Thursday, December 30, 2010

The Rising Tide May Keep Rising

As of this morning, the S&P 500 is up over 13%, including dividends, for 2010.  This performance is significantly above long-term average returns, and remarkable when considering all of the headwinds that the markets faced in 2010.

These impressive results are largely due to the exceptional growth in corporate earnings, which will increase nearly 47% over 2009.  Of course, the above average growth in both stock prices and corporate earnings came after exceptionally low earnings and market prices in 2008 & 2009.  The S&P 500’s current Price/Earnings ratio (P/E) will be about 15.0 for 2010, modestly below the long-term average.  We see this as evidence that the market has not rebounded excessively from the low in March, 2009.   Rather, it is much more likely that the March 9, 2009 S&P 500 low of 676 was excessively low.

In our view, the overshooting of a “fair value,” be it a high or a low, has become the new normal of the stock performance.  For a number of reasons, we believe it is becoming increasingly possible that US stocks could overshoot on the upside over the next year or two.   Part of this is based on our view of how human emotions influence stock market movements.  At times, it seems there are only two emotions, at least when it comes to investing – fear and greed.   When a market trend, which may have begun for legitimate reasons, reaches a certain point, it often becomes self-sustaining and poised for an overshoot.

That is, the market often moves in a direction primarily because it has been moving in that direction, not because of underlying fundamentals justifying a continued rise or fall.  People tend to believe that what has been happening will continue to happen.  Their fear or greed amplifies that tendency, and the market overshoots or undershoots, as the case may be.  Also, with roughly 70% of all trades today being driven by electronic algorithms meant to capitalize on momentum and not fundamental values, volatility and overshoots are further amplified.

There are two catalysts we see forming that could send stock prices much higher in the coming year: 1) Many Wall Street economists have recently hiked GDP growth for the coming year as a result of the stimulus effect of the $858 billion Tax Relief Act of 2010.  The curious thing to us is that Wall Street has not increased 2011 earnings estimates materially in weeks.  We understand GDP growth does not fall directly to earnings, but we believe earnings are likely to grow faster in 2011 than investors now predict. 2) The other catalyst is the likely reversal of the 2008-2010 money flows out of stocks and into bonds and cash.  

The nearby chart shows a nearly $1 trillion cumulative difference in money flows out of stock mutual funds and into bond funds from December 2007 to today.  Adding to this the similar money flows out of individual stocks into individual bonds and short-term bank CDs, means there are trillions of dollars currently sitting in extremely low yielding investments that were formerly in stocks.

As fear continues to subside and economic growth continues to climb, we believe more and more investors will shift their assets back to stocks and out of bonds and cash.  Stocks will end 2010 nearly 90% higher than at the bottom in March of 2009.  There are certainly still doomsayers aplenty, but a recovery of the magnitude that we have witnessed is just too big to ignore.  In short, a 1% CD is starting to look pretty paltry compared to the performance of quality stocks over the last two years.

It is possible that this bond to stock shift will be gradual enough not to cause stocks to become over-priced.  We hope that will be the case.  However, as the chart below shows, over the last 15 years stocks have gone from overvalued to undervalued with regularity

This is where our dividend investing philosophy should serve us well.  As we have said before dividends fill two important roles for us. 1) They are real cash and have represented over 40% of the total returns of stocks since 1926; 2) Companies that pay a consistently rising dividend can be more accurately valued than non-dividend payers or irregular dividend payers.  Our dividend valuation models give us a ballpark idea of the “fair value” of a company at any point in time.  In our minds, as stocks continue to march higher, our models will be very helpful in assisting us in knowing when the fair value line has been crossed.

We will offer a few counterpoints to this bullish view for stocks in a coming blog.  As always, there are some clouds on the horizon.