Tag Archives: s&P 500

Stock market rally justified by earnings, reasonable market value

Posted on February 1, 2013 | Leave a comment

The U.S. stock market turned in a strong first month of 2013 as the S&P 500 gained 5.2%.

This coming after a 16% total return for the S&P 500 in 2012 has some wondering if the rally is close to exhaustion.

While we don’t expect double-digit gains to build throughout 2013, we don’t think the market is close to being overheated either. We’re not making a forecast but thought it might be helpful to see a couple charts that help explain value of the market. Of course, these charts and analysis portray a rational view and markets can become irrational from time to time. There’s no sense in trying to predict a return for the year or any short time frame. As Warren Buffett has said: “short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also grown-ups who behave in the market like children.” However, we can confidently forecast that you’ll want stock market exposure over long periods regardless of short-term results.

So on with the show.

Two charts from presentations I’ve watched recently demonstrate how market prices may have room to grow to catch up with the reported earnings of U.S. companies.

This view of S&P 500 inflection points is from J.P. Morgan. Look at the first peak, March 2000. A measure of market value is the price/earnings ratio of the market. What price are investors paying for each dollar of company earnings. At this euphoric time, the P/E ratio (based on forward earnings expectations) was over 25. It had become excessive and the market needed a cleansing to get back down to a P/E ratio closer to historic norms.

The recovery from the internet bubble peaked in October 2007. At that time, even though the price of the S&P 500 had surpassed the March 2000 price, the price/earnings ratio was 15.2, 40% below the 2000 P/E ratio. The market had not been bid up by speculative investors quite like in 2000. Of course, that didn’t stop a significant bear market due to the credit crisis and recession of 2008.

So where are we at today? The recovering S&P 500 has crossed a price of 1,500 again. But corporate earnings have also grown at a strong rate. This means the price is generally justified by the earnings. The forward price/earnings ratio at the end of 2012 was just 12.5, roughly half of the irrational exuberance peak of March 2000.

Add January’s price appreciation and the forward P/E ratio is about 13.3.

SP500InflectionPoints

The combination of earnings and investor confidence in the trajectory of those earnings will be critical to determining how long this rally will continue.

Here’s another view – from economist Fritz Meyer – demonstrating how the market price has some catching up to do if history can be trusted as a guide.

SPearningsJan2013

 

The black line of the S&P 500 price over the past 25 years has generally kept an edge above the red line (S&P 500 earnings). It’s clear to see however, that the late 1990s S&P 500 value and the 2007 value grew disconnected from the reality of earnings.

Since 2010, though, good corporate earnings have not been reflected in stock prices that grow at the same pace. The S&P 500 black line has spent most of the time below the earnings line. Look at projected earnings going forward for 2013 and 2014 and you could rightfully judge that there is justification for stock prices to continue growing without getting too expensive.

Recovering investor confidence could have something to do with that. If cash flows shift back toward stocks and away from the bond market, gains may continue.

Of course, there are many potential shocks to the global economy which could erode emerging confidence and disrupt the growth in corporate earnings. But at this point, even significantly lower earnings would justify the current value of the S&P 500.

The S&P 500 is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor’s.

  • How confident are you in the stock market?
  • Have you changed the weight of stocks in your portfolio recently?

~ Gary Brooks, CFP® – Brooks, Hughes & Jones – Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

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You’re an international investor, even just owning the S&P 500

Posted on August 29, 2012 | Leave a comment

Standard & Poor’s recently published its analysis of the sources of revenue for companies in the S&P 500 index. Of the companies with full financial reporting available through 2011, only 53.9% of company revenue was generated from U.S. sales. With 46.1% of revenue generated outside of the United States, it’s clear that even investing only in companies headquartered in the U.S., you are a global investor exposed to local economies and currencies around the globe.

The amount of foreign revenue generated by these companies has ticked down consistently over the past four years from 47.9% in 2008 according to information published in August by S&P Dow Jones Indices.

Many investors have purposefully reduced international holdings, particularly those that are exposed to Europe. But even if you invest in no companies headquartered in Europe, the S&P 500 companies still generated 11.1% of their sales in Europe in 2011. This was down from 13.5% in 2010. Canada accounted for 9.3% of 2011 S&P 500 revenue. Japan’s influence on U.S. companies has declined more than 50% over the past two years. In 2011, Japan sales represented 0.72% of S&P 500 revenue, down from 1.52% in 2009.

Looking at sectors, Information Technology continues to dominate with over 56.3% of its declared sales coming from outside of the United States. Financials were more locally based, deriving 34.7% of revenue abroad.

