If you’re tired of hearing about the lousy stock market from all the talking heads on TV (or tired of hearing about it from us!), well, we wish we could say this was a report about the fantastic stock market. Instead, this post is about the lousy stock market.
The timing of this report coincides with a market currently in freefall, and testing the lows the S&P 500 reached back in January and March, both of which were almost 20% down from the highs reached last October. Meanwhile, the Dow yesterday broke through its January and March lows, and now is also sitting on a 20% drop. As you may know, a more-than-20% drop is the standard definition of a bear market. The Nasdaq, Russell 2000 (small-cap stocks), EAFE (foreign developed stocks), and MSCI Emerging Markets Index have already suffered losses of more than 20%. China’s stock market, in particular, is down 52%.
There are a lot of good reasons for the gloomy mood on Wall Street, and the tangible sources of hope are few and far between. We are sticking with our party line: we honestly have no idea whether this is another bottom, as we suspected in January, or whether the market will continue to fall. All we can do is put on our hats that say “Long-Term Investor;” if you haven’t seen anybody in the investment business wearing one, well, what does that say? Next, we take note as to whether the long-term outlook for corporate profitability is still intact. Looking out years ahead gives us the luxury of looking past the malaise affecting the financial services industry. Not all banks will have that luxury, as some will fail. But if we’re confident that we own banks that will survive, we can afford this luxury.
As we have said numerous times, corporate productivity is the driving force behind long-term profit growth. What has changed to affect the outlook for productivity? Commodities inflation for sure. But if we allow that the Fed has learned lessons from our 1970’s experience with stagflation, perhaps commodities inflation won’t affect labor inflation, which is the biggest risk to productivity in our opinion. And supply and demand eventually do work; in other words, prices can’t go up indefinitely without some effect on either supply or demand. We recently summarized our thoughts on oil here on our website… Manhunt Over – Crude Villains Found.
An unwinding of global trade would be risk #2, which is a risk given rhetoric from the Democratic Party. We have a small measure of blind faith that Obama, if he were elected, would not unwind trade as he has been threatening to do on the campaign trail. While he shares no love for Wall Street, we believe he is slightly more pragmatic with regards to corporate America. Unwinding NAFTA sounds good to unions, but is unfeasible and completely illogical. McCain is an adamant supporter of global trade.
Lastly, we gauge whether there is value in stocks at this point, as earnings have begun to fall. Earnings outside of financial companies are actually still rising. Earnings excluding both financials and energy are even still rising. The short answer on value can be seen in the following charts.
The first chart highlights just how bad the 2000’s have been for stocks. As we have said before, in order for the stock market to make no money in a 10-year period, this has required not only a Great Depression, but also really bad timing. In fact, if an investor had bought stocks in the mid-1920’s and held for 10 years into the heart of the Depression, he would have made a decent return (at least 6% annually). If he would have bought stocks early in the Depression (like 1932 or 1933), and held for 10 years through the Depression, his return would have been similarly pretty good (6-9% annually). Since 12/31/99, the market’s return (including dividends) has been…..0%. In order for this decade to avoid making the top 10 list of worst decades ever, which so far includes only periods surrounding the Depression and the awful market crash of 1973-74, stocks need to go up 76% by the end of 2009. That’s a tall task! At least making this list, historically, has meant good returns in the following 10 years, as the right-most column shows.
The next chart is the Baseline chart for the market, showing an annual return of 31% is required in the next 2 ½ years for the market just to get back to the most undervalued part of its range.
Next, the Monarch Dividend Growth portfolio’s dividend yield has reached parity with the 10-year Treasury bond yield. When we first constructed this portfolio in 2003, we were utterly shocked that we could get dividend yields that were at parity with Treasury bondson a tax-adjusted basis (with dividends taxed at a favorable 15% rate starting in 2003). Now that comparison shows tax-adjusted dividend yields well above Treasury yields.
Finally, Strategas today gives us kind of a worst-case scenario – valuations in a recession. Keep in mind, this is a short-term measure, not what the market should be worth once it gets through its current malaise. The average earnings drop in a recession historically has been 17%. Given current interest rates, a 17 P/E is historically a low watermark in recessions. The end result is where the market is currently valued. We’re hopeful earnings won’t fall this much, but the market seems to be expecting that they will. To access the report, Strategas 06/27/08.