2

Buffett's annual letter: What you can learn from my real estate investments
 
By Warren Buffett February 24, 2014
 
FORTUNE — “Investment is most intelligent when it is most businesslike.” –Benjamin Graham, The Intelligent Investor
 
It is fitting to have a Ben Graham quote open this essay because I owe so much of what I know about investing to him. I will talk more about Ben a bit later, and I will even sooner talk about common stocks. But let me first tell you about two small nonstock investments that I made long ago. Though neither changed my net worth by much, they are instructive.
 
This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble’s aftermath as in our recent Great Recession.
 
In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming, and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.
 
I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop, and prices would sometimes disappoint. But so what? There would be some unusually good years as well, and I would never be under any pressure to sell the property. Now, 28 years later, the farm has tripled its earnings and is worth five times or more what I paid. I still know nothing about farming and recently made just my second visit to the farm.
 
In 1993, I made another small investment. Larry Silverstein, Salomon’s landlord when I was the company’s CEO, told me about a New York retail property adjacent to New York University that the Resolution Trust Corp. was selling. Again, a bubble had popped — this one involving commercial real estate — and the RTC had been created to dispose of the assets of failed savings institutions whose optimistic lending practices had fueled the folly.
 
Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant — who occupied around 20% of the project’s space — was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property’s location was also superb: NYU wasn’t going anywhere.
 
I joined a small group — including Larry and my friend Fred Rose — in purchasing the building. Fred was an experienced, high-grade real estate investor who, with his family, would manage the property. And manage it they did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our initial equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I’ve yet to view the property.
 
Income from both the farm and the NYU real estate will probably increase in decades to come. Though the gains won’t be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and, subsequently, for my children and grandchildren.

I tell these tales to illustrate certain fundamentals of investing:

You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.” Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.
 
If you instead focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so. Half of all coin-flippers will win their first toss; none of those winners has an expectation of profit if he continues to play the game. And the fact that a given asset has appreciated in the recent past is never a reason to buy it.
 
With my two small investments, I thought only of what the properties would produce and cared not at all about their daily valuations. Games are won by players who focus on the playing field — not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.

Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)
 
My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following — 1987 and 1994 — was of no importance to me in determining the success of those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.

There is one major difference between my two small investments and an investment in stocks. Stocks provide you minute-to-minute valuations for your holdings, whereas I have yet to see a quotation for either my farm or the New York real estate.
 
It should be an enormous advantage for investors in stocks to have those wildly fluctuating valuations placed on their holdings — and for some investors, it is. After all, if a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his — and those prices varied widely over short periods of time depending on his mental state — how in the world could I be other than benefited by his erratic behavior? If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.
 
Owners of stocks, however, too often let the capricious and irrational behavior of their fellow owners cause them to behave irrationally as well. Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits — and, worse yet, important to consider acting upon their comments.

Those people who can sit quietly for decades when they own a farm or apartment house too often become frenetic when they are exposed to a stream of stock quotations and accompanying commentators delivering an implied message of “Don’t just sit there — do something.” For these investors, liquidity is transformed from the unqualified benefit it should be to a curse.

Conclusion

We believe the economy is growing between 3% - 4%.  Fears of an imminent recession are overblown.  3%-4% annual economic growth is an excellent environment for high-quality companies to grow profits which will grow stock prices over time.

 
We believe the near-term hurdles for the market to overcome are:

• the election in 8 days;
• trade negotiations with China on November 26^th;
• likely FED rate hike in December and further clarity on the path for future FED rate hikes.

Each of these hurdles will be overcome and it is the uncertainty around these events that is helping drive the P/E ratio lower.  When these hurdles are overcome, it is likely the P/E ratio will migrate higher.  
 
Importantly, we also believe that the market is more volatile because of algorithmic trading (computer program trading). In the United States approx. 70% of the overall trading volume is generated through algorithmic trading with an expected increase of 10.3% per year through 2020 (1).    We experienced what felt like an unnatural run-up in the market in January only to be followed by a 10% market correction.  That market correction was followed by the market hitting new highs this summer.  This market correction will likely have the same fate given the aforementioned backdrop.
 
We will look for opportunities like portfolio rebalancing and tax loss harvesting to take advantage of the current environment. 
 
As always, if you have any questions, or if your objectives or liquidity needs change, please contact us.