The Bubble Burst on this Former Industry Stalwart
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Barron’s recent publication puts John Hussman in the spotlight. He says that now is the worst of times to buy stocks. I couldn’t disagree more and I will highlight the reasons below. It also makes me wonder when the financial world, both stock investing and economics, will stop giving press to those who consistently get it wrong. Sure, Hussman has a decent ten-year record, but talk about stumbling down the stretch. He hasn’t won a game in three years and in NCAA basketball parlance, his bubble has burst and he won’t be receiving an invitation to the Big Dance.
Barron’s notes that his Strategic Growth Fund (HSGFX) has done five times better than the S&P 500 since June 2000, the date of the fund’s inception. Maybe so, but he is now living in the perma-bear camp and appears unable to grasp current realities. I think most of this is because of the flawed Shiller P/E that he vastly overstates. His fund is down 5.3% YTD through 3/9/12 against a +9.4% total return for the S&P 500. Ok, what about three years? Surely that would be a decent indicator and should have some weight regardless of how well he did a decade ago. Well the Strategic Growth Fund is down 5% over the last three years against a total return of +115% for S&P 500. Oops!
The Shiller P/E, available at this link, takes the current price of the S&P 500 and divides by the average earnings over the last ten years. It is great in theory because you get a valuation of mid-cycle earnings, which is better than getting too giddy when earnings are peaking or too bearish at earnings troughs. Unfortunately, this tool is only good in theory. First off, the ratio is now incorporating two recessions and starts in early 2002, the exact earnings trough for that recession. Thus, the average earnings will climb each and every month for at least the next couple of years. This will put downward pressure on the Shiller P/E if everything else remains constant. Secondly, the Global Financial Crisis was unprecedented in what it did to S&P 500 earnings- collapsing real earnings by more than 90% according to the data provided by Robert Shiller himself.
Let’s do a hypothetical flash forward to 2018. The beginning of the ten-year window will still incorporate the GFC and the Shiller P/E will be artificially elevated due to this unprecedented collapse in earnings that happened NINE years earlier. If the S&P 500 remains unchanged through 2019, the Shiller P/E will collapse as the GFC earnings, or lack thereof, are rolled off. So one day the market will be extremely overvalued and a year later, with no change in price, it will be extremely cheap. That does not make any sense. The flaws are just too obvious to look at this ratio and take it as fact.
The other reason Hussman, and many others, say to wait before adding to stocks is the current elevated sentiment readings. Sentiment levels get a lot of press, but are not good indicators at identifying market tops. They are EXCELLENT at identifying market bottoms, but not tops. For example, the American Association of Individual Investors (link) has historical data back to 1987. Excessive bullish readings, at least 60% bullish, were recorded in 1987, 1992, 1996, 1997, 1999, 2000, 2001, 2003, 2004, and 2010. Certainly, there were a couple bad times to invest, but there is no clear trend or warning sign. How about 1992? That would not have been a good time to go full cash as it was right in the middle of the greatest bull market of all time. Same goes for 1996, right before the market was about to double over the ensuing four years. The market advanced 28% in 2003 and another 10% in 2004. When was the last reading above 60% on the AAII sentiment survey? December 23, 2010 with a reading of 63% bulls and the S&P 500 has since produced a total return of +12% through 3/9/12. Long-term investors should ignore sentiment as a sell indicator.
So what is the best valuation indicator for long-term investors? My preferred method has the fair value on the S&P 500 above 1600, almost 20% above current levels. I won’t get into the details, but instead provide a link. Essentially, when you have earnings advancing, low inflation, and ALL central banks easing, it is a wonderful time to be accumulating stocks!
One stock for a rising market
Investors should consider Hartford Financial Services (NYSE: HIG) as a viable option in the financial sector. Hartford Financial Services is a leading provider of life, retirement products, and property/casualty insurance to individual and institutional customers. The company’s products include annuities, workers compensation, auto and homeowners insurance, life insurance, and mutual fund services. Their core earnings are evenly split between life insurance and property/casualty.
The Global Financial Crisis brought the company to its knees and they were likely saved by the alphabet soup of government/FED programs enacted during the worst of the crisis. The Hartford was an aggressive leader in the variable annuity space prior to the recession. They increasingly offered higher guarantees of minimum returns to sell product. When the crash ensued, the company’s risk management failures were exposed. The stock price would plummet from $106 to less than $4 per share!
