For well over a year I have been bullish on stocks, arguing it made little sense to own a bond yielding 2% instead of well-managed blue chip stocks yielding 2-5% with dividend growth of 5-12%. If all went well, I argued, a \u201cvaluation levitation\u201d was likely.\u00a0 With the S&P 500 up 11.7% in the first half of this year, it has happened.\u00a0 To coin a clich\u00e9, the easy money has been made.\u00a0 What now?\u00a0 Over the next couple of years the public, with apologies to Dr. Strangelove, will stop worrying and learn to love equities. This process has already started and will push up PE ratios at least modestly, making stocks a good investment over the next 2-3 years.<\/p>\n
Since March 2009 the S&P 500 has more than doubled even as investors ran away from stocks; there were net outflows<\/b> of $258 billion from equity mutual funds and $654 billion net inflows<\/b> into bond funds.\u00a0 Individuals particularly hated U.S. equities, selling $353 billion in domestic equity funds, but they loved gold. \u00a0Investors didn\u2019t worry about missing the bull market in stocks because they were making good money in bonds and gold. But now the \u201csafe haven\u201d status of bonds and gold has been shattered, necessitating a rethink. Over the next couple of years stocks will become respectable again<\/b> as we shift to a new investment regime.<\/p>\n
The ABEI Regime (2001-2013) . . . <\/b><\/p>\n
Abei is not a city in the Middle East; it stands for Anything But Equity Investing.<\/b>\u00a0 The bursting of the tech bubble, 2000-2002, discredited long-term investing in equities — a view that was confirmed by the 2008 crash.\u00a0 So investors flocked to:<\/p>\n ABEI has driven a cultural shift in the markets that younger investors don\u2019t appreciate.\u00a0 There is today an absurd fixation on macro issues, such as Wall Street\u2019s current \u201ctaper tantrum.\u201d\u00a0 ETFs facilitate aggressive trades in obscure macro variables that were out of reach of most investors a few years ago. \u00a0\u00a0Brokerage firms have shifted their focus from researching long-term growth opportunities to spotting short-term trades.\u00a0 At the morning meeting, salesmen are less interested in Starbucks\u2019 growth rate than how SBUX options will trade when the company reports same store sales on Wednesday.\u00a0 The Street\u2019s new short-term ethos is nicely captured in the entertaining book Buy Side<\/b> by former hedge fund trader Turney Duff, a man of many vices (cigarettes, booze, coke, pot, hookers, porn) and considerable literary talent.\u00a0 Duff describes the often zany interaction between traders at \u201cbuy side\u201d money management companies and the \u201csell side\u201d (brokerage firm) salesmen and sales traders who help them make money for their investors\u2014or at least live well in Manhattan while failing to do so.<\/p>\n During the ABEI regime influential institutions, such as Ivy League endowment funds, shifted from U.S. equities to the above-named alternatives, particularly hedge funds and private equity.\u00a0 For example, Harvard\u2019s allocation to domestic stocks fell from 38% in 1995 to 11% in 2013.\u00a0 The current allocation of Yale and Princeton to domestic equities is even lower at around 7%.\u00a0 Stuck in illiquid assets, they are missing out on the rally in U.S. equities.<\/p>\n . . . and Four Reasons Why ABEI is Fading<\/b><\/p>\n Reason Number 1.<\/b>\u00a0 Investing is about the future, not the past.\u00a0 If I look at the stocks I own \u2013 CAT, PM, SBUX, whatever \u2013 it is not their fault that stocks collapsed in 2000-2002 because they became overvalued.\u00a0 Nor is it their fault that in 2008 the financial system almost collapsed due to a housing bubble created by Washington with ample help from Wall Street and Main Street.\u00a0 Stocks may be volatile, but with everyone on the lookout for the next bubble, they are actually less risky than before 2000.<\/b>\u00a0 And if you own stocks for long-term dividend growth, price volatility doesn\u2019t matter much.\u00a0 Even during the 2008-2009 crash, more S&P 500 firms raised than cut dividends.<\/p>\n Reason Number 2.<\/b>\u00a0 Macro bets are little more than gambling<\/b> because no one except George Soros can make money anticipating macro trends and investor psychology. Even the Fed, with its platoons of economists and unlimited access to financial information, has failed to anticipate the last three recessions.\u00a0 Currently some big-name fund managers, such as John Paulson and David Einhorn, are losing big money in gold.