There's plenty of fear on Wall Street these days.
The main fear is that the economy may be heading for recession, which is scaring investors away from stocks. But at times like this, I like to look to history for inspiration -- and cues to profit. And based on some painstaking research during the past couple months, I've concluded that, yes, stocks are in fact cheap right now.
Here are four reasons why...
1. Recession is Not a Foregone Conclusion
A main question nagging at investors is whether the U.S. is on the cusp of a new recession. Indeed, many will suggest the recent market rout is correctly signaling just such an outcome.
Yet as market strategist Jeffery Kleintop at Boston's LFL Financial recently wrote to clients: 'The markets' obsession with recession does not make it a foregone conclusion.' It's simply unclear whether the economy will slow from here, and even if it does, stocks prices already largely reflect a coming recession.
Just because the market looks like it's warning of dire times to come, the outcome isn't always severe. UBS noted that the S&P 500 Index has fallen by at least 17% from its peak on 14 occasions (as it has now), but the eventual result was recession in only nine instances.
2. Corporate Profits Could Stay Strong -- Even During Negative GDP Growth
Let's say we do see negative GDP growth this fall and winter. Does this mean corporate profits will also fall sharply?
Perhaps in the past, but maybe not today. Merrill Lynch notes that companies in the S&P 500 index have 'much greater sensitivity to the global economy and business spending.' Since 1995, profits derived from foreign operations of S&P 500 firms have risen from 23% to 40% of total profits.
So where are the global hotspots in 2012? Goldman anticipates a 9% economic growth rate in China in 2012 (though I'm a bit dubious of that) and roughly 4% growth in places like Brazil, Mexico, South Korea and Australia.
Back in the United States, Merrill Lynch sees no reason to expect a big slowdown in U.S. business spending either: 'Strong balance sheets and cheap financing should incent many companies to continue to spend on equipment and software despite weak U.S. growth.'
3. P/Es Are Low -- And So Is Inflation
Inflation pressures simply don't exist. Even if key inflation measures bubble up toward the 3% mark, stocks still look quite cheap on a historical basis.
Right now, the S&P 500 should be trading at 18.6 times projected 2011 profits, based on data compiled since 1950. Even if you assume inflation will bubble up to about 3%, then the projected multiple should still be 17.6, if history is any guide.
So where is the S&P 500 right now? A quite reasonable 11 to 12 times projected earnings, according to Merrill Lynch and UBS forecasts. Moving that multiple to 15 implies a 20% gain from current levels. A multiple of 16 implies a 30% gain. That's good news for stocks.
4. Stocks Pay More Than Bonds
The market is historically cheap by yet another measure. The average dividend yield on the S&P 500 is 2.2%, right in line with 10-year U.S. Treasury Bond yields. This is quite unusual -- 10-year bonds have almost always offered a higher yield than the average dividend paying stock in the S&P 500.
What's more impressive is that lately, companies have been less inclined to pay dividends than they have been historically. Between 1950 and 1990, the dividend payout ratio for dividend stocks was about 53%. But since 1990, it has dropped to 41%, according to Morningstar. This means dividend yields are relatively high despite companies being less willing to pay out profits to shareholders.
Citigroup strategists looking at corporate profits relative to fixed income investments came to the same conclusion. They think the S&P 500 is undervalued by about 15%, even if you assume corporate profits will never grow again and stay flat in perpetuity. Similar periods of undervaluation have led the market to an average gain of 25% in the subsequent 12 months.
There are definitely risks to consider before going all-in on stocks. Although the market is already pricing in a modest recession, a deep and long-lasting recession would surely lead strategists to lower their profit forecasts for the S&P 500, blunting any potential rally that may come. The economic data of the next few months should paint a clearer picture of what kind of economic performance we should expect in 2012.
The Investing Answer: I think blue chip companies with strong balance sheets are likely to be winners this year and next. Investors should look for solid names trading at cheap valuations. As economic uncertainty remains, you need to focus on value-oriented names, highlighted by strong balance sheets, solid free cash flow yields and defensible market positions. I'll keep focusing on stocks like these until things change.
