By David Sterman
There's plenty of fear on Wall Street these days. One of the main fears is that the economy is heading for recession, which would imply there's no reason to find stocks appealing right now. But this fear is off the mark. It's simply unclear whether the economy will slow from here, and even if it does, stocks prices already largely reflect a coming recession.
At times like this, it helps to look to history for inspiration -- and cues to profit. And based on some painstaking research during the past couple months, I've concluded that, yes, stocks are in fact cheap right now. (Later on, I'll point to five stocks I particularly like, but there are many others out there.)
Here are four reasons why...
1. A recession is not a foregone conclusion
A main question that nags at investors revolves around concerns the U.S. is on the cusp of a new recession. Indeed, many will suggest the recent market rout is correctly signaling just such an outcome. Yet as market strategist Jeffery Kleintop at Boston's LFL Financial recently wrote to clients: "The markets' obsession with recession does not make it a foregone conclusion." Just because the market looks like it's warning of dire times to come, the outcome isn't always severe. UBS noted that the S&P 500 has fallen by at least 17% from its peak on 14 occasions (as it has now), but the eventual result was recession in only nine instances.
The Merrill Lynch analysts actually think we'll dodge a bullet and not slip into recession, assigning a 40% chance of such an outcome. Instead, they see the economy growing 2.3% next year, which should help boost profits in the S&P 500 by 7% in 2012.
2. Corporate profits could stay strong -- even if GDP turns negative
Let's start with the assumption that gross domestic product growth (GDP), which slowed to just 1.0% in the second quarter, indeed turns negative this fall and winter. Does this mean corporate profits will fall sharply from their current peaks? Perhaps in the past, but less so now. Merrill Lynch sees a major disconnect between U.S. economic growth and profits for the S&P 500, noting that companies in the index have "much greater sensitivity to the global economy and business spending." And they note many other economies where U.S. multinationals operate are likely to keep growing, even if we slip into recession. Emerging market economies are likely to collectively expand 6.5% this year, helping total global growth to stay at roughly 4.0%. This surely helps. Since 1995, profits derived from foreign operations of S&P 500 firms have risen from 23% of total profits to 40%.
Rising foreign sales underpin a similarly positive outlook at Goldman Sachs. That firm notes U.S. exports rose 11.3% in 2010, and will likely rise by roughly 8% in 2011 and 2012.
So where are the global hotspots in 2012? Goldman anticipates another 9% economic growth rate in China in 2012 (though I'm a bit dubious of that), and roughly 4% growth in places like Brazil, Mexico, South Korea and Australia.
Back in the United States, Merrill Lynch sees no reason to expect a big slowdown in U.S. business spending either: "Strong balance sheets and cheap financing should incent many companies to continue to spend on equipment and software despite weak U.S. growth," adding "underinvestment during the current cycle has left many companies with outdated equipment."
3. P/Es are low -- and so is inflation
But veteran market watchers note that stocks started the 1970s at low valuations and only got cheaper from there. It wasn't unusual to find quality blue chip stocks with a price-to-earnings (P/E) ratio of just 5 or 6. Yet the low P/E multiples were largely the result of runaway inflation that ultimately led the Federal Reserve to push benchmark interest rates above 10%. So why buy stocks when bonds offer such fat yields? Well, this time, as they say, is different.
Inflation pressures simply don't exist. Even if key inflation measures bubble up toward the 3% mark, stocks still look quite cheap on a historical basis.
Right now, the S&P 500 should be trading at 18.6 times projected 2011 profits, based on data compiled since 1950. Even if you assume inflation will bubble up to about 3%, then the projected multiple should still be 17.6, if history is any guide.
So where does the S&P 500 actually sit right now? A quite reasonable 11 to 12 times projected earnings, according to Merrill Lynch and UBS forecasts. Just moving that multiple to 15 implies a 20% gain from current levels. A multiple of 16 implies a 30% gain. That's good news for stocks...
4. Stocks are paying more than bonds
The market is also historically cheap by yet another measure. The average dividend yield on the S&P 500 is 2.2%, right in line with the 10-year U.S. Treasury Bond. This is quite unusual, considering 10-year bonds have almost always offered a higher yield than the average S&P 500 dividend.
What's more impressive is that companies have actually been less supportive of dividends than they have been historically. Between 1950 and 1990, the dividend payout ratio for dividend stocks averaged about 53%. But since 1990, it has dropped to 41%, according to Morningstar. So corporate profits -- and the yields they offer -- are actually even more robust than fixed income yields. (In fact, I recently noted that free cash flow yields of roughly 15% or more for companies in the S&P 500 now exceed 10%.)
Strategists at Citigroup looked at corporate profits in relation to fixed income investments and came to the same conclusion: "When studying the differential between the 10-year bond and the inverted trailing 12-month S&P 500 P/E ratio relative to historical moving averages, the deviation is at levels seen during some of the worst market periods such as 1973-74 and 2008-09." They think the S&P 500 looks undervalued by about 15%, even if you assume corporate profits will never grow again and stay flat in perpetuity. They also conclude similar periods of undervaluation before have led the market to an average gain of 25% in the subsequent 12 months.
Risks to consider: Although the market is already pricing in a modest recession, a deep and long-lasting recession would surely lead these strategists to lower their profit forecasts for the S&P 500, blunting any potential rally that may come. The economic data of the next few months should paint a clearer picture of what kind of economic performance we should expect in 2012.
What does this mean? I think blue chip companies with strong balance sheets are likely to be winners this year and next. My favorite current blue chip names include Ford Motor (NYSE: F), Hasbro (NYSE: HAS), Charles Schwab (NYSE: SCHW), Ingersoll-Rand (NYSE: IR), and Cisco Systems (Nasdaq; CSCO). All are solid names trading at cheap valuations that I've written about in the past.
All of this goes to say that now is a good time to buy. But even though the broader market looks inexpensive, stock selection is crucial. These five stocks are just a good place to start. As economic uncertainty remains, you need to focus on value-oriented names, highlighted by strong balance sheets, solid free cash flow yields and defensible market positions. The companies I mentioned fit this bill, and I'll keep focusing on stocks like these until things change.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.