|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||September 30, 2011|
Nobel Prize-winning economist Paul Samuelson once quipped that the stock market has correctly predicted "nine of the last five recessions". Well, for a good two months now, many investors (and pundits and forecasters) have made it seem a foregone conclusion that another U.S. recession is imminent. And week after week, the data continues to show that -- to this point -- the recession they've been predicting appears to be one of those four non-recessions to which Samuelson referred.
This week, for example, we got some positive news from the labor market, with new unemployment claims falling about 9% to reach their lowest level in nearly six months. They're still high by historical standards, but we're just not seeing the surge in unemployment that many were forecasting when the stock market was swooning in July and August.
Decent news also came from the housing market. After falling in three of the past four months, existing-home sales jumped 7.7% in August, the National Association of Realtors reported. And both the 10-city and 20-city S&P/Case-Shiller Home Price Indices rose 0.9% in July, new data showed. When adjusting for seasonal factors, however, the indices were both about flat for the month. Pending home sales, a forward-looking indicator based on contract signings, declined slightly in August, falling 1.2%, NAR reported.
Regional manufacturing reports, meanwhile, were disappointing. The New York Federal Reserve's manufacturing index indicated the sector contracted for the fourth straight month, falling at about the same pace (-8.8%) as the previous month (-7.7%). The Philadelphia Fed's mid-Atlantic manufacturing index also remained in negative territory, though it indicated that the sector contracted at a significantly slower pace than it did in August (the September reading was -17.5, vs. -30.7 in August). Businesses appear to think the recent downturn is temporary, however; the Philly Fed's report showed a big jump in companies' expectations for what business conditions will be like in six months, and the New York Fed's six-month forward-looking indicator also rose.
It's also important to keep in mind that the New York and Philly numbers haven't exactly been an accurate bellwether for the nation in the past couple months -- broader national manufacturing figures have remained positive even as those two indices have been weak.
Supporting the improving outlook for manufacturers was a new Commerce Department report that said new orders for non-defense capital goods (goods used to produce finished products and services) rose 5.2% in August, despite all the talk of a possible double-dip recession.
Good news also came regarding the U.S. consumer. According to new Federal Reserve data, Americans' household debt service ratio (which compares debt payments to disposable income) fell in the April-June period for the ninth quarter in a row. In fact, it reached its lowest level since the fourth quarter of 1994.
Of course, the market hasn't been too concerned with fundamental data of late. It's instead remained fixated on the European debt crisis. And the speculation on how that will turn out has improved recently, as more countries have agreed to participate in the European Financial Stability Facility, the Eurozone's bailout fund. Much remains to be done, however, and it's likely that investors will continue to fret over the unpredictable, day-to-day news that emerges from Europe until some resolution is reached.
Investors have also been speculating about the impact of the Federal Reserve's new "Operation Twist" plan, through which the Fed will extend the average maturity of its securities holdings. The move is designed to keep downward pressure on long-term interest rates. With rates already extremely low -- 30-year mortgage rates fell to the lowest level in at least 40 years this week -- many are criticizing the move as unnecessary. We'll have to wait and see if it has the impact the Fed desires.
Since our last newsletter, the S&P 500 returned -4.0%, while the Hot List returned -14.6%. So far in 2011, the portfolio has returned -22.3% vs. -7.7% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 109.7% vs. the S&P's 16.0% gain.
Fear, Facts, and Fundamentals
Europe, Europe Europe -- it's all anyone seems concerned with these days, and that can be a difficult environment for disciplined, bottom up, stick-to-the-facts investors like me. It's not that the impact of Europe's financial situation is overblown (though it may well be -- I've previously noted that only about 15% of sales of S&P 500 companies' sales come from Europe; given all the Europe fear, you'd think it would be more like 50%). The issue, rather, is that very, very few people -- perhaps not even policymakers who are involved -- have any idea how the Europe situation is going to play out. Seventeen countries need to approve the enhanced Eurozone bailout plan for it to go into effect, and each has its own unique set of internal politics. It's hard enough to predict what one country will do, let alone all 17.
Yet every short-term event -- and the "events" are often mere statements by European officials -- is taken as a strong, clear signal that the debt crisis resolution will be "good" or "bad" for the world. Investors rush for the door on what they perceive as bad news, only to rush to get back in on what they view as good news.
This process -- the process of jumping in and out of the market based on the tenor of comments that some European official makes on a particular day -- is nothing more than sheer speculation. It is the sort of thing that I believe would make Benjamin Graham, Warren Buffett, or any of the highly successful gurus I follow, shake their heads in disapproval. In his classic The Intelligent Investor, Graham said of speculation, "The people who persist in trying it are either (a) unintelligent, or (b) willing to lose money for the fun of the game, or (c) gifted with some uncommon and incommunicable talent. In any case, they are not investors." I agree.