Interestingly, S&P Dow Jones Indices also determined that S&P 500 companies paid more taxes to foreign entities than they did to the U.S. government. S&P 500 companies sent a cumulative $142 billion to non-U.S. governments and $117 billion to the U.S. government.

“Only 45.3% of all income taxes paid by U.S. companies went to Washington in 2011 versus 54.7% paid abroad,” noted S&P’s Howard Silverblatt. “Tax policy has become a major issue, even before election posturing started, with the current trend not working in favor of the U.S.”

The full report, S&P 500: 2011 Global Sales, is available at www.spindices.com under “Resources.”

While Apple generates the majority of its revenue abroad and Coca-Cola is close to 80% foreign revenue, this is a two-way exchange for foreign companies as well. Many of the largest foreign companies (i.e., Nestle, Samsung, BP, Toyota, many global pharmaceutical companies and banks) generate much of their revenue in the United States.

How do you feel about international investing?

Do you know the actual weight of foreign investments across all your investments?

Are stocks in Europe or the U.S. better priced given their future prospects?

~ Gary Brooks, CFP® — Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

www.BHJadvisors.com

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Keeping up with inflation – income vs. dividends

Posted on March 2, 2012 | Leave a comment

Inflation is a critical measure that determines whether our income (from employment and investment) allows us to keep up with our cost of living.

Two charts caught our eye recently, each using inflation to put financial security and investment opportunities in a relative context.

First, John Maudlin’s newsletter Outside the Box relays this chart from Greg Weldon (weldononline.com). It presents information from the Bureau of Labor Statistics comparing the Consumer Price Index and U.S. Disposable Income from 1996-2011. The copy is a bit blurry but the lines tell the story. Since 2005, disposable income (black line) has trailed inflation (pink line) and the difference grew significantly in 2011.

Personal disposable income, mostly generated by earned income from employment, is flatlining but another form of income is growing at a faster pace than inflation.

This next chart looks at the amount of dollars paid out as dividends by the stocks in the S&P 500 Index of large U.S. companies. The green bars show how the amount of dividend payments has easily surpassed the level of inflation over the past 20 years. The dollar amount of dividends came down during the 2008-09 recession when some companies reduced or eliminated their dividends. Even at the rate much lower than the 2007 peak, dividends offer an alternative that keeps up with the cost of living.

http://www2.blackrock.com/US/individual-investors/education/shareholder-magazine/article-1

Of course, dividend-paying stocks are not a risk-free asset and the stock prices of the companies paying dividends are more volatile than the bonds of high-quality companies. But for investors who expect to hold the dividend-paying stocks through market ups and downs and use the dividends to supplement their income, the ability to outpace inflation has been consistent.

~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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Earnings overshadowed by less important economic news

Posted on November 22, 2011 | Leave a comment

Every Thursday morning at 8:30 Eastern, the government tells us how many people signed up for unemployment benefits during the previous week. Before this announcement, the talking heads in the media tell us what number they expect.

Once the announcement is made, the media breathlessly tells us whether that number is higher or lower than the number that the prognosticators said it would be, and whether the trend in this number is going up or down. If you are a prognosticator, this number becomes either an outlier or a proof point depending on whether you think the global economy and financial system is getting better or it is going downhill.

whether the number of new people signing up for unemployment each week increases or decreases by 10,000 is not a useful statistic. We do not change our thinking about our investments based on this information.

One piece of information we do follow that seems to be under-recognized is the profitability of the companies in the S&P 500 Index.  During third quarter earnings reporting over the past several weeks, of the 80+% of the companies in the S&P 500 that have reported their earnings for the third quarter, most have outperformed their earnings expectations. According to estimates from J.P. Morgan, operating earnings per share for 3rd quarter 2011 were running at $25.61, up nearly 19% from a year ago and about $1 per share ahead of previous peaks. That means that in spite of all of the negative information about the U.S. economy, the European economy, unemployment, housing, and the threat of recessions, these companies are still earning near-record profits.

It used to be that if trends were widespread, this information would spur a market rally because companies have done exactly what we wanted them to—increased their profits.

At present, however, the market response to record earnings has been muted. Stock prices remain attractively valued compared to historical levels. On the scales of investors psyche, negative economic news, although often less important to investing, is outweighing real positive news about companies that are in much better position than they were three years ago.

While the media focuses on tiny changes in unemployment, Super Committees and Greek interest rates, it is missing the point of investing in companies that are returning value to their shareholders.

Here are couple visuals to help explain:

Source: Standard & Poor’s, FactSet, J.P. Morgan Asset Management.

