Yesterday marked the launch of the Q1 earnings season.  As we look back at the first quarter, the equity market strength continued, with the S&P up 5.4% despite the global and economic concerns that abound.  This seems to indicate that the expectation is for solid earnings during the quarter and growth going forward.  However, we are not convinced. 

Commodity costs are on a tear and we don’t see how that doesn’t have some sort of margin impact at the corporate level.  Everything from oil to corn to cotton has seen substantial moves so far this year.  This leaves companies either absorbing the higher costs themselves and margins/profits taking a hit.  Or, they pass on the costs via price increases but risk hurting an already tenuous demand.  Either scenario doesn’t look rosy for margins or profit/EPS growth.

Our other concern is consumer spending.  Oil prices are treading $110, an all-time high for April and a level we haven’t seen since the last big spike in mid-2008.  However, back then unemployment was under 6% and the economy was rolling.  Today, we have unemployment of around 9% and an economy that is still digging its way out of the hole.  How does this not have an impact on the consumer level and play into the outlook for Q2 and beyond? 

The problem with the equity market is that it relies on growth.  For equity prices to increase, there needs to either be further PE expansion or earnings growth.  But with the PE ratio on the S&P 500 at 24x (based on the Shiller Index), well above historical means and medians of about 16x, it is hard to make the case for further PE expansion.  And with the margin pressure, continued economic issues, and a potential new hit to consumer spending driven by higher gas and food costs, it seems hard to make the case for significant earnings growth.

One of the biggest benefits to bond investing is that you aren’t relying on growth for your investment to pay-off.  Bonds have a natural exit strategy, via the maturity, and we just need the company to plug along and pay its bills to that point of maturity or refinacing.  Growth is nice if it means higher profits, but not necessary (and we only favor growth if it doesn’t come at the expense of higher debt associated with empire building).  Instead we are focused on the company’s balance sheet, cash generation, liquidity, and ability to sustain their capital structure.  As we analyze the individual names in our portfolios, we look to discount the numbers to make sure that we see a cushion should the high commodity costs and lower consumer spending have an impact on revenue and margins. 

While the equity market waits for growth, we are happy to generate our yield from the coupon income and not worry about PEs and growth projections.