Guru Strategy: Jim Stack's naked truth about the current bull market
Nov 13th 2009 7:15PM
Updated Dec 4th 2009 4:45PM
Even in the face of dismal corporate earnings, Stack says we have truly turned the corner and that recent stock market gains will not be short lived. In fact, he says they will continue through 2010. We caught up with Stack to discuss why this is the case. He makes an important point: Investors would be wise not to look at corporate earnings to figure out where the stock market is headed. Read on to find out why.
DailyFinance: You make an interesting point in InvesTech Research that most seasoned investors agree that the stock market leads the economy. Yet they somehow jump to the opposite conclusion that corporate earnings should lead stock prices.
Jim Stack: Yes, that is true. But that has seldom been the case -- especially coming out of recession. In fact, there is an average eight-month lag between the end of the recession and when investors start seeing a positive earnings increase.
Why such a lag?
One reason is that any astute corporation will use a recession as an opportunity to increase profit margins and clean up its balance sheet. Unprofitable segments or divisions are shut down. Depreciable assets or amortization will be written off as an expense. The impact on earnings is negative, but it significantly improves the potential profitability coming out of the recession.
And this has been one of the longest recessions in a long time.
Yes, it has been the longest in 76 years, so it's normal to expect a lot of restructuring to have a major impact on corporate earnings. Based on the time period, if the recession ended in June, we shouldn't see the first increase in corporate earnings until the first quarter of 2010, although we expect it by the fourth quarter of this year.
So what is your view on corporate earnings now, as we come out of a long recession?
If you look at operating earnings, instead of reported earnings, which include the recessionary write-offs, the total earnings for the S&P 500 companies are down 43% from their high in 2007. Yet the stock market is up. But sector by sector, the story is very different. Frankly, outside of the banking debacle and boom-to-bust cycle in commodities, we're fairly impressed with the stability in corporate earnings. In fact, some sectors are seeing healthy increases from what were previously "peak earnings" in the second quarter of 2007.
Which sectors showed the strongest increases in earnings?
Consumer staples, health care and utilities have actually seen strong increases in earnings since that pre-recession peak in the second quarter of 2007. Technology and telecom are down only slightly, while consumer discretionary and industrials are off about what might be expected from a severe recession.
In other words, if you look past the boom-to-bust commodity cycle and the financial debacle (which is the focus of the government bailout), then corporate earnings are not as scary as they seem.
But they still look scary by some metrics. If you look at reported earnings, a price-to-earnings ratio of 145 for the S&P 500 appears downright frightening!
But that's far from the whole story. If you look at the alternative of sitting in cash, or in a money market fund or T-bills, then stocks look pretty attractive by comparison. For example, it's pretty easy today to step out there and find healthy companies paying a 3% to 4% dividend yield. One valuation metric that we have used in the past is the ratio of T-bill yields to the S&P 500 Dividend Yield. And by that comparison, one might say that stocks have never looked cheaper.
So what are the lessons, here, for investors?
When looking at valuation arguments from Wall Street pundits or in the media headlines, always remember:
- Earnings never tell us where the stock market is headed... instead, the stock market tells us where earnings will be a year from now.
- Measuring valuation is not black and white... there's always a lot of "gray" involved.
- In many cases -- especially after a recession -- all the hype about earnings and valuations is simply "noise"... the kind of distracting information that keeps you from focusing on what's important.
Do you believe, then, that the current bull market should continue for sometime?
If this bull market is for real, and we believe it is, then it could still be in its early stages. Yes, there are lots of obvious problems and dark clouds overhead, yet that is usually the case in the first year of a new bull market. The first six months to 12 months of a new bull market are always the most disbelieved and unloved. And from the weeks immediately preceding the March 9 low through this scary month of October, there have been more than enough ominous headlines to frighten investors to the sidelines and keep them there.
Coming out of one of the longest bear markets, should we now expect a long bull market?
We believe this will not turn into one of the longer bull markets, or perhaps not even match the average Bull Market Duration of 3.8 years. But I also would say that it would be a rare exception to see this bull market expire before the end of next year. Note that not one bull market in the past 60 years has lasted less than two years.
James Stack is the editor of top-rated, InvesTech Research.
Meet Jim Stack at The World Money Show Orlando, February 3-6, 2010 at The Gaylord Palms Resort.