Both the Dow Jones Industrial Average and the Standard & Poor’s 500 stock index hit record highs this year despite concerns about high energy costs, the housing market slump, tightening credit markets, persistent inflation fears and a slowing economy. But recent sharp pullbacks left many investors wondering whether they would face a new version of what happened in 2000-when the tech-stock bubble burst and a bear market drove down prices for years.
Are we facing Bubble II? Recently investment strategist Edward Yardeni was asked that question, and his answer was a resounding “No!” In 2004, at a time when the stock market was struggling, Yardeni forecast a rousing bull market. He was right. Now he explains how 2007 is different from 2000 and why he thinks that despite pullbacks, stock prices will continue to move higher in 2007 and beyond…
Stocks are not overvalued. The price-to-earnings ratio (P/E) of the S&P 500 stocks averages 17 now, based on earnings for the past 12 months. That’s close to historical averages and far below the P/E of 29.4 that was reached in 2000. Reason: This bull market has been built on earnings growth, not on unreliable measurements of value that many tech companies were inventing seven years ago. Since then, profit growth among US companies has risen much faster than stock prices.
It’s not just tech stocks going up. The range of companies whose stock prices were soaring in 2000 was very narrow. In the current rally, stocks of all sizes and styles have risen, led by laggards of a decade ago, such as energy and commodity companies. This confirms that economic prosperity and corporate profitability are much more broadly based.
This bull market is global. The economic boom in the 1990s was centered around the US. The current global economic expansion is more diverse and more sustainable than any other in the past half-century. Emerging markets now are major contributors to global economic activity. These trends are creating prosperity around the world. They will keep US markets rising much longer than in previous eras.
Inflation is tame and will continue I to be low. It looks as if the Federal Reserve will pull off a soft landing for the economy, slowing growth to a manageable pace while staving off recession. Core inflation remains subdued at about 2% as productivity continues to grow at an annual rate of about 3%. Global competition should continue to keep a tight lid on inflation because products and services are available from many sources.
Easy money will continue to drive domestic and overseas markets. Long-term bond yields remain stock-friendly. Even though the yield on the benchmark 10-year Treasury note has increased to around 5%, that’s lower than the 6.17% level at the 2000 market peak. Interest rates remain low enough to keep the economy and corporate profits growing.
Also, US policies concerning interest rates, government spending and trade have combined to create what may be one of the most bullish environments ever for stocks.
A significant amount of money that Americans have sent to other countries by buying their products has poured back into the US as foreigners bought nearly $1 trillion in US stocks and bonds over the past 12 months, suggesting that they have confidence in, the US economy. S&P 500 companies have used strong cash flow to fund shareholder-friendly actions-including more than $110 billion in stock buybacks in just the first quarter of 2007.
Mergers and acquisitions should keep stocks buoyant. Because credit has been cheap, private-equity firms have aggressively purchased underperforming public companies at lofty prices.
Of course, tighter credit conditions are likely to stop most of the more speculative deals, but that is a good thing.
Activity in “strategic” mergers and acquisitions motivated by sound business goals should remain strong.
HOW TO INVEST NOW
Corrections that pull back the stock market by 10% or even more are possible in any market environment. The recent turmoil in credit markets may continue to weigh on stock prices for a while longer. And a super-spike in gas prices caused by some terrorist action…or an unforeseen economic implosion in a place such as China, could have an immediate and dramatic effect. put all the current conditions suggest that stocks overall will move higher and that any pullbacks will be short-lived-and provide opportunities.
While I’m not expecting the market indexes to post 20% annual gains as in the 1990s, tangible economic growth around the world will mean returns in the 10% range through the end of this decade and beyond.
Recommended portfolio allocations for small investors: 75% in stocks, with emphasis on today’s most undervalued category, which is large-cap growth stocks…25% in bonds, with emphasis on high-quality, short-term debt, because yields on higher-risk bonds currently are not compelling.
SECTORS TO FAVOR
Financials. I especially like industries that benefit from the increased demand for self-funded retirement accounts and health insurance, such as asset-management companies and health and life insurance firms.
Energy. There is plenty of upside left, although these stocks will be very volatile. I like the earnings momentum at drilling and equipment firms.
Industrials. This sector provides a good way to play the global economic boom without being overexposed to the volatility of commodity prices. I like aerospace and defense companies… farm machinery and heavy truck companies…industrial machinery manufacturers…and railroads.
SECTORS TO AVOID
Utilities. This sector has had a huge move up in recent years, thanks in part to the low 15% tax rate on dividends. But it also has among the highest P/Es of any stocks in the market. With the yields on bonds (which compete with many utility stocks for investors) moving higher, it’s time to lighten up on utilities.
Consumer durables. I would notbe a bottom picker here. And for now, avoid anything housing-related, such as builders and mortgage lenders.
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September 20th, 2007 at 9:17 pm
I don’t buy it. First, a P/E of 17 is only a 5.9% earnings yield. Doesn’t sound too exciting to me. And even that number is based upon recent earnings, which I believe are unsustainable as pointed out in my market timing article http://www.investingminds.com/a/2007/07/19/does-market-timing-work/. And lets not forget that there have been periods when the P/E ratio has been in the single digits.
Furthermore, Fed easing is only going to result in inflation and feed the next bubble - yet to be determined. The dollar is crumbling and with it commodity prices are soaring.
I’m only 60% stocks.
September 22nd, 2007 at 5:48 pm
I’m shocked that someone as bearish as you would hold 60% of their portfolio in equities. If a 17 P/E doesn’t excite you, why in the world would you hold 60% of your portfolio in equities? P/E ratio in single digits? Hmmm, I think they called that the Great Depression. Are you telling us that you believe we are at risk of entering a depression? If so, why do you own any equities?
Yardeni, who happens to have been a very well respected Wall Street economist and market strategist for the past 30 years, and who as well has had as good a track record at forecasting economic growth, interest rates and stock market returns as any analyst I am aware of to date, is not suggesting the market is inexpensive relative to Depression era returns, but simply that valuations are near historical averages and certainly not overvalued when compared to valuations that occurred at the end of the millenium. Given an outlook for continued economic growth, Yardeni’s view is for a continued rise in stock market valuations. A not unreasonable assessment.
October 15th, 2007 at 5:27 am
Portfolio management shouldn’t be binary. Even if you are in a bubble there is no way to know how long a bubble will last. The NASDAQ was overvalued for years before it deflated. It’s more prudent to modify your asset allocation. For me, someone who was 100% equities for almost 20 years, 60% is very bearish.
As for the P/E ratio, it was in the single digits during the 80s also. It’s not beyond the realm of possibilities. Large deficits, a plummeting dollar, rising commodity prices, large debt loads, a mortgage crisis, plummeting home prices, inflated profits, and a looming environmental crisis scare the heck out of me.