Farr: When Wish Replaces Thought

After exceptional lows in March, markets rallied in the second quarter. While the advance was broad-based, the groups that suffered most in the decline bounced most. Banks and materials led the charge higher with each sector enjoying returns of over 100%! Investor sentiment improved, and other economic indicators declined at a more moderate pace. "Green shoots" was the buzz phrase in the press, and determined optimists began to hunt for whatever data they could find to construct a sustainable, positive argument.

Steven Goldberg wrote an interesting book a few years back called "When Wish Replaces Thought."In it he criticizes advanced education for abandoning the honest, open Socratic dialogue which catechizes students using open-ended questions to discern a conclusion. In its place, Goldberg suggests that modern educators begin with a conclusion they find philosophically appealing and construct supporting logic.

A 15.9% return for the S&P 500 would be a great year, so it was certainly an outstanding quarter. After reaching a sub-670 level on the S&P 500 in early March, investors wondered if stocks could possibly recover and even if capitalism and corporate America might be doomed. What a difference 90 days can make! While the increase in share prices brings relief to frazzled nerves and diminished accounts, there has been scant evidence of sustainable earnings increases.

Perhaps the March decline was overdone (as most major swings are), but this rally’s foundation is more emotional than empirical. A simple measure of share price is a multiple of earnings: a share of stock trading at $14 with $1 per share in earnings has a multiple of 14. When share prices increase, either the earnings or the multiple is increasing (or both). The recent rally from March lows was based on a 6 point increase in the multiple and not an increase in the earnings.

As choruses of insistent, happy voices declare that the worst is over, it seems as if the higher share prices resulting from exuberant multiple expansion have fully discounted a very positive recovery scenario. A multiple-driven price increase always creates a vacuum. These vacuums are resolved when either the multiples contract or earnings increase and "catch up." Our analysis of the broad market suggests that it will take longer than the consensus expects for earnings to merit the current rate of increase in the average share price of index members. Stock selection is critical in this environment, and our fundamental, dogged analysis has never been more important.

Read what other contributors are saying on CNBC.com


Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.