Here's Why We Think Stocks Will Rise

At our Investment Policy Committee meeting today our discussion focused mainly on three topics. 1) Is the risk discount built into current stock prices excessive? 2) How tightly is the US economy tied to Europe? and 3) How tied are the companies we invest in to either the US or European economies? 1) The Committee believes that by almost any traditional measure, today’s stock market (S&P 500) is significantly underpriced. Current estimates of 2010 and 2011 corporate earnings have held at their current high levels for weeks – right through the Greek debt crisis, China economic slowdown fears, Korean conflicts, volcanic ash-induced slowdown of European commerce, etc., etc. In addition, Q1 earnings exceeded analysts’ estimates by a near record level. In fact, total corporate profits for the entire US economy on a rolling 12 month basis as of 03/31/10 were just 6% below their record high in Q3 2006. Finally, employment costs, inflation, and interest rates are low and unlikely to increase much this year, adding up to a very favorable earnings environment. Using almost any traditional measure of stock market valuation, the market is undervalued. Using the “Fed Model” (Est Future Earnings/ Current Stock Price = Yield on 10-yr Treasury Note) the S&P should now be at 2562 vs. its actual level of 1085 – a 57% discount! It’s reasonable to argue these are exceptional times, especially for Treasury yields. With the world fleeing European debt and buying US debt, Treasury yields are exceptionally low. So, to be exceptionally conservative, we could use a more “normal” 10-yr yield of 5% instead of the current 3.3% and we could use low historical earnings instead of high estimated future earnings. Even with that calculation, the market should be 20% higher, or about 1296. ( DCM has previously estimated 12/31/10 S&P 500 to be between 1200 – 1300.) Today’s market valuation is low primarily due to perceived risk, not low projected profits. That risk has mostly come from fears that the Greek debt crisis would pull down Europe, and then the rest of the world. Europe has definite problems, but the recent $1 trillion bailout we believe has successfully bought a few years of time to fix them. Therefore, we believe the current “risk discount” for US stocks is overdone and is more due to a holdover of fear and anxiety from the 2008 – 2009 experience. Once the world sees that Europe is not going to collapse, we fully expect market valuations to edge back up toward the historical norm. 2) We have previously discussed estimates that 25% of U.S. corporate earnings comes from Europe. New data from the Bureau of Economic Analysis estimates that now only 20% of U.S. earnings come from exports to Europe. Two observations, the estimates are getting lower, not higher. And, both are in the 20% - 25% range. Europe has been losing significance to US multi-national companies for a few years because growth has been so scarce in Europe. Twenty percent of sales and earning is not insignificant, but even if Europe has more trouble than we now forecast, sales and earnings aren't going to zero, thus we believe the US stock market is overreacting to the goings on in Europe. 3) We have long said that we don’t invest in economies. We invest in companies. The data on corporate earnings discussed earlier show that U.S. companies in total are expecting to increase earnings dramatically in 2010 over 2009, and as much as 20% again in 2011. An estimated 60% of U.S. exports goes to developing economies like China, India, and Brazil. Each of these countries is expecting near double-digit GDP growth this year. Even for the Rising Dividend companies that do not have large export businesses (mostly the banks and utilities) overall economic growth does not necessarily dictate individual company growth. In fact, even in the terrible economy of 2008 – 2009, there were still winners, both relative and absolute. Since we choose Rising Dividend companies in part based on their proven success at outperforming competitors, we believe that many, if not most, of our companies will do well even if the world GDP grows more slowly than we expect this year. Most large companies these days really are more global than domestic. Many derive far less than ½ of their business from inside the U.S. We believe that gives them a greater opportunity to grow earnings at a much faster rate than the economies of any of the developed nations of the world. Back to #1, we observed that institutional investors (think big investment banks, brokerage houses, etc.) now represent 70% of market volume, double the 35% they represented in 1975. And, we have seen statistics that claim on a given day, high-speed, computer–driven trading, alone, can be 70% of total volume. That means on many days, market prices are determined by very short term (even nanosecond) factors, not long-term fundamentals. Since this short-term trading tends to accentuate, not reduce momentum, then up days go higher and down days go lower than if the day to day market prices were determined by investors buying a stock to hold for years…or even months. This short-term trading certainly adds to volatility, but it cannot indefinitely hold back the stock prices of companies that truly increase value for customers year after year. For many of the stocks we hold, the correlation between dividend growth and price growth is over 80%. The price growth does not come in a tit-for-tat basis but "equalizes" about every two to three years. We see countless valuation charts that indicate many of the companies we hold are undervalued in the range of 30%-40%. In the past 3 months, 9 Cornerstone model companies increased their dividend by an average of nearly 9%. The value creation continues. In short, the Committee continues to believe that earnings and dividend growth will ultimately win the day (as they always have), and the market will push to much higher levels. The unanimous feeling among our 5 portfolio managers was that it is a great time to buy great companies at great prices. Sources: briefing.com; Yardeni.com; and, Bloomberg