# Why it's Time to Go Back to Blue Chips

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If, like me, your eyes glaze over with boredom every time one of the financial media channels wheels out Jeremy Siegel in order to argue that equities look cheap relative to bonds, you would be entitled to view the following article with great circumspection. Yes, stocks do look inordinately cheap on a relative basis but no, that is not my point. The aim of this article is to demonstrate that stock prices and evaluations really are moved around by sentiment rather than any strict adherence to relative evaluations.

I’ll start this tortuous discourse by looking at a long term chart of the equity risk premium as defined by comparing E/P (for the S&P 500) versus long term interest rates (US 10 year treasuries).

A few things are immediately apparent. Equities certainly look relatively cheap right now but then they spent a large part of the 50’s looking even cheaper. Similarly, there is a long period in the 70’s where equities looked cheap. There is also a remarkable period from 1980-2000 where this relationship holds in sync. In fact I am going to contend that it was this period that contributed so much to the structure of the financial crisis.

What happened from 1980 to 2000?

In order to demonstrate this relationship between equity evaluations and interest rates, I am going to perform a regression analysis on the data. Now, hold on, before you run off! It’s not really that complicated.

Essentially, it is just a way of measuring correlation (or rather R^2) between two data series. Simply speaking, the closer the R^2 gets to 1, the closer the two data series move with each other. Here is what happened between 1980 and 2000.

The x-axis is the interest rate and the y-axis is the E/P ratio. Note that the R^2 is remarkably high here.  In addition the best fit equation is suggesting that if long term interest rates are say at 5% the correct E/P ratio should be .9894*5-1.6431=3.3 and the P/E is then likely to be 30.

Granted some of this data is skewed by the nutty period in the late 90’s but nevertheless the relationship is quite accurate over those 20 years.

A graphical depiction of those 20 years here.

This wasn’t just a chart; it was a way of life. A 20 year bull market in which any objector was swept aside in the rush to get long. Not only were they swept aside, but the guys who took on the most risk were the ones rewarded the most. There are a lot of heroes in bull markets.

Unfortunately, this is likely to have caused a concentration of uni-directional ‘punters’ who don’t really understand risk at the higher echelons of the financial services industry. And, boy, did the financial services industry do its best to prove this theory right!

What About From 2000 to Now?

I chose the phrase ‘uni-directional’ carefully, in order to express that this is not just about someone who wants to be long only equities. That game went out of fashion in 2000, as we can see from a chart of the equity risk premium during the period.

Equities start off the decade being expensive, then the crash comes and they are historical cheap from '04-'08. The recent recession definitely wasn’t caused by equity overvaluations, but it was caused by the self same people who had been promoted in the 20 year bull market. They took their ‘skills’ and knowledge of risk and applied them to the next investment fad, in other words housing. The truth is that no one wanted equities post the dot-com crash and everyone wanted commodities, China and housing. Some of that has changed now.

However, the key point for this article is that the relationship between bonds and equities did break down in this period, and it is a fallacy to regard this relationship as something inevitably mean reverting. In addition, the equities that did outperform in this period were small caps rather than large caps.

Where to Next?

Having established that the bonds/equities relationship is nothing set in stone and really a ‘marker’ of investor sentiment and asset class preference, I am now going to argue that good old fashioned blue chip equities could be the way forward!

Purely by way of example here are some current PE ratios and dividend yields for some of the largest cap stocks in the US.

Now if investors can take a long term view then these sorts of stocks look like good value right now. You don’t even have to rely on the equity risk premium to justify these valuations. Wal-Mart (NYSE: WMT) is likely to have its long term growth rate align with the US economy. Coca-Cola (NYSE: KO) arguably has good long term growth prospects within emerging markets and people won’t stop drinking soda anytime soon.  The market may fret over the patent cliff and future reimbursement issues but Pfizer (NYSE: PFE) looks like good value and has a few very exciting drugs in its pipeline.

Another company experiencing short term worries recently is McDonald’s (NYSE: MCD) as the market concerns itself with its European exposure. So what? In the long term the company has a great brand and lifestyle changes (single parent families, trading down etc) are favoring it.  Everyone hates the banks –me included- but as we’ve seen the politicians bend over backwards to keep these guys afloat, perhaps it’s better to look at JPMorgan (NYSE: JPM) and conclude it will get over its short term trading difficulties?

Over the last decade or so we’ve had an emerging market bond bubble, a gold boom, localized housing booms all over the world, small caps outperforming, a commodities boom, a boom in leverage etc. In other words, investors have wanted anything but large cap equities.

Perhaps it’s time for blue chips to make a comeback in sentiment? And if they do, it will be sentiment rather than anything that Jeremy Siegel and the equity risk premium enthusiasts tell you about it.

SaintGermain has no positions in the stocks mentioned above. The Motley Fool owns shares of JPMorgan Chase & Co., The Coca-Cola Company, and McDonald's. Motley Fool newsletter services recommend McDonald's, Pfizer, and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.