Friday, August 2, 2013
Revisiting My Bullish Thesis from August 2011
Two years ago, in August 2011, I joined the head of our bond area on a conference call that was broadcast to employees in my company.
The call was more popular than the organizers expected; shortly after we began our broadcast we received word via email that the phone system had crashed. Still, a good portion of our fellow employees were able to hear our remarks.
At the time, the economic recovery which had began in June 2009 was showing signs of slowing, and the stock market was off about-5% for the first 7 months of the year.
As it turned out, however, we were on the verge of an explosive rally. In the two years since our call, the S&P has climbed from just over 1250 to 1700 - a gain of +36% in just 24 months.
Two years ago I was one of the few bullish investors in my company.
As I recall, the problem was largely what behavioral scientists call "recency bias", or a tendency to predict the future based on what has happened most recently in the past.
For the 10 years prior to August 2011, stocks had been largely disappointing.
After trading as high as 1550 in the middle of 2000, the S&P 500 stocks had stumbled badly in the next decade, most notably a -25% sell-off in the first quarter of 2009. You were not much better off 10 years later if you had bought stocks in August 2000.
The lessons that most (younger) investors took from the market's action was that stocks were largely a trading vehicle, but bonds were the only place for longer term investments.
I have not been asked to do another call (fame can be so fleeting!) but with the market hitting record highs I thought I should revisit my bullish thesis from 2011, and see what changes I should be making in my investment thinking.
Here's an excerpt from a piece titled "Notes on the Market" I wrote on August 11, 2011 (I used the notes for the conference I mentioned earlier):
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 what has changed now?
I was struck when I looked at my list at how many of the bullish factors I discussed two years ago remain intact.
True, the valuation of the S&P is no longer at rock-bottom levels, but it still remains below the historic averages.
Interest rates, meanwhile, have moved higher since the lows in 2012, but interestingly they are basically back to the same level as two years ago:
I thought then, and continue to believe now, that bonds offer little appeal for longer term investors.
While there is much discussion about when the Fed might reduce its presence in the credit markets, no one believes that short maturity interest rates are headed much higher any time soon, regardless of who is named the new Fed chairman.
In short, bonds and cash still do not stack up well relative to stocks.
Corporate earnings have also continued to surprise on the upside. Company managements have been cautious on their outlook for the remainder of the year, but in my opinion this is now the way the game is played: set low expectations, and any reasonable results will be viewed favorably.
I am not wildly bullish, by the way. I recognize that any time you have a strong market rally there is usually the tendency for a market "correction" of -5% to -10% along the way.
But until the factors I first listed in August 2011 change significantly, I would stick with a full allocation to stocks.