The article below is taken from Prudential Securities' website:
Flat Out Bullish on Long-Term Equities
By Edward Keon, Jr.
Despite dramatic moves in U.S. financial markets that caused significant shifts in our recommendations over just a few days, we are not changing our recommendation to shift funds towards somewhat riskier assets, both equities in general and technology and growth/cyclical stocks in particular.
We think the numbers say 'buy stocks.' There are of course no guarantees that the past and historical relationships will repeat. We would not minimize the risks and uncertainties that investors face today: There's a war on, and the economy remains weak. But in our opinion, these risks are adequately reflected in equity prices, and we think that the outlook for stocks looks better from a quantitative perspective than it has in five years. Of course, past performance is not a guarantee of future results. Each historical event is unique, and so are market reactions.
We repeat the need for diversification across asset classes and sectors; we do not encourage concentrated equity portfolios. But we do think it is time to tilt towards somewhat riskier assets.
Technology was a winner in October. To recap our positions since the September 11 attacks, our historical analysis of the Gulf War and World War II suggested that the markets would probably dip for a few months, then recover and shift away from safer stocks towards risky stocks. On October 1, we wrote a piece warming up to tech stocks; on October 8, we predicted a rally and urged a shift towards tech/growth stocks.* In general these calls seemed to work: Tech was the best performer among the sectors in October, with double-digit gains; growth beat value by 6.1% in October per Frank Russell Co.; and the major indexes gained ground in October.
But it seemed to us to be a bit too much too fast, so on October 29 we wrote, "We Think Valuations Are Fair, Not Cheap, So Investment Discipline May Be More Rewarding Than Chasing Rallies." We expressed concerns that the market had rebounded too quickly, falling for just a week once the market reopened; in World War II and the Gulf War it took months to move forward permanently. And we were a bit worried about valuations.
Bond valuations compared to equity valuations suggest it is time to be bullish. But by October 31's close, the situation had changed. Stock prices fell sharply on October 29 and 30, whereas the government bond market had a tremendous rally on October 31 after the Treasury announced that it would not be selling more 30-year bonds (at least for a while).
On November 1, we wrote as part of our weekly Valuation and Earnings Trends Report that valuations had radically improved; the ten-year bond yield had fallen 11% below the S&P 500's forward earnings yield. In a related First Call note published that morning, we calculated that stock prices had averaged 17% gains in the year following periods with similar relative valuations over the past 20 years. We turned "flat out bullish" on equities.
In such volatile times, we think it's worthwhile to step back and consider the fundamentals of equity valuation. Although reasonable persons may disagree about how it should be measured and interpreted, by any standard valuations are significantly higher now than they have been historically. The S&P 500's dividend yield is about 1.5%, about one third of its typical levels over the past 75 years. The P/E is about 35x on a trailing basis and 21x on a forward-operating-earnings basis. Despite the measurement controversy, both numbers are well above averages near 14x-15x.
Some, most notably Professor Robert Shiller of Yale, author of Irrational Exuberance, have argued that equity valuations must inevitably revert to the mean and that poor equity returns for the next generation are highly likely. Back in 1999, we argued in Long-Term Equity Returns (LETR) that higher valuations occurred because historical valuations had been too low and that a P/E in the low 20s was justified in a low-inflation world.
Both arguments have scored some points over the past two years, but neither has landed a knockout blow. Equity prices did drop at about the time that Prof. Shiller published his popular book, but he first started making his argument in 1996 when the Dow was about 3,000 points below today's levels. Our 5%-10% estimate seemed wildly conservative back in 1999 with a backdrop of 20% or greater S&P gains and 80% Nasdaq gains, but equity prices are generally lower now than they were in 1999. Nevertheless, forward-P/E ratios have held in the low 20s that we thought made sense under low inflation; in fairness, Prof. Shiller would probably quietly add, "so far."
We feel that history is a good indicator of what's in store for the economic future. We would argue that even conceding the arguments of the harshest equity critics, assuming the next 75 years are no worse (and no better) than the past 75 years, equity returns are likely to be 3%-4% better than government bond returns going forward. (These 75 years included the crash of 1929, the Great Depression, World War II, the Korean War, the Vietnam War, numerous other global conflicts, assassinations of U.S. presidents, two impeachment proceedings, the crash of 1987, the Internet bubble of 1999/2000, the attacks of September 11, and many, many other cataclysmic events.) That's down from 5%+, and it does not mean that bonds should not be an important part of the total portfolios of many investors.
We think the old 60%-40% stocks-bonds rule of thumb might look good again after seeming too bond rich over most of the last two decades. But if history is a trusty guide, even though we think equity returns will be lower (5%-10% rather than 11%+) than they have been historically, we believe equities will continue to serve as the bedrock of most investment portfolios.
Looking at the 'Fed Model,' when stocks are cheap relative to bonds, one should be looking to increase equity positions. In 1997, three researchers at the Federal Reserve Board published a study that examined earnings yields (using a combination of trailing and forward numbers) and bond yields from 1979-97 (pre-Bubble). They found that these data had established relationships over time and that investors could profitably trade on these relationships.
When stocks were cheap relative to bonds (i.e., when earnings yields were high relative to bond yields), investors should buy stocks.
When earnings yields were low compared to bonds (as they were in 1999 and early 2000), then investors should buy bonds or stick to cash.
We have written extensively about this model in the past, but last Thursday we ran the model versus corporate bonds and calculated a target equity return of 9%-16.6% over the next year. That seems about right to us. The model is strongly signaling stocks rather than cash or bonds at these levels.
Ibexx
PS: The rally is 8-weeks old - 8 weeks young I mean. Prudential apparently uses the same pivotal point to label market reversal as Larry Dudash did.
Larry, thanks again. |
