5 Reasons for Optimism About This Market (Or Not)

Natively, I tend to be an optimist. The present environment has given thin gruel for optimism, so I haven’t been as perky as I might otherwise be. Here are a few reasons for optimism:

• Credit spreads have been declining, and more corporate bond deals are getting done in the credit markets.
• Commodity prices have fallen and stabilized.
• The balance sheet of the Federal Reserve is shrinking.
• Money market and other short duration funds seem to be safe.
• Equities might be cheap relative to cash, but are still expensive relative to junk and low investment grade bond yields.

On that last point I want to quote Doug Kass, who I respect as an investor:

On multiple fronts, equities appear to have incorporated the bad news and are undervalued both absolutely and relative to fixed income:

1. The risk premium, the market’s earnings yield less the risk-free rate of return, is substantially above the long-term average reading.

2. Using reasonably conservative assumptions (most importantly, a near 50% peak-to-trough earnings decline, which is over 3x the drop in an average recession), the market has discounted 2009 S&P 500 earnings of about $47.

3. Valuations are low vis-à-vis a decelerating (and near zero) rate of inflation. Indeed, the current market multiple is consistent with a 6% rate of inflation.

4. Stock prices as a percentage of replacement book value stand at 1x, well below the 1.4x long-term average.

5. The market capitalization of U.S. stocks vs. stated GDP has dropped dramatically, to about 80%, now at the long-term average. Warren Buffett was recently interviewed in Fortune Magazine and observed that this ratio was evidence that stocks have become attractive.

6. The 10-year rolling annualized return of the S&P is at its lowest level in nearly 75 years, having recently broken below the levels achieved in the late 1930s and mid 1970s.

7. A record percentage of companies have dividend yields that are greater than the yield on the 10-year U.S. note. At 46% of the companies, that is over 4x higher than in 2002 and compares against only 5% on average over the last 30 years.

On point 1, I will say that equities are cheap to cash and Treasuries, but not Corporate bonds and bank debt.

For point 2, we have gone through a massive levering up; it would be no surprise to see a leveraging down.

Point 3 — I don’t get it. Inflation has a small effect on valuations.

Point 4 — This is true but it could go lower because there is no one that wants to buy and hold at present.

Point 5 — In this environment, where there is a lack of buy and hold capacity, why are we satisfied with normal valuations?

Point 6 — True for Treasuries, wrong for corporates.

Point 7 — The 10-year Treasury is artificially low. It is not a good metric for dividend yields.

Mr. Kass is a bright man, and probably a better investor than me, but there are reasons to be concerned in this economic environment. Be careful, and don’t make rash moves in this volatile environment.

Comments

[dawase@gmai...:]

The point isn't that we're at a bottom - it's that on a long-term average basis, we're below the mean. ie This might not be the bottom but if you have a 10-year horizon, stocks should perform well.

G-d I hope we're not turning into Japan...

Feb 18 07:04 AM

[Erez Attiya:]

The other one of my friends (which is not in the financial market arena and don't understand nothing in the financial activities) said to me that the GBP got very very weak against the jpy (I translate it for your convenient but believe me, the conversation was very hard to understand cause he couldn't explain himself very well), and he "can't understand how could it be, how the UK's gov let that happened, it MUST (!!!, he is so sure in his believes) goes back up- let's buy some pounds!!"
Well, optimistic or not, my friend is a fool. I offered to take him to the casino, at least he'll get to have some fun while losing all of his money...

Feb 18 07:26 AM

[Roger Knights:]

In early 1931 perhaps a similar argument could have been made about stocks being low priced. Then banks in Austria failed, with ripple effects, and another down-leg began. So I'd hold back from buying stocks just yet, because of systemic risk. (From the same location too!)

Feb 18 08:13 AM

[pacman1947:]

David,
You make valid points. The most lucid comment is not to gamble in such a volatile environment.

We may face Latin American style hyperinflation soon as well, meaning that if you stuff money in a mattress it loses value too.

There is no easy solution for the investor. Gambling in a casino becomes just one of many valid options.

Feb 18 08:46 AM

[Alphameister:]

The most insightful among the above were the quotes from Kass and the comment by Dawase. As to the closing ungrammatical paragraph of the article, truly one of the all-time great contributions to investment commentary!

Feb 18 08:55 AM

[Stock Marke...:]

Roger Knights, great comment, you must be future teller as just that scenario is unfolding as the Eastern European bombshell got dropped today in the WSJ...nice work!

Feb 18 11:01 AM

[Fred Voetsch:]

I like your comments because you seem to be realistic. It is easy to promote stocks as cheap because they have fallen but in fact, history shows that they are likely to fall well under "fair value", which is actually probably lower than were we are currently, before they once again rise back to, and above, fair value.

In my rule book of investing the number one rule is to know where we are in the generation trend and we are back in the early 1930 period were people are revaluing equities and this will take years and even decades as we see more realistic valuations, with P/E ratios of 10-15 rather than 15-25.

The next rule is to look at Leading Economic Indicators and they are still bearish and a realistic look at the future suggests no reasons for them to begin turning bullish in the next year or two. Housing is getting worse and that leads everything else. The consumer is strapped and that won't change for years.

A third rule I have is to know demographics and what effect they may have on my investments. Demographics are terrible for the next two decades unless you are invested in the right health care companies.

The stock market does not have much going for it until it drops well below 5,000 (500 on the S&P 500), IMO.

Feb 18 11:59 AM

[Crank Monkey:]

Predicting markets is probably best done with chicken bones or goat entrails. At least that way you can make soup when you're finished.

Feb 18 01:29 PM

[EJW3:]

Agree with freddyv 100%. It is no use talking about reverting to mean or average. Clearly we are going well well below mean. This is pretty catastrophic when you throw in sustained decline in earnings and large contraction in multiples. The fact is 'growth' expectations primarily drive multiples. The outlook for growth in next 10-20 years is anemic at best due to the head winds in front of us such as deleveraging, higher savings rate, higher commodity prices, higher interest rates, aging population, etc, etc.

Feb 18 05:43 PM

[Moon Kil Woong:]

People tend to believe we are at the bottom because the government will keep throwing money until things turn around. So far they have been right about government throwing money around. But like Japan's endless recession, we are liable to find ourselves in a deep dark hole without any tools left. We are digging our own grave with this useless string of spending.

Unless stimulus is combined with fundamental change and/or is geared towards creating future efficiencies (technological or scientific enhancements and/or discoveries) we are just burning our national economic safety for naught.

Feb 18 09:54 PM