You and I, however, are investors. And as investors, we look at facts and data, and use them to make rational decisions about value. Given all of the fears surrounding stocks today, I thought it would be a good time to review some of the cold, hard facts and data about the current market's valuation, to try to give a comprehensive, rational picture of where we stand.
For starters, let's look at price/earnings ratios, of which there are several. First we'll look at trailing 12-month P/E ratios, using both operating earnings and as-reported earnings (we'll use the S&P 500 as a proxy for "the market"). Using the S&P's Thursday afternoon price of 1162 or so, the index trades for about 12.8 times trailing 12-month operating earnings, and 13.9 times as-reported earnings, according to Standard & Poor's data.
How does that compare to historical norms? Pretty well. The as-reported figure is below the 1872-2000 historical average for U.S. stocks, which is 14.5, according to SmartMoney. The operating figure is much lower than the historical average of 19.1, but that average is based on a relatively small sample -- S&P keeps historical data on operating earnings P/Es going back only to 1988.
Now, on to projected earnings. They aren't my favorite way to gauge valuations, given how often analysts' projections are wrong. But, just for kicks, let's see how the market's forward-looking P/E looks. According to Standard & Poor's, the S&P 500 trades for about 11.2 times projected operating earnings for the next year, and about 12.4 times projected as-reported earnings. Again, a pretty good picture, for what it's worth.
Of course, some say corporate earnings have been goosed by the Federal Reserve's money-printing binge. So let's look at some non-earnings-based metrics, like the stock market/GDP ratio. This compares the total market value of the stock market to the value of all the goods and services produced annually in the U.S. -- the gross domestic product. Warren Buffett has said the stock market/GNP (gross national product) is one of his favorite valuations metrics, and GDP and GNP tend to run quite close to each other. The website GuruFocus.com tracks the daily stock market/GDP ratio, and as of Sept. 29, the ratio was 79.9%. That sits toward the cheaper end of the "fair value" range (75% to 90%), which was derived by an analysis of historical data, the site says. (It uses the Wilshire Total Market Index, not the S&P 500, as a proxy for the market.) Another good sign.
Then there's the price/sales ratio, which was pioneered by Kenneth Fisher, one of the gurus upon whose writings I base one of my top-performing strategies. Fisher developed the PSR in the 1980s as a way to value individual stocks. His logic: While earnings can fluctuate wildly from year to year because of factors that have nothing to do with a firm's underlying business (accounting changes, lawsuits won or lost, tax changes), sales are far more stable, and provide a better gauge of a company's position.
My Fisher-based model finds PSRs below 0.75 to be tremendous values, and those between 0.75 and 1.5 to be good values. My James O'Shaughnessy-based model also uses the metric, looking for PSRs below 1.5. Currently, according to data from Morningstar, the S&P 500 has a PSR of 1.2.
The Longer View
Critics who say recent earnings have been boosted by the Fed also point to longer-term P/E ratios, like the 10-Year Price/Earnings Ratio. Graham was a pioneer of this metric, and Yale Economist Robert Shiller is now the tool's foremost proponent. His 10-Year Cyclically-Adjusted Price/Earnings Ratio (CAPE) looks at earnings over the past 10 years and factors in inflation. The benefit of this particular P/E is that it compensates for short-term anomalies in earnings results. At the end of the first quarter of 2009, for example, the S&P traded for 116 times TTM as-reported earnings, a figure that looks on the surface to indicate that the market was wildly overvalued. But that was due to the fact that a horrific short-term stretch had driven TTM earnings down to less than $7 -- a figure that surely underestimated the future earnings power of the companies in the index.
The downside of the 10-year P/E is that the timeframe it examines is somewhat arbitrary. Typically, business cycles run significantly shorter than 10 years -- the average has been about six years in the post-World War II era, according to the National Bureau for Economic Research, the group charged with declaring the start and end points of recessions and expansions. Going back to the 1850s, the average is even lower, at about four-and-a-half years. So depending on when you look at the CAPE, the past decade of earnings can include a combination of recessionary and expansionary periods that is atypical.
How does the 10-year P/E look now? It's hovered around 20 for the past couple months. That's significantly above its 140-year historical average of about 16, though far from the peaks hit in 1999 (44.2) and 2007 (about 27.5). The latest data on Shiller's web site uses the Sept. 26 close (which is almost identical to the S&P's price as of this writing on Sept. 29), and shows the 10-year P/E to be 19.8. That's an overvaluation of about 24%.
There's some logic to using post-World War II data on any cyclically-adjusted P/E, however, since it was after World War II that policymakers began to make inflation a permanent part of the economy, and inflation is a dagger for stocks' biggest competitor, bonds. I thought it would be interesting to look at the post-World War II era, and tweak Shiller's data to use the average post-World War II business cycle of 70 months worth of earnings (rather than ten years). On that basis, the cyclically adjusted P/E ratio has averaged 17.3. The current level: 18.3. Still elevated, but only by about 6.1%.