Clearly, fourth quarter 2008 was a massive outlier, one so far out of the norm that it’s hard to imagine a repeat.

The value of the S&P 500 historically has traded ahead of the level of earnings as you can see in this next chart from economist Fritz Meyer. However, lately, the S&P 500 value has not reflected recorded earnings or projected earnings gains into 2012. The S&P 500 closed November 22 at 1,188. It would take a healthy rally to get back on track with the company earnings.

~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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The P/E debate. Are stocks overvalued, undervalued or priced just right?

Posted on April 18, 2011 | Leave a comment

Jeremy Siegel, author of Stocks for the Long Run, and professor at the University of Pennsylvania’s Wharton School, offered a promising view of stock market opportunities in his conference call with advisors April 14.

The way Siegel determines whether markets are overvalued, undervalued or neutral is largely based on the ratio of stock prices divided by expected earnings for companies. This is called the price/earnings ratio.  If you take the collective price of the companies in the S&P 500 and compare it to those company’s estimated earnings for 2011, you get a price/earnings ratio of approximately 13.5. This is an attractive figure compared to historical P/E ratios but Siegel suggests that the P/E ratio declines to 11.86 if you look forward to the expected company earnings for 2012 compared to today’s S&P 500 value.

These numbers speak to clear undervaluation, at least for large U.S. companies. Siegel estimates that “stocks have good room to appreciate another 15%.” He thinks this is particularly true because the low P/E ratios are also supported by very low interest rates.

Siegel thinks European stocks are an even better buy. He estimates that they trade at a 20% discount to U.S. stocks. The general P/E ratio of broad European markets is in the 10-11 range and even in the single digits for many companies when looking to 2012 earnings.

Of course, Siegel’s view is not shared by everyone. An argument exists over whether the present attractiveness of the market should be viewed with projected future earnings in mind or from the standpoint of actual past earnings. Siegel contends that stock prices are based on future earnings expectations so it is logical to evaluate whether they are over- or undervalued solely by looking at projections. Many others, particularly Yale University’s Robert Shiller, suggest that the past earnings are a more important measure. From this view, the market looks moderately overvalued.

The investment management team at Dodge & Cox, an 80-year-old mutual fund management firm, sides with Siegel in their outlook. In doing so, they wrote the following four reasons for optimism in their annual report.

1.       The S&P 500 traded at a 14 price/earnings ratio at the end of 2010. “A price-to-earnings ratio of 14 times has historically been an attractive starting point for equity returns.”

2.       U.S. companies still hold record amounts of cash, estimated at $1.5-$2 trillion. “We see that as a positive sign of the overall health of the economy and for investors.”

3.       Signs of progress in economic recovery include the highest quarterly corporate profits in 60 years, rising manufacturing and exports.

4.       Economic growth in the developing world continues to raise the standard of living for millions of people. Growing populations with rising income should purchase and use more consumer products, technology, pharmaceuticals, etc.

Whether you look forward or back to evaluate the value of the stock market, what seems to be growing in consensus is the idea that high-quality stocks have more upside potential than riskier stocks of companies with low-quality financials. This has not been the case for the majority of the recovery rally. More speculative and smaller stocks have had the best returns off of the bottom. Through April 15, small-cap stocks, represented by the Russell 2000 Index, had gained 143% since their low in March 2009. The S&P 500 Index of larger companies gained 95%. It seems that companies with less debt, higher cash flow, higher dividends and competitive advantages may be well positioned to extend gain.

The Royce Funds annual report captured this sentiment well. “As value investors, we are always all for caution, but we see the intelligence with which so many companies have managed themselves over the last two or three years as more meaningful than the economic problems we are currently laboring to solve. This is what inspires our confidence in the economy going forward. … We suspect that the reign of high-beta (volatile prices), often low-quality companies is likely to end soon, usurped by companies with characteristics such as high returns on invested capital, free cash flow generation and dividends.”

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Earnings reports indicate market has some catching up to do

Posted on October 4, 2010 | Leave a comment

Dr. Bob Froehlich, senior managing director at Hartford Mutual Funds, regularly communicates his view of market expectations. Despite uninspiring economic results he remains bullish on stocks.

Here is some compelling support for his thinking from his September 29 commentary.

On September 30, 2007—before the market meltdown began—the Standard & Poor’s 500 Index (S&P 500) was at 1,526, with quarterly earnings of $20.87. When the market hit its quarterly bottom on March 31, 2009, the S&P 500 was trading at 797, with quarterly earnings at $10.11. In other words, the market went exactly where earnings took it—namely, down. Over that time frame, earnings were down 51.56 percent and, almost in lockstep, the overall market was down close to the same amount, falling 47.74 percent.

