Wednesday, August 23, 2006
From a pure statistical perspective, stocks, bonds,inflation and the economy are all about normal. Three years of terrific earnings growth and lackluster price growth from large caps have driven PEs back to historical norms. Based on 2006 earnings, both the S&P 500 and the Dow Jones 30 are trading at about 14.5X earnings, which is near their 80 year averages (Down from 30+ PE in 2000). Inflation, on a year over year basis, is about 4%, again at approximately the long-term average of inflation. The 30 year Treasury bond is about yielding 5%, just under the long-term average of 5.5%. Annual GDP growth is approximately 3.5%, you guessed it, near the long-term average. Since we all know there is no such thing as an average market, what do all these reversions to the mean, mean? You can think about this for a few minutes or a few weeks and you will come to the same conclusion: both the stock and bond markets are signaling slow growth and a fair amount of confusion. If we extend all of the normalcy we have identified here, the market appears to be saying that we cannot expect any more earnings growth for the next several years than the 80-year average of 7%. If this is the case, then my recent mantra of big over small, value over growth, and dividends over all makes more sense. If 7% earnings growth is about all we can expect from the average stock, why not take the less risky route of high quality, dividend-paying banks, utilities, and REITs that yield 4% or more with secure dividend growth of 3%-9%, and selected energy,industrial, and consumer staples companies that offer 2%-4% dividend yields and 7%-12% dividend growth? Tech is anybodies guess, basic materials don't work well in slowing economies, consumer cyclicals have housing weakness and energy cost headwinds; and telecommunications are running in place. With the US economy slowing, doesn't that put question marks on China and the emerging markets? Finally, why do I want to pay near 18X earnings for small and midcap stocks that pay little or no dividends and take the chance that they can dodge the slowing economy. Things can always be different this time, but will they? Big money goes where it is treated the best. It has been in cyclical, international, and riskier small and mid caps for the last 4 years and has been rewarded handsomely. However, the flight path of the economy over the next two years appears to be down and, as earnings accidents become more widespread among the more economically sensitive sectors, the move to large, quality, dividend-paying companies will accelerate. That is what normally happens, and it's a hard to argue that things will not be "normal" this time.