Monday, April 2, 2012

Stocks are still attractive

With the end of a pretty exciting quarter for equities just behind us, what does the future hold? Here's my simplistic view, which remains optimistic because I continue to see signs that tell me the market remains pessimistic. 

As the chart above suggests, the S&P 500 is currently right about in the middle of its long-term upward trend. The 6.8% annualized trend lines that I've drawn translate into a total return of over 8% a year when you included reinvested dividends, and this trend is consistent with the 11.1% annualized total return of the S&P 500 since the end of 1949. The existence of many trillions of dollars "sitting on the sidelines" in the form of cash and cash equivalents that pay almost nothing, while stocks have reaffirmed their ability to move higher over time by at least 6.8% a year, is a good indicator that the market as a whole has very little confidence in the long-term outlook.

As of the end of March, the trailing 12-month PE ratio of the S&P 500 was 14.56, which is about 12% below its 52-year average. No sign of excessive optimism here: in fact, since reaching a peak of 30 in June 1999, multiples have fallen by more than half while after-tax corporate profits (as calculated by the National Income and Product Accounts) have surged some 160%. This is a market that holds out no hope that profits will do anything but languish and/or decline in the years to come.

Another way of looking at profits is to compare the earnings yield on stocks (the inverse of the PE ratio) with the yield on corporate bonds. The first of the two charts above uses the average yield on long-term BAA-rated corporate bonds as a proxy for yield on the typical corporate bond. Here we see that earnings yields are still substantially higher than bond yields, a condition that has been relatively rare over the past 52 years. When the market is very confident in the ability of earnings to rise over time, as it was from the early 1980s through the early 2000s, earnings yields were consistently below the yield on corporate bonds, because investors were willing to forego a portion of the relative safety of bond yields in order to capture the expected price appreciation of equities.

The second of the two charts above compares the earnings yield on stocks to the yield on 10-yr Treasury bonds. When Treasury yields are higher than equity yields, it's a good sign that the market is distrustful of the ability of earnings to grow. "Distrustful" is a rather timid description of investors' outlook today, since the market is essentially indifferent to earning 2.2% on risk-free bonds while stocks are offering 6.9%. That spread of 4.7% today is much wider than the 3.2% recorded at the market's bottom in early March 2009, and only moderately tighter than the all-time high of 6.2% recorded late last September. In short, the sizable gap between the current yield on equities and the yield on risk-free Treasuries reflects a very pessimistic outlook embedded in current prices.

Of course, the market may well be correct in its belief that the outlook for the economy and corporate profits is miserable. But everything I see tells me that the economy continues to grow, albeit relatively quite slowly given the depths of the recent recession. The story of the equity rally to date is one of stocks moving higher because the reality has continually proved to be less awful than the expectations, and I think this will continue to be the case for the foreseeable future.


Benjamin Cole said...

NEW YORK (Dow Jones)--U.S. stocks rose Monday to trade near multi-year highs in the first session of the new quarter as a reading on domestic manufacturing bolstered investor sentiment.

Stocks opened nearly flat Monday, but drifted higher following the release of March manufacturing data. The Dow Jones Industrial Average traded up 71 points, or 0.5%, to 13283 in early afternoon trading, on track for its highest close since December 2007. All but two of the 30 blue chips were higher.

This tells me that if the Fed can keep the dollar in a favorable trading range, we can have better time in the USA.

The globe has changed since the 1970s; there are huge buying markets out there. Cutting off access to those markets through a "strong dollar" philosophy no longer makes sense.

When globe was not much of a market anyway perhaps it made sense to buy cheap through a strong dollar. Now there are huge opportunities to sell to the growing global economy.

Anonymous said...

March average daily withholding tax receipts were about 7% over last year's figures. Another good jobs report is in store on Friday.

Anonymous said...
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Anonymous said...

A bit more color on those withholding receipts numbers.

In March, $166,353 billion in withholding tax receipts were collected.

In March of last year, $162,081 billion were collected.

That's a y-o-y increase of 2.64%. There's a particular calendar quirk going on to make the daily average % increase larger than the total for the month. Split the difference between the two and it should give you a general idea

Anonymous said...

I just realized one other thing. There were only 22 weekdays in March this year compared to 23 last year (which would also explain why the per-day average was so much greater than the monthly total). If we've still got a 2.64% y-o-y growth in withholding taxes with one fewer weekday (and one day can actually make a big difference), then that really points to pretty good growth in tax receipts.

Now I'm *really* interested in tomorrow's auto sales.

William said...

UPDATE: 3/28/2012 data

PERCENT BULLISH - 50.5% up from 43.6% two weeks ago.
PERCENT BEARISH - 22.6% down from 26.6% two weeks ago.
The percent bullish first rose to 50.5% on 12/28/2011 and has been no higher than 54.8% since then. The previous significant high was 58% in January 2011.

LIPPER U.S. FUND FLOWS (includes ETF funds)
February 2012

EQUITY FUNDS - inflows of $11 Billion

TAXABLE BOND FUNDS - inflows of $36.4 Billion

March 2012 (my estimate)

EQUITY FUNDS - inflows of $3.48 Billion

TAXABLE BOND FUNDS - inflows of $19 Billion

No over exuberance here.

L.A. said...

Scott, just curious what sets the upper and lower bounds for the two trend lines?

John said...

Never thought I'd see "higher tax receipts" treated as good news on this blog.

Scott Grannis said...

L.A.: the upper and lower bounds are set subjectively--my intuition.

John: supply siders are not always against higher taxes; higher tax receipts are a welcome thing if they come as a result of more people working. Supply-siders' main tax argument is that higher tax rates do not always yield higher tax receipts, and lower tax rates can yield higher tax receipts than static analysis would suggest. Raising and lower tax rates has an important impact on incentives, and this is largely ignored by liberal politicians.

Squire said...

My small sample of investor friends and associates universally:
Fear inflation but don’t see stocks as a hedge preferring ETFs for commodities and such;

Fear reduced deficit spending is necessary but will hurt the economy;

Fear that big government will continue to be oppressive to small & medium size business;

And most of all, universally wait for a correction to invest the small portion of their cash allocated to stocks.

When my barber turns bullish I will short stocks.