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 thismean 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 isinflation
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.
Action to Take -->
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.
-- David Sterman
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.