Now let’s fast-forward to the most recent quarterly numbers, as of June 30, 2010. Earnings have recovered from their March 31, 2009 low of $10.11, and as of June 30, 2010, stood at $20.90. So earnings are back above the September 30, 2007 peak of $20.87. What about the market? The S&P 500 as of June 30, 2010 stood at 1,030. So even though quarterly earnings now exceed the September 30, 2007 highs, the overall market is still down 32.5 percent for that same period. If you believe, as I do, that the market goes wherever earnings take it, then our market has a little catching up to do.

Looked at another way, since the lows of March 31, 2009, quarterly earnings for the S&P 500 as of June 30, 2010 are up 106.73 percent. For that same time frame, the overall market is up only 29.18 percent. Remember what’s important: earnings, earnings, and then earnings.

This evidence may be partly responsible for the strong September rally, the best month of September for U.S. stock markets since 1939. We don’t expect the market to continue to rally as sharply, but clearly there is a disconnect that could lead to growth if company earnings continue to meet expectations.

It’s these expectations of future earnings that influence the mood of the market.

Further evidence from Morningstar demonstrates that it’s the largest “blue chip” stocks that are most undervalued. In reviewing performance of companies within the S&P 500, Morningstar shows that returns of the largest companies are significantly behind smaller companies in the index.

Consider this chart that breaks the S&P 500 into deciles by size  (market value) and lists year-to-date performance through September 16, 2010.

S&P 500 performance by market cap decile

Do you think there remains a buying opportunity with suitable upside for stocks?

What would make you comfortable that stocks are undervalued?

~ Brooks, Hughes & Jones, Partners in Wealth Management — Gary Brooks, CFP®, Allyn Hughes, CFP®, CLU, ChFC, Nancy Jones, CFP® — Tacoma, WA

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Stocks are undervalued, stocks are overvalued ― depending on direction you look

Posted on July 21, 2010 | Leave a comment

The significant lack of consensus outlook for U.S. stock markets comes largely from the direction at which differing parties view the market. Those looking forward, basing market valuation on estimated future company earnings believe that markets could be 25+% undervalued.

Those who prefer to use trailing actual figures to evaluate current stock prices, believe nearly the opposite, that the recovery rally went too far and will correct more than the 16% dip in the S&P 500 between April 23 and July 2.

The Bullish View

Jeremy Siegel is a professor and author whose viewpoint is widely followed. He has tracked stock market performance back over 200 years. He believes in reversion to the mean – over time, no matter whether markets race ahead of fair value to overly correct below it, they will self correct and return to long-term mean returns.

In a July 8 interview, he said: “When I draw that line over 200+ years of return data, I find we are about 25% to 30% under trend. But trend lines are only one aspect of it. There has got to be a valuation behind that. That is very much what supports the position that stocks are undervalued. When I look at earnings going forward on the S&P 500, for instance projections for 2010 and 2011, we are looking at either 13-times earnings this year or 11-times next year’s earnings. In this interest rate environment, that is unprecedented and, again, demonstrates around a 25% or 30% undervaluation in the market.”

Siegel goes on to explain that even if he takes a pessimistic view of future earnings that current prices remain undervalued, just not to the same extent.

Jeremy Grantham, a money manager historically bearish in his outlook, leaves open the possibility for stocks to rally strongly. “Despite growing nervousness and a slowing economy, there is still a 45 percent chance, thanks to low interest rates, that the S&P 500 will rise above 1,400 (1,083 on July 21, 29% increase to reach 1,400) by October of next year, accompanied by a speculative spin. High-quality stocks have been cheap for five years, and may spend most of the next several years underpriced, bouncing back up to fair value from time to time.”

The Bearish View

Other analysts and economically-focused investment managers are more pessimistic given the mix of a rear view of real company earnings in tandem with fairly dreadful economic expectations.

Economist and mutual fund manager John Hussman hasn’t found a reason for a promising outlook.

“I continue to urge investors to have wide skepticism for valuation metrics built on forward operating earnings and other measures that implicitly require U.S. profit margins to sustain levels about 50% above their historical norms indefinitely,” Hussman wrote July 19. “I can’t emphasize enough that when you hear an analyst say ‘stocks are cheap based on forward operating earnings’ it would be best to replace that phrase in your head with ‘stocks are cheap based on Wall Street’s extrapolative estimates of a misleading number.’ ”

While Hussman thinks that expectations for 25% U.S. stock market gains are misguided, he does not predict extended negative returns. His forecast in the second quarter outlined a scenario where U.S. markets could log 7% average annual returns over the short-to-intermediate term. While that would be a third lower than long-term market returns, 7% annually will still build wealth, especially in a period where inflation is tame.

