A long-term investment outlook in an uncertain world

By Norman F. Klopp, Jr., CFA, Partner

While I don’t know what the stock market will do within the next six months (the short term), I have some per-spective on what the market might do over the next five years or so (the long term).

A long-term market perspective is important in setting expectations (both ours and our clients) because it can influence a long-term investment plan and serve as a basis for realism in a personal financial strategy.

Our benchmark

When we speak of “the market”, we are re-ferring to the Standard and Poors 500 Index. When we speak of “returns” we are referring to total returns—price appreciation plus dividend yield.

We have a fundamental belief that “real” cor-porate profits drive “real” equity returns over the long term. “Real” returns are those adjusted for inflation. The chart on page 4 supports our belief.

Numerous influences

In analyzing long-term market performance, almost every economic factor is translated into real corporate profits which, in our opinion, drive equity returns.

Over the shorter term, the direction or magnitude of interest rate changes, inflation, employment levels and a few other factors can contribute to short-term market volatility, and over the long term are reflected in corporate profits.

Near-term outlook

Consensus estimates call for S&P 500 aggregate earnings to be up 18% in 2004, following gains of 7% in 2002 and 15% in 2003. Additional gains of 7% are projected for 2005 and 2006—meaning that 2006 earnings would be up 66% from the recession trough of 2001. Corporate profitability has benefited significantly from increases in real demand, increased productivity, and low interest rates.

Non-economic factors

The “war on terror” is probably with us for the long term. If a major terrorist act occurs, the market will most likely react negatively and then quickly revert to considering economic factors. The implications of the war itself are difficult to factor into a market outlook. But war creates uncertainty and the markets (investors) hate uncertainty. The market has had and will continue to build-in a “war discount.”

Long-term view

If corporate profits can continue to grow at their historic 7% nominal annual rate, and are combined with the current yield of 1.5%, they should provide a long-term return of 8.5% for equities. This assumes no significant change in price/earnings ratios, which appear reasonable at the current 16.7 times earnings.

At Midwest Investment Management, we remain dedicated to buying stocks of high quality, profitable companies. Because we are very disciplined about the prices we pay for individual stocks and adhere to a long-term strategy, our clients do not have to be significantly concerned about “the market.”

• • •

If you are not currently a Midwest Investment Management client, why not consider Norm Klopp’s disciplined approach to long-term growth for your portfolio? To get started, contact Norm at (216) 830-1135 or nfk@mimllc.com