Notes On The Market

I'm getting ready for several meetings in the next couple of days, so I thought I would post my latest thoughts on the markets and investment strategy.

First, a bullish anecdote:

In August 2000, I was on vacation on Nantucket when I received a call from the office.

A good client of mine - who also happened to be a pretty savvy Harvard Business School professor - needed to speak to me immediately. When I called him, he directed me to sell all of his stocks - immediately.

It turns out that he had read Robert Shiller's book Irrational Exuberance, which described how the market had become unhinged from the fundamentals, and was likely to have a serious correction at some point.

Professor Shiller was absolutely right, of course, and my client's move was very prescient. The S&P 500 was above 1500 those days, and now is trading around 1,150.

My client largely has been out of the market for the past 10 years, and has been investing in corporate bonds. During that (painful) time period, the S&P has produced a total return of +29%, while high-grade corporate bonds have returned +100%, or more than 3x the return of common stocks.

So when I received a call this morning from my client asking me to put together a list of common stocks that I would suggest buying, I paid attention.

His logic, by the way, is in line with my thoughts of the past few days: namely, while there is no denying that there is risk in owning common stocks, the potential returns from stocks going forward is vastly superior to most alternatives, and so returning just a portion of his assets back to stocks makes sense.

Back to getting ready for my meetings.

Here's why I think investors should be sticking with stocks:

1. The economic fundamentals are OK, even if recent data is pointing to a slowdown. For example, the Leading Economic Indicators (LEI) has risen almost without interruption since March 2009, according to Ned Davis Research, even though it has slowed in recent months. Other data points would include last week's employment report, which showed some modest improvement in job creation;

2. As I wrote on Monday, there have been 93 corrections of 10% or more since the beginning of 1928, according to Ned Davis. In 25 cases, those downturns turned into full-fledged bear markets, defined as a decline of 20% or more. Put another way, the historical odds suggest that 73% of the time corrections do not turn into long bear markets. With interest rates low, and corporate profits robust, it seems that a prolonged bear market is less likely;

3.Bloomberg indicated this morning that insiders (i.e. company executives) have been buying stocks at the highest rate since March 2009, when the S&P 500 hit a 12-year low. As former money manager Peter Lynch once observers, insiders can sell the stock of their companies for lots of reasons, but they only buy for one reason: to make money;

4. Three-quarters of the companies in the S&P 500 beat earnings expectations in the second quarter. True, guidance for future earnings was muted, but this too would be expected given the current market volatility;

5. The Fed just announced on Tuesday that short-term interest rates would remain at 0% for next two years. If you don't need to make any money, and are worried about the world, then banks are a good alternative. Otherwise you are going to have invest somewhere;

6. Bond yields are puny. Are you really going to invest your retirement assets at less than 1% for the next 5 years or so? Really?;

7. Unlike 2008, credit conditions are very accomodative. A recent survey of small business owners said that 93% reported no trouble in getting necessary credit. Coporate bond yields continue to hit record lows;

8. Corporate America is flush with cash - nearly $2 trillion worth. The Fed's move is try to make holding this cash "painful" so that managements will invest in new plants and create jobs. These funds can also be used for M&A activity;

9.JP Morgan indicates that the after-tax dividend yield on the S&P 500 is 12 basis points higher than US Treasurys. This is the first time this has happened since 1962. If you need income, stocks are the better alternative;

10. Valuation of stocks is attractive. The S&P 500 is trading at 12.3x trailing 12 month earnings, compared with its average since 1954 of 16.4x, according to Bloomberg.

So is the picture totally rosy?

Unfortunately, no. Here's what I'm watching to see if I need to change my bullish position:

1. The financial sector is a mess, lead by Bank of America (BAC). Banks still have huge legacy problem loans from the last decade that they have yet to deal with. BAC is off nearly -40% since the beginning of July, and their debt is trading at 4% in the money markets - scary stuff;

2. Demand is still tepid. To get a truly robust recovery, consumers and businesses need to start spending, but most are still too worried;

3. While the US is wounded, the euro is on a death-watch. It will take a concerted action, lead by Germany, to save the eurozone from imploding. If the euro goes, debt problems could soar, taking the financial sector down with it;