Natively, I tend to be an optimist. The present environment has given thin gruel for optimism, so I haven’t been as perky as I might otherwise be. Here are a few reasons for optimism:
- Credit spreads have been declining, and more corporate bond deals are getting done in the credit markets.
- Commodity prices have fallen and stabilized.
- The balance sheet of the Federal Reserve is shrinking.
- Money market and other short duration funds seem to be safe.
- Equities might be cheap relative to cash, but are still expensive relative to junk and low investment grade bond yields.
On that last point I want to quote Doug Kass, who I respect as an investor:
On multiple fronts, equities appear to have incorporated the bad news and are undervalued both absolutely and relative to fixed income:
- The risk premium, the market’s earnings yield less the risk-free rate of return, is substantially above the long-term average reading.
- Using reasonably conservative assumptions (most importantly, a near 50% peak-to-trough earnings decline, which is over 3x the drop in an average recession), the market has discounted 2009 S&P 500 earnings of about $47.
- Valuations are low vis-à-vis a decelerating (and near zero) rate of inflation. Indeed, the current market multiple is consistent with a 6% rate of inflation.
- Stock prices as a percentage of replacement book value stand at 1x, well below the 1.4x long-term average.
- The market capitalization of U.S. stocks vs. stated GDP has dropped dramatically, to about 80%, now at the long-term average. Warren Buffett was recently interviewed in Fortune Magazine and observed that this ratio was evidence that stocks have become attractive.
- The 10-year rolling annualized return of the S&P is at its lowest level in nearly 75 years, having recently broken below the levels achieved in the late 1930s and mid 1970s.
- A record percentage of companies have dividend yields that are greater than the yield on the 10-year U.S. note. At 46% of the companies, that is over 4x higher than in 2002 and compares against only 5% on average over the last 30 years.
On point 1, I will say that equities are cheap to cash and Treasuries, but not Corporate bonds and bank debt.
For point 2, we have gone through a massive levering up; it would be no surprise to see a leveraging down.
Point 3 — I don’t get it. Inflation has a small effect on valuations.
Point 4 — This is true but it could go lower because there is no one that wants to buy and hold at present.
Point 5 — In this environment, where there is a lack of buy and hold capacity, why are we satisfied with normal valuations?
Point 6 — True for Treasuries, wrong for corporates.
Point 7 — The 10-year Treasury is artificially low. It is not a good metric for dividend yields.
Mr. Kass is a bright man, and probably a better investor than me, but there are reasons to be concerned in this economic environment. Be careful, and don’t make rash moves in this volatile environment.