Stuck in the Middle With You
The reason that the S&P looks 'cheap' is because the index is skewed towards financial stocks - when we strip out financial stocks, which account for as much as 45% of earnings, we are kind of...well...stuck in the middle.
And I'm wondering what it is I should do,
It's so hard to keep this smile from my face,
Losing control, yeah, I'm all over the place,
Clowns to the left of me, Jokers to the right,
Here I am, stuck in the middle with you
Did you ever wake up on a Monday morning and a song is just stuck in your head? Totally random of course with a song done by a 'one hit wonder' like Stuck in the Middle with You by Stealers Wheel. It was so random, in fact, that I actually bet my wife I knew the name of the band! Unfortunate for her I got the name right, but unfortunately for me, I spelled the name of the band wrong! So call it a draw. Anyway, back to the concept of what brought this song into my brain in the first place.
I keep hearing about how stocks are 'cheap' based upon the forward (like we can actually predict the future) price/earnings ratio of the S&P 500. I am told stocks are 'only' 16x forward earnings; and that they are cheap relative to interest rates. In this article I will address a few important points.
First, why are interest rates where they are in the first place? My contention is that interest rates are low because of the insatiable appetite for US bonds by foreigners (Foreign Central Banks, etc). Let's face it, if they weren't buying, who would be forced to buy? Yep, you guessed it - me and you. And would I buy 10 year Treasury notes at 4.66% with inflation running at close to 3%? Nope. When I take a random 'straw poll' of where investors would buy 10 year notes when considering inflation and messy deficits, the answer I usually get is 6-7%. So let's just say that rates are artificially low. And this means that any analysis based upon "stocks are 'cheap' compared to bond yields," in my book, is flawed in the first place.
This brings me to the wonderful lyrics mentioned above. In a vacuum (a vacuum that demands that we compare stocks to unusually low yields), are stocks really cheap? I would say no. When we look at the S&P 500 from a macro perspective, we do see, in fact, that stocks are indeed 17x trailing earnings and 15.99 times 2007 'forward' earnings according to Bloomberg. Mind you, the dividend yield on the overall index is a rather un-appetizing 1.77%!
In March 2000, at the peak of the stock market bubble, can you guess what the median stock (the stock 'stuck in the middle with you') traded at? 13 times earnings. Yep 13x. And lo and behold, a bull market in the 'median' stock has been in force ever since. I keep hearing that stocks have gone sideways for the better part of seven years with earnings growth growing nearly 100%. Well of course they have when we consider that the S&P 500 is a capitalization-based index (one where the largest company has the largest impact). But what about the guy in the middle, courtesy of Stealers Wheel? The median stock when using the price earnings metric trades at 19.5 times earnings while the median stock using the dividend yield as a metric trades at 1.13%. Are these bargains? Hardly.
The reason that the S&P looks 'cheap' is because the index is skewed towards financial stocks - whether they are true financials like Citigroup (C) or 'quasi-financials' like General Electric (GE) (GE generates half of its income from GE Credit). When we strip out financial stocks, which account for as much as 45% of earnings, we are kind of…well…stuck in the middle. With stocks at 20 times earnings that are...well…not the highest quality earnings we have ever seen considering the financial engineering (stock buybacks, questionable options accounting, etc) and a yield barely above 1%, I have to take issue with the 'cheapness' of the market.
As a result, while respecting the momentum of the market, and the widespread belief that stocks are cheap (against a 'mis-priced' 10 year Treasury note), we are now once again, underweight equities across the board. I love to ask people what they think the median price/earnings ratio was in March 2000. The S&P 500, at the time, was around 35x earnings as I recall and seemed expensive, which it was. Those that owned the index for the last seven years have of course made nothing on an absolute basis, forgetting inflation. Those that owned the median stock have done wonderfully.
Looking forward, I would say that now, neither the index nor the median stock offers much value. So it is time to tread carefully. Even at the expense of being unpopular (usually the best stance)...my firm has been fortunate to have been invested with those managers along the way that understand buying value. Unfortunately, today, for a number of stocks, based upon the median stock's valuation, there aren't many values left. So my firm will be invested in sectors that still have value and bonds that have good risk/reward characteristics and look to protect capital while making as much as we can in a prudent manner.
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