Stocks Climbing a Wall of Worry – Jan 2012
U.S. stocks rose nearly 12% in the fourth quarter of 2011, but you would not know that based on investor sentiment. Generally speaking, investors are not an optimistic bunch. To prove this point, one needs to look no further than mutual fund redemptions, which recorded the second-worst year on record in 2011.
It is easy to understand why investors are unnerved. Between April and October of last year, U.S. stocks dropped over 19%, the worst decline since 2008. At the same time, daily volatility intensified. During the third quarter, the S&P 500 moved 2.4% on average between its intraday low and high. The Dow Jones Industrial Average alternated between gains and losses exceeding 400 points on four straight days in August—the longest streak ever. With such dramatic swings, investors seemed to lose confidence that stocks were trading based on any fundamental measures or valuations. As a result, many opted for the relative safety of cash and bonds.
Similar to individual investors, hedge funds have also grown weary of stocks. As a group, hedge fund stock exposure is now only slightly greater than it was during the March 2009 low. In the spring of 2009, hedge funds were caught leaning the wrong way as the market bottomed, then quickly moved higher. We suspect late 2011 and 2012 could follow a similar pattern.
In terms of earnings and other valuation measures, stocks look very favorably valued. The S&P 500 currently trades at 13.5 times reported earnings, which is much less than the average P/E ratio of 16.4 since 1954. Overall, earnings for companies in the S&P 500 are expected to be up 7.5% in the final three months of 2011 versus the same period in 2010. And even if fourth quarter earnings (which are starting to be released now) prove disappointing, earnings for 2011 will still be more than 10% above 2010 earnings.
More importantly, based on consensus estimates, earnings are expected to rise again in 2012, reaching more than $105-per-share for the S&P 500. At current stock prices, this would mean a P/E ratio of only twelve. The last time stocks were that cheap on an earnings basis was in the mid-1980s. At that time, more than 25 years ago, 10-year Treasury yields were between 7%-9%. This compares to yields of less than 2% today. In other words, in the mid-1980s, Treasury bonds yielding in the high single digits were a very attractive, riskfree alternative to stocks. But today, stock earnings are being valued no more favorably than in the mid-1980s, even though the riskfree alternative to stocks today is yielding less than 2%.
In addition to earnings, other valuation measures paint a similarly favorable picture. For instance, the ratio of debt to assets, which measures the financial strength of companies, reached its best level since 2002. And, stock dividends continue to rise, with the yield on the S&P 500 now greater than 2%, which is also higher than the yield on the 10-year Treasury. It has been more than 50 years since the dividend yield on stocks has been above 10-year Treasury yields.
Today’s low-yield environment has investors wondering where to turn for attractive yields. Of course, higher yields come at the price of higher risk, but one higher-risk area which offers an attractive reward trade-off is high-yield bonds. Our preferred high yield bond investments currently offer yields better than 7.5%, which is net of any defaults within the portfolio, and much higher than other bond classes. Considering that inflation in the U.S. is below 2%, and that the U.S. economy is expected to keep growing, we believe high-yield bonds continue to offer attractive yields for long-term investors interested in income. In addition, due to their modest correlation with stocks (about 50%), high yield bonds can add meaningful diversification to portfolios, as well as potentially attractive returns.
Low expectations and attractive stock valuations, coupled with under-invested individuals and institutions, have created an environment in which the market could easily move higher. While we are not expecting a breakout year in terms of economic growth, we are expecting growth, and feel like the market still has some catching up to do from last year’s selloff. Furthermore, we expect 2012 will see lower volatility, making it easier for investors to return to stocks.
