A Stock Buying Moment For Long-Term Investors

Includes: DIA, IVV, SPY, VOO
by: Tim Ayles

Would you have been interested in buying the Dow at under 4000? Today, you very well may have that chance.

Last August, I wrote an article telling readers to ignore the fear mongering and buy stocks. The world was in the midst of ending yet again as Europe was falling apart, yet again. Here we are, less than a year later, and the market is in pure risk off mode. News abounds with reports of Greece about to leave the Euro and the massive amount of short term problems that will rattle the markets. In an attempt to be the first one out of the burning building, investors have sold the S&P 500 (NYSEARCA:SPY) down 7.75% in a matter of 12 days. They are now running to the safety of Treasuries

To their long term detriment I might add. While I have written articles over the past few years stating one needs to own Treasuries, and that all of the calls the past few years for a Treasury bond blow up are off base, I am getting more and more interested in stocks long term. We typically like to have 60% in stocks and 40% in bond and bond equivalents, but the past year we have been getting invested more in stocks.

This sell-off, which has wiped most of the year's gains away, is just another buying opportunity.

Many Fearful Freddy's are asking in their heads right now, "Why?" "Tim, can't you see how bad things are? It's the end. The shell game is up. The house of cards is about to fall apart. You are CRAZY!"

I hear you.

Which is why I want to be buying here over the next few weeks. The majority feels the same way you do as can be seen in this chart from Pragcap.com via AAII:

Everyone knows stocks are terrible right now, and nobody wants to own them. Everyone knows that the world is about to end. You just have to go and read Zerohedge.com to find that out.

When everyone knows it, it's time to do the opposite.

I know the contrarian call can be a bit too cute. Therefore, I will back it up with some numbers.

In the end, income is king. Whether from a job, or dividends, or capital gains, we all need income to survive and pay the bills and buy food. Even those gold bugs who are confounded at the moment why gold is not at $10,000 need gold to go higher in order to "make money" to live on.

That said, the 10 year Treasury is currently earning a mere 1.70%. If someone has $100,000 and they want a risk free and safe return, they can plunk that $100,000 into a 10 Yr and make $1,700 a year. Beats the bank, but still not that exciting.

At year end 1999, that same 10 year Treasury would have earned an investor $6,500 or 6.5%.

Looking at stocks, one can argue - "Stocks have gone nowhere for 11+ years now." In fact - to be more accurate, stocks have fallen in price 11.1% total in price in 11+ years not including dividends. If you add dividends, stock owners have barely made money in nominal terms. So why would we want to own stocks today?

Simply put, because they earn a heck of a lot more money today than they did at year end 1999, and a ton more than the 10 year treasury today. Take a look at some of the largest companies in the world from the Dow Jones Industrial Average (NYSEARCA:DIA). Looking at how much Free Cash Flow the business generates today compared to back then tells the story. I use Free Cash Flow as this is the true owner earnings from the business. If you were able to buy any of these companies whole, this is the take home pay you could have based on your investment at year end 1999 vs. 2011 year end reported FCF, but using today's prices to calculate the return. I am using Cash flow from operating activities minus capital expenditures to calculate the free cash flow, and dividing that number by the current market cap. I could use Enterprise value by adding the debt to the market cap and then subtracting cash, but that would only make the numbers look better than I have below as many of these companies have 2-10 times more cash on the books than debt. So let's stay conservative:

Stock YE 1999 FCF% YE 2011 FCF%
MMM 4.02 6.67
AA 3.39 9.98
T 3.20 7.44
BA 6.76 4.40
CAT 5.86 5.38
CVX 1.00 7.38
CSCO 0.07 9.98
KO 2.06 3.86
DIS 0.92 4.33
DD 3.21 7.23
XOM 2.08 6.36
GE 3.02 10.36
HPQ 2.90 18.57
HD 1.40 7.58
IBM 3.89 6.89
INTC 2.84 7.74
JNJ 3.02 6.53
MCD 1.91 4.84
MRK 2.85 9.21
MSFT 1.33 9.86
PFE 1.88 10.99
PG 2.31 5.66
UTX 3.01 8.39
VZ 2.27 11.52
WMT 1.41 5.11
Equal Weight Total 2.66% 7.85%
10 Year Treas. Yld 6.50% 1.70%
Difference -3.84% 6.15%

Do you see the shocking reality here? Back in 1999, you could have 244% more income buying the risk free 10 year Treasury. Stocks were priced so richly that they implied a buyer back then would only earn 2.44% going forward. People should have realized that bonds were the place to be as they implied 6.5% per year going forward. And in fact, that is pretty much what happened. Stocks broke even or made a little money with dividends. Bond yields dropped around 65% in that time span.

Today, we have the exact opposite scenario, but even more pronounced. Buying these 25 Dow stocks today, an investor receives 461% more income going forward than they do buying the 10 year Treasury. Yet investors today are now flocking to Treasuries.

Here is a little perspective for you to chew on. For the 25 stocks above to go back to bubble territory and have a FCF yield of only 2.66% again like it did in 1999, the Dow would need to rise to 36,771 today. So Dow 11497 in 1999 is the equivalent of Dow 36,771 today. Basically, the underlying businesses have more than caught up to the bubble valuations of 1999.

Put another way, buying the 25 Dow stocks in my list above at today's price of 12450 is like buying the Dow in 1999 at 3897. If I could send you back in time and offer you the chance to buy the Dow at 3897, would you be interested? If bonds were to yield over twice as much as stocks today, the Dow would have to be at 139,617 - over 1000% higher than today.

What is most likely going to happen is bond prices will go down, and stock prices will go up. I would not be surprised to see all time stock index highs within the next 12 months. Today you have a chance to buy the Dow at prices that in 10 years might be similar to buying the Dow at 3897 11+ years ago.

Take advantage of it.

Additional disclosure: I am long many stocks that make up the Dow and S&P 500 Indexes.