...earnings recovery is in full swing.
I'm Finally Turning Bullish
By Donald Luskin
June 14, 2002
I'VE WRITTEN MANY times in this column that stocks are overvalued — especially technology stocks — even after two years of pain following the great market top of March 2000. But now, economic recovery is beginning to spill over into a recovery of corporate profits, even though that fact is scarcely discussed in the media.
With the market getting near the lows established after the Sept. 11 terrorist attacks, I'm beginning to change my tune. Technology stocks are still too pricey for my taste, but on average, across the market as a whole, valuations have finally come back into the range that has historically been considered normal — and this could represent a significant buying opportunity.
It's been 5 1/2 years in the making. As I wrote here on May 10, the stock market, in December 1996, launched into a prolonged period of consistently high valuation. Ever since then, the prices that investors have been willing to pay for stocks have been far greater in relation to average expected earnings than ever before in postwar history. Ironically, this period of high valuation began almost immediately after Federal Reserve Chairman Alan Greenspan warned for the first time of "irrational exuberance." Only during the panics of October 1998 and September 2001 did the markets return — and then only briefly — to anything like what Greenspan would consider "rational." Those brief moments proved to be bottoms. We might be approaching such a moment right now.
A handy yardstick for measuring market valuation is what I call the "yield gap." To calculate the yield gap, you start with the average consensus earnings forecast for the coming year for all of the stocks that make up a broad-based index such as the Standard & Poor's 500. Right now that's 56.49, and with the S&P 500 at 1009 at Thursday's close, those earnings represent 5.6% of the index's price. Think of 5.6% as the "earnings yield" of the stock market — the value of all the profits you'd be entitled to pocket if you owned every share of every stock (and if all of the earnings forecasts turn out to be true). Now compare that 5.6% earnings yield with the absolutely riskless yield of 5.5% that you could lock in today if you bought long-term Treasury bonds instead. The difference between the earnings yield of stocks and the income yield of bonds — 0.1% — is the "yield gap."
When the yield gap is positive, it means that the risky stock market is priced to pay more than the riskless bond market. When it's negative, stocks are priced to pay less. This measure of value is more robust than just looking at price/earnings ratios. For one thing, the yield gap looks at estimates of future earnings. And for another, it compares those with current interest rates, which represent competing opportunities for investors' dollars.
The chart below shows the history of the yield gap for the S&P 500 from January 1985 to Thursday, June 13, 2002. The average is negative 0.2%. The fact that the average is negative suggests that, on average, investors have been willing to accept a lower earnings yield for stocks — even though stocks are riskier than bonds — because they expect the earnings of stocks to grow, while the yield of bonds is locked in. Today the yield gap is positive by just a little bit — 0.1% — and that puts it 0.3% above the average. As you can see on the chart, that's not a place it has visited very often lately.
The "yield gap"
S&P 500 earnings yield versus 30-year Treasury bond yields
Source: Trend Macro
This means that by the standards of the last 5 1/2 heady years, stocks are cheap. Over the longer sweep of history, they've been even cheaper, and they could certainly get cheaper from here. Indeed, the deeply negative sentiment that pervades the market would suggest that there are lower prices ahead. And yet that's precisely the sentiment that one sees at market bottoms. Remember how everyone felt last Sept. 21?
But there's more than mere sentiment behind my suspicion that the market could find support and move higher off of these levels of relatively cheap valuation. Even as it seems that the much-touted economic recovery isn't taking hold very strongly, a significant — and underpublicized — resurgence in corporate earnings has begun. But you have to know where to look in order to see it. And where not to look.
The earnings resurgence is masked because the earnings of technology and telecom companies in the S&P 500 aren't rebounding at all. After a brief recovery in January, they turned south again, and are now making new lows at an annual rate of $52 billion — following their calamitous cascade from their peak in October 2000, when they were $109 billion. No wonder sentiment is so bad: These are the companies that many individual investors still have the highest hopes for, yet they continue to turn in worse and worse earnings performances.
Annual earnings: S&P 500 Technology and Telecom stocks
Source: Trend Macro
But take a look beyond tech, and you'll like what you see. The S&P 500 companies other than technology and telecom are now generating earnings at an annual rate of $385 billion — only 3% less than their all-time high of $397 billion in May 2001. For these companies — which represent collectively about 80% of the market value of the S&P 500 — the recession hasn't been a wipeout, merely a hiccup. And the recovery has been robust and sustained.
Annual earnings: S&P 500 Without Technology and Telecom stocks
Source: Trend Macro
As readers of this column know, I've been bearish for a long time. And I'm still bearish about technology stocks. As a sector, they're still overvalued by the same yield-gap method I've talked about today, and there's no sign of earnings recovery. But forget about tech stocks and look at the overall market. On an aggregate basis — even factoring in the overvalued techs — the market is now a little bit undervalued. If you take out tech, it's greatly undervalued. And an earnings recovery is in full swing.
There are no guarantees in this game. But the stars are aligning: the best valuations in 5 1/2 years, and an earnings recovery that no one seems to know about. This bear is starting to get interested in stocks again.
Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com. |
