The reasons given for a stock sell off are full of language about momentum, price gains, and too much-too soon. We want to add very quickly that few of the "stocks are too high" crowd today were among the "stocks are too low" crowd at the market bottom in March of 2009. Indeed, if you go back to their blogs and read what they were saying around the bottom of the market, you will find many of them were saying "stocks are too high," even then.
In the blizzard of words we see written about the stock market, we seldom see the word valuation. Valuation, it would seem, has no meaning in a high-octane traders' market, where computers are trading with computers for about 70% of the daily volume. Individual investors seem to have decided that long-term value investing has gone the way of the Oldsmobile.
Ah, but we beg to differ! In the long-run, valuation will rule just like it always has.The reason is over the last 80 years, S&P stock prices are highly correlated to both After Tax Profits and Dividends. The computers and traders will wage their daily battles of betting on zig or zag, but in the long-run, zigs and zags will ultimately be seen as vanity, a chasing after the wind.
From a valuation perspective, stocks are still cheap and could only become expensive if the economy were to fall off a cliff and drag earnings and dividends with it. The chart below shows index of the S&P 500 (red line) compared to Total U.S. After Tax Profits Index (blue line). Please note that After Tax Profits reached an all time high in December of 2010 and, based on S&P estimates, will rise by nearly 13% in the second quarter of 2011 versus the same quarter a year ago. Tracking the After Tax Profits Index is our favorite way of measuring earnings, because it measures only earnings that companies actually paid taxes on.
The graph below vividly shows that while After Tax Profits have reached an all time high, the S&P 500 has not. In fact, the chart suggests that the S&P has a long way to go to reach fair value.
Corroborating the view that stocks are still undervalued is the graph of the S&P 500 Index (red line) compared to Total Corporate Dividends Index (blue line). Total Corporate Dividends paid is an important indicator of the health of the current turn-around in the stock market, because dividends are paid in cash and not promises. As the chart shows, dividends took a hit during the sub prime crisis. Importantly the chart also shows that they have turned higher. S&P is predicting that dividends will grow nearly 10% on a year over year basis for the first quarter of 2011. Dividends have not reached a new high, but we believe the old record will be eclipsed over the next 12 months. This would be good news for continued stock price gains.
These two simple, yet important measures of stock market valuations are still flashing green. That does not mean that stocks will go straight up from here. In our judgment, it does mean, however, that saying stocks are too high is nonsense, and "Sell in May and Go Away" is worse.