Finally, let's look at one last measure of market value -- dividend yield. In what has been a rarity in recent decades, the S&P 500's dividend yield is well above the 10-year Treasury yield. As of Sept. 28, the S&P's dividend yield was 2.64%, while the 10-year Treasury yield was 2.03%.
While most investors seem to be focusing on fear-filled headlines, smart investors will keep their focus on the facts. And right now, when it comes to assessing market valuation, the broader market seems reasonably priced. By all of the one-year earnings metrics, it looks cheap. And if you don't trust recent and projected earnings, the market is also trading at a reasonable price compared to sales and GDP. Plus, its dividend yield is some 30% higher than that of the 10-year Treasury bill.
The lone metric we examined that shows an overpriced market is the 10-year P/E. That's cause for some concern. But when we adjust the metric to more accurately reflect normal business cycle time periods, the gap between the current P/E and the average post-World War II P/E shrinks to about 6% -- indicating only a slight overvaluation.
In the short term, of course, the market will continue to move based on the macroeconomic headlines. But over the longer term, valuation will matter. And, looking at the totality of the information, stocks appear to be priced at levels from which solid long-term returns typically follow -- returns that are much better than those of bonds or bills or even gold. And, more importantly, many individual stocks are trading at exceptionally low valuations, despite having strong track records of earnings and sales growth. For stock-pickers like the Hot List, that's very good news.
Does that mean the market is guaranteed to surge in the next month, or quarter, or year? Of course not. There are never any guarantees in the stock market. But at some point, I believe the Europe fears will pass, and the market will recognize the many bargains that investors have been ignoring amid the fear-filled headlines -- and those who have stayed disciplined will be rewarded.
As we rebalance the Validea Hot List, 3 stocks leave our portfolio. These include: Micron Technology, Inc. (MU), Gt Advanced Technologies Inc (GTAT) and Marketaxess Holdings Inc. (MKTX).
7 stocks remain in the portfolio. They are: Forest Laboratories, Inc. (FRX), Devry Inc. (DV), Career Education Corp. (CECO), Asiainfo-linkage, Inc. (ASIA), Ternium S.a. (Adr) (TX), Capella Education Company (CPLA) and Bridgepoint Education, Inc. (BPI).
We are adding 3 stocks to the portfolio. These include: Hi-tech Pharmacal Co. (HITK), Jos. A. Bank Clothiers, Inc. (JOSB) and Petroleo Brasileiro Sa (Adr) (PBR).
Newcomers to the Validea Hot List
Hi-Tech Pharmacal Co. (HITK): This three-decade-old specialty pharma firm focuses on difficult-to-manufacture liquid and semi-solid dosage forms, and manufactures a range of sterile ophthalmic, otic and inhalation products. It's also a leader in over-the-counter and nutritional products targeted at diabetics.
Amityville, N.Y.-based Hi-Tech ($422 million market cap) gets high marks from four of my models -- my Joel Greenblatt- and Peter Lynch-based models, the model I base on the writings of Motley Fool creators Tom and David Gardner, and my Momentum Investor approach. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.
Jos. A. Bank Clothiers (JOSB): Based in Hampstead, Maryland, this prior Hot List favorite is back. The 100-plus-year-old retailer sells a variety of men's tailored, casual, and sports clothing, as well as shoes and accessories such as hats and belts. The small-cap ($1.4 billion), has about 500 stores across the U.S.
Bank, which has had several previous stints in the Hot List -- including one in which it gained 78.2% from Feb. 20 to Oct. 2 of 2009 -- gets strong interest from my James O'Shaughnessy growth model and my Warren Buffett-based strategy. To find out more about the stock's fundamentals, see the "Detailed Stock Analysis" section below.
Petroleo Brasileiro SA (PBR): Brazil-based "Petrobras" is active in 28 countries, and is one of the world's largest integrated oil and gas companies ($146 billion market cap). It gets high marks from several of my strategies, including my Peter Lynch-, John Neff-, and James O'Shaughnessy-based models. To read more about it, scroll down to the "Detailed Stock Analysis" section below.
News about Validea Hot List Stocks
AsiaInfo-Linkage, Inc. (ASIA): AsiaInfo's shares tumbled last week after the stock was downgraded from "positive" to "neutral" by an analyst, who cited industry concerns. Through Sept. 28, the stock was down about 23% since the Hot List acquired it on Sept. 2. The firm's fundamentals remain intact, however, and the Hot List is holding onto the stock.
GT Advanced Technologies (GTAT): Like those of many solar industry firms, GT's shares have fallen sharply since our last newsletter. A few reasons seem to be behind the decline, including the controversy surrounding solar firm Solyndra, a glut of solar panels, and falling prices for the panels, according to Forbes. My strategies remain fairly high on GTAT, but not high enough. Other options have passed it by, and it's being sold from the portfolio this week.
The Next Issue
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