Sellout or Buy In
Is It Time to…Sellout or Buy?
While I do usually try to look at the bright side of things, my enthusiasm for the long-term prospects of undervalued stocks has a lot to do with historical precedents. We frequently mention that according to data calculated by Morningstar, equities have returned 10.4% (large-cap) to 12.7% (small-cap) per annum dating back to 1926, with stocks trading for inexpensive fundamental valuation metrics performing even better.
Adding to our arsenal of historical data, we have also been busy this year crunching equity performance figures on a going-forward 1-, 2-, 3- and 5-year basis, based on the release of various economic statistics. The fact is that stocks actually do better over the long-term when economic data points are signaling economic contraction, rising unemployment and/or recession. This is primarily because the markets have already sold off by the time the statistics turn negative, with subsequent rallies beginning before evidence of recovery emerges.
Recently, there were three main economic numbers that caused quite a bit of consternation for investors, including the Philadelphia Fed General Activity Index, which came in much worse than expected at a reading of -24.0 in February. Interestingly, history shows that when the Philly Fed index was positive, large-company stocks posted an average gain of 11.1% one year out, while small-company stocks had an average gain of 12.6%. On the other hand, when the Philly Fed number was negative, which indicates contraction in the manufacturing sector, large-company stocks had a 14.1% average gain and small-company stocks had a 23.4% average gain over the next 12 months.
Next, the Conference Board’s Index of Leading Economic Indicators (LEI) declined for the fourth straight month in January. The Conference Board said, “The leading index has continued to decline since its most recent highest value reached in July 2007, and the weakness among the leading indicators has become more widespread…The current behavior of the composite indexes suggests increasing risks for further economic weakness, and that sluggish economic growth will likely continue in the near term.”
Sounds pretty ominous until one looks at these long-term (non-annualized) equity performance numbers when the monthly change in this gauge is negative, as it is today, versus when it is positive:
Negative or Zero LEI vs. Positive LEI
1-Year Large-Cap: 11.4% vs. 11.7%
1-Year Small-Cap: 18.9% vs. 15.9%
2- Year Large-Cap: 26.7% vs. 23.9%
2- Year Small-Cap: 44.0% vs. 32.5%
3- Year Large-Cap: 40.6% vs. 38.4%
3- Year Small-Cap: 66.0% vs. 55.0%
5- Year Large-Cap: 77.1% vs. 73.2%
5- Year Small-Cap: 129.4% vs. 110.4%
Inflation was also spooking investors recently as the Labor Department reported that the Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5% percent in January before seasonal adjustment, with the year-over year figure climbing 4.3%. While the so-called ‘core’ rate, which includes the volatile food and energy components, rose ‘only’ 2.5% on an annual basis, inflation is certainly higher than the Federal Reserve would like, although Ben Bernanke & Co. are still widely expected to continue to lower interest rates when they get together next month.
Interestingly, once again, long-term-oriented investors are likely to see better returns when the CPI-U is high than when it is low. Using the current 4.3% reading as the inflection point, take a look at the following (non-annualized) performance figures:
CPI-U 4.3% or Higher vs. CPI-U Less than 4.3%
1-Year Large-Cap: 11.5% vs. 13.1%
1-Year Small-Cap: 19.2% vs. 17.5%
2-Year Large-Cap: 28.4% vs. 25.6%
2-Year Small-Cap: 49.0% vs. 33.2%
3-Year Large-Cap: 47.1% vs. 38.3%
3-Year Small-Cap: 70.8% vs. 48.3%
5-Year Large-Cap: 88.2% vs. 67.9%
5-Year Small-Cap: 156.7% vs. 100.2%
Obviously, there remain numerous issues about which we might fret, including the impact of the slowdown in the U.S. economy on corporate profits, and we certainly know we have endured turbulent market conditions on many previous occasions, including whopping 40%+ peak to trough declines in 1998 and 2002. Nevertheless, our experience has shown that equities remain the place to be for long-term-oriented investors. Staying the course in difficult times has historically been the right strategy with our value-oriented approach as recoveries have often been sharp and quick. It is very difficult for the folks who have bailed out of stocks to have the courage to step back in at just the right time.
Market Outlook:
We understand that earnings estimates will continue to come down, but valuations of equities in general remain very inexpensive, especially relative to interest rates. We’ve commented in the past on the so-called ‘Fed Model’, which compares the earnings yield (the inverse of the P/E ratio) on stocks to the yield on the 10-year U.S. Treasury. Equities are cheaper today than they were at previous market bottoms in October 2002 and March 2003.
I do think that stock prices will be higher by the end of the year and, more importantly, I believe that they will be significantly higher three-to-five years out, which is always the time frame that we work with. In addition to factors outlined above, some reasons for my continued optimism include:
1) The likelihood of additional Federal Reserve interest rate cuts
2) The tremendous amount of pessimism gripping investors
3) The $3 trillion that is sitting in money market mutual funds
4) The lack of significant insider selling (and the increase in actual buying) by corporate executives
5) The relative health (outside the financial and housing sectors) of corporate balance sheets