Others do leave open significant likelihood of negative returns from U.S., and likely European, stocks.

Yale economist Robert Shiller uses a backward-looking calculation of 10-year average actual net earnings and concludes that U.S. stocks are substantially overvalued.

Everyone is right at some point

For another perspective, consider this graph from Morningstar. It charts collective over or undervaluation of the 1,700 stocks that Morningstar rates. This view is of the past year, suggesting a lightly undervalued market in general. It’s important to remember that individual stocks can get wildly undervalued or overvalued with no relation to the overall market.

What do we think?

The tug-o-war between forward-looking optimists and backward-looking pessimists is at a point where each side maintains a lot of strength. It could be that both sides are right. We may see a lot of up and down moves without a clear winner from either viewpoint.

One may be right in the short term but the other over a more meaningful longer term.

We favor evidence over expectations. That leads us to believe that the U.S. stock market is unlikely to add 25% or 30% to its value in the next year. Multi-national companies able to pay increasing dividends and established emerging markets companies appear most attractive. U.S. Treasuries are least attractive.

While we accommodate for occasional tilts in emphasis within our clients’ portfolios, we still operate from a core asset allocation that is globally diversified. This is the best way to remain aligned with client goals that will endure beyond the uncertainty of today.

– Gary Brooks, CFP®

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If you can’t predict, at least prepare

Posted on April 21, 2010 | Leave a comment

When we make investment and financial planning decisions for clients, most often we are not able to predict with any certainty how markets will behave, how or when personal or business situations will change, or the timing and impact of the variety of life events that change considerations.

Though we cannot predict, we can at least prepare.*

We prepare with financial plans that accommodate “What if?” scenarios. We prepare with investment strategies that target specific objectives but have the flexibility to correct course if need be. We prepare by seeking insight from analysts and experts from a wide variety of sources. Often, a forecast or opinion from one source is in direct conflict with that of another. Whether or not there is consensus on the most attractive investment opportunities at any given time, we strive to position our clients for a balance of risks and reward that is consistent with their goals. We prefer not to be outliers at either end of the spectrum of outcomes—with significant reward but similarly elevated risk or with no reward for too little risk.

With this perspective in mind, here are a few themes we think are worth noting as we manage clients’ accounts.

Improving sentiment drives pent up demand

While many analysts and investors think that the global bull market for stocks will continue, others continue to be worried about a market correction.

Fidelity market strategist Jurrien Timmer commented in a conference call April 15 that “fundamentals are good and getting better.” He’s referring to the underlying characteristics of evaluating companies, such as their earnings, free cash flow, etc.

As fundamentals improve, market sentiment climbs and the herd of unsophisticated investors moves in. When comfort with risk increases, the risk of returns not meeting expectations also increases.

Timmer said that there is moderate risk of a correction but “the market is running on pent up demand.” Therefore, the confluence of price, confidence and sentiment could easily push S&P 500 beyond what is considered fair value today.

We have seen many market analysts raise their forecast for the S&P 500 from the 1,200 range that was passed last week to 1,500 and beyond.

It’s all about corporate earnings

If global stocks are to continue their march back toward peak values of October 2007—requiring approximately another 20% of gains—company earnings will have to grow beyond expectation, beyond what is already priced into the market. Expected earnings growth is very strong—in fact, record earnings for S&P 500 companies are predicted for 2011  but these earnings may already be fully factored into prices.

Most analysts base their projections for stock prices on the value of a company and its projected earnings levels.  Stock prices are anticipatory more than reactionary. If there is too much good news already priced in, even moderately good news will be disappointing.

This is more of a problem in growth stocks where earnings growth is expected to generate higher future profits and escalating price.  Because of the uncertainty of earnings and the extent to which expectations are already priced into stocks, we currently favor high-quality, dividend-paying companies.

Wisdom from Warren

As Warren Buffett noted in the Berkshire Hathaway annual report, times when confidence is growing are not the most rewarding for investors. He was happy to put money to work when the investment environment was far more bleak than it is today.

 “A climate of fear is their (investors) best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business—through the purchase of a small piece of it in the stock market—and what that business earns in the succeeding decade or two.”

* This thought comes from a Morningstar Q&A with Chris Davis, a money manager for Selected Funds and Davis Advisors.

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