Why Stocks This May Will Be A-OK
Don't let baseless historical patterns keep you from capturing the next leg of the recovery.
Why fight this? Looking at that table, in 1998 we had the worsening Russia/long-term capital management crisis, 2000 marked the peak of the dot-com bubble, in 2001 we were in recession and suffered through tragedy of 9/11, 2002 was the high-yield crisis/WorldCom bankruptcy, 2008 was 2008, and last year was the debt ceiling standoff in the US along with the worst bout yet of the European crisis. There were good reasons for all of the big drawdowns; it wasn't just some cute seasonal coincidence.
Which brings us to today. Why should 2012 break the cycle? For one, the growth picture in the US is much better. First-quarter GDP, reported on Friday, came in lower than expected at 2.2%. But GDP is noisy. Inventories and net exports bounce around. And in the late stages of a balance sheet recession, like we're in now, government's impact is a lagging indicator and won't be the drag in the future that it has been in the past. Focus on personal consumption expenditures and residential fixed investment – those are the foundation of the US economy, and those are in much better shape now, having accelerated for three consecutive quarters, than they were at this time last year. And unlike the growth these categories saw in 2009 and 2010, this time around there's no impact from government stimulus.
With building permits now clearly in a recovery, we should expect an even bigger contribution from residential fixed investment over the balance of the year. There will be no recession in 2012.
Additionally, valuations, especially relative valuations, are a lot more attractive today than they were a year ago. Back then, according to Goldman Sachs, the S&P 500 traded at an EV/EBITDA multiple of 8.4x, a free cash flow yield of 5.6%, and a forward P/E ratio of 13.4.
Today, it trades at an EV/EBITDA multiple of 7.8x, a free cash flow yield of 6.4%, and a forward P/E ratio of 12.9. To simply be at the same valuation multiples that we were at last year at the end of April, the S&P 500 would need to be at 1450 on a forward P/E basis, 1500 on an EV/EBITDA basis, or 1600 on a free cash flow yield basis.
The 10-year yield was also around 3.3% vs. today's sub-2%. Stocks are a fair amount cheaper and bonds are much richer than they were a year ago.
For all we know we're in a new secular bull market already. I believe we're there in tech, with last August representing the once-in-a-lifetime valuations we're not likely to see again. And in secular bull markets, especially early on, stocks rally as growth either turns out to be better than expected or fears don't come to pass. As Goldman Sachs noted last week, "1Q EPS is tracking 2.5% above the aggregate consensus estimate at the start of reporting season. Based on the historical seasonal pattern of earnings, a 1Q EPS of $24.50 implies a full-year 2012 EPS of roughly $102, slightly above our estimate of $100."
When well-worn aphorisms lacking any fundamental justification are taken as gospel, it may be a sign that they're due to be incorrect. Remember "house prices never go down?" And in fact, from 1982 to 1997 the S&P 500 was up during the May through September period 14 of 16 years, with just a small loss during 1986 and a more substantial loss during the beginning of the 1990 recession.
"May" may have already happened in April, with equity fund redemptions at their highest in any April going back at least 17 years. Don't let baseless historical patterns keep you from capturing the next leg of the recovery.
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