Today, the company continues to struggle under the weight of its previous decisions. Management has been turned over, 30% of the business has been placed in run-off, and the life segment remains weak. The company remains highly sensitive to equity market performance as a result of their variable annuity business.
The valuation on this stock is extremely cheap and one of two key factors in a bullish call. The price-to-book is currently just 0.4x, the lowest in the entire industry and HALF the industry average of 0.8x. Valuation is partially justified with an industry low ROE, but I still think it has carved out a bottom.
A rising equity market is the second reason to favor HIG in the financial space. It has significant exposure to such a scenario and if investors think markets have substantial upside, it makes logical sense to own a name highly levered to such a scenario. Since the stock market bottomed on March 9, 2009, HIG has outperformed during market rallies. The initial rally was mostly because it wasn’t going bankrupt and the biggest losers during the downturn were the biggest winners in the initial months of the rally. However, it has vastly outperformed on two other occasions. The stock rallied 50% from 8/31/10 to 2/16/11 against a 28% rally in the S&P 500. And most recently, gaining more than 40% from the fall 2011 low to today’s writing. This is a notable outperformance to the 24% rally in the Index.
Two more names to consider
Textron (NYSE: TXT) is a diversified conglomerate comprised of business jets, helicopters, military, and industrial segments. Annual sales exceed $11 billion and the company has a market capitalization above $7 billion. The company’s earnings are roughly 1/3 defense with very stable cash flows, 1/3 Industrial with GDP type growth, and 1/3 business jets, which I believe offers extreme upside. The stock has rallied notably of late, but has tremendous upside potential over the next five years.
A name that offers a similar story, but a bit more defensive, is General Dynamics (NYSE: GD). General Dynamics is a key military contractor and operates in segments such as tanks, munitions, submarines, military communications, and aerospace via its Gulfstream brand. The company gets about 70% of revenues from the Department of Defense and approximately 20% from its Gulfstream segment. General Dynamics ended 2011 with sales of $32.6 billion.
This stock gives you the business jet thesis and a compelling valuation. The FCF yield of 10% and price-to-earnings ratio of 10x are both significantly cheaper than the market average. This stock has great dividend attributes and makes a good addition to anyone’s portfolio. The dividend yield is an above-average 2.6%, the payout ratio a modest 26%, and the five-year average dividend growth rate is a strong 15%.
Technology price-to-earnings ratios are near an all-time low
The S&P 500 Technology sector is trading with a price-to-earnings ratio on par with 1994 and offers a compelling opportunity. There seems to be plenty of pent-up demand from investors that either doubted its long-term viability or simply didn’t understand it enough to invest their hard earned money. Below are the two largest technology companies by market capitalization and they make viable candidates for any portfolio.
Apple (NASDAQ: AAPL) designs consumer electronic devices that are becoming ever more mainstream. Their PCs (Mac), tablets (iPad), phones (iPhone), and music devices (iPod) continue to gain market share amid industry leading innovation. The stock has exploded to the top of the pack in recent years and will have a big influence on how the technology sector performs. There are literally thousands of opinions on this stock, but just looking at the valuation of it, and others on the current list, there doesn’t seem to be any major warning flags.
Microsoft (NASDAQ: MSFT) is the largest maker of enterprise and consumer software products with $70 billion in revenues. The main business divisions are the Office suite (32% of sales), Windows operating systems (27%), Server and Tools (24%), Entertainment (13%), and Online Services (4%). Their market cap declined by $63 billion despite earnings-per-share of $2.64 in 2011 versus $0.93 in 2002. The culprit was a collapse in the P/E ratio from 34x to 11x.
Ignore Hussman and the perma-bears that have been wrong for three years and counting. Also ignore the perma-bulls that were outcast in 2009, but are starting to make it back into the media spotlight. Use common sense and be flexible. Rising earnings, low inflation, and the fact that every central bank is easing monetary policy make for a potent concoction. I highlighted five stocks that I think are viable buy candidates, but the bottom line is that long-term investors need to accumulate stocks and stay clear of cash, Treasuries, and low yielding corporate bonds.
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