\u00a0 And the crown is slipping from the brow of \u201cBond King\u201d Bill Gross, who proclaimed nearly a year ago that the \u201ccult of equities\u201d was dead because stocks are a \u201cPonzi scheme.\u201d\u00a0 Stocks are up 18% since Bill shared his insights with the public.\u00a0 (For why Bill was wrong, see our Aug. 3, 2012 post, “Another Stock Market Buy Signal from Bill Gross?<\/a>“)<\/p>\n Reason Number 3.<\/b>\u00a0 From the point of view of shareholders, large U.S. companies have rarely been better managed.<\/b>\u00a0 Companies cleaned up their corporate governance act after Sarbanes Oxley was passed in 2002, and they became even leaner and meaner after the 2008 liquidity scare.\u00a0 Margins have never been higher and firms are judiciously allocating free cash flow toward capex, M&A, dividends and buy-backs in a very shareholder friendly manner.\u00a0 Corporate tax reform that liberated\u00a0overseas cash would further\u00a0enhance this theme.<\/p>\n Reason Number 4.<\/b>\u00a0 Hedge funds have several serious flaws that are gradually becoming recognized.\u00a0 They are tax inefficient because\u00a0gains are taxed annually as ordinary income, not eventually at a lower capital gains rate.\u00a0 Second, trading strategies that try to exploit short-term market inefficiencies fail to benefit from the fact that stock prices really do rise over time<\/b> \u2013 for example, at a 6.7% annual rate since 1966 (not including dividend yield, which averaged 3.0% since 1966).\u00a0 Hedge funds are also illiquid and expensive.<\/p>\n Bottom line:<\/b> \u00a0As the alternatives lose their luster stocks will become more popular with investors and, assuming inflation and rates stay low, the PE ratio will trend higher.\u00a0 Rising PE on rising EPS is a potent combination; it is multiplicative, not additive.\u00a0 (Eg., if PE rises 10% and EPS 20%, price rises 32%, not\u00a030%).\u00a0 If the S&P 500 earned $124 in 2015 and the trailing PE rose from the current 15.2x to a very reasonable 17x,\u00a0the year-end 2015 price would be 2111, up 32% from the current level.\u00a0 Throw in dividends and you\u2019re looking at a total return of nearly 40% in two and a half years.<\/p>\n Historical Perspective:\u00a0 Stock Market Regimes Since 1950<\/b><\/p>\n 1950s:\u00a0 A Hedge Against Inflation.<\/b>\u00a0 With bond yields very low in the 1950s investors\u2014still scarred by the 1929 crash\u2014cautiously crept back into stocks, which rose 258% as the trailing PE on GAAP EPS rose from 7x to 17x. \u00a0The market mantra was that you had to be in stocks as a \u201chedge against inflation\u201d (which is mostly true as long as inflation is not too high).<\/p>\n 1962-1972:\u00a0 Stocks a Go-Go \u00a0<\/b>In the sixties, stocks went from necessary to sexy.\u00a0 Financiers started to create what the media called \u201chigh-flying conglomerates\u201d that flattered their earnings by using their high-PE shares to acquire companies with lower PEs.\u00a0 Conglomerates\u2019 glamour was tarnished by poor performance during the 1970 recession, but investors moved on to \u201cone decision growth stocks\u201d in 1971 and 1972.\u00a0 The \u201cnifty fifty\u201d were mostly tech, healthcare, and consumer growth issues that were, in many cases, excellent companies. But they became too expensive (median PE: 41x) and collapsed when inflation spiked in 1973.<\/p>\n 1970s: Inflation and the \u201cDeath of Equities.\u201d<\/b>\u00a0 Stocks were a terrible investment during the inflationary 1970s; the S&P 500 was no higher in 1982 than 1972, meaning its inflation-adjusted price fell 57%.\u00a0 Corporate America was over-regulated and poorly managed (why bother cutting costs when you can raise prices?), and risk capital nearly dried up as capital gains taxes soared.\u00a0 With investors fleeing equities in favor of real estate, gold, industrial commodities, and collectibles, Business Week<\/i><\/b> flashed an early \u201cbuy\u201d signal with its 1979 cover story, the \u201cDeath of Equities.\u201d<\/p>\n 1980s:\u00a0 Rebirth of Equities<\/b>\u00a0 The collapse of inflation in 1981-83, and a surge in corporate takeovers (many financed with new-issue junk bonds invented by Michael Milken) drove stock prices up 227%. But high real interest, stock market volatility caused by program trading, and the 1987 stock market crash kept the public on the sidelines.<\/p>\n 1990s:\u00a0 Stock Market Mania<\/b>\u00a0 Very low interest rates after the 1990-91 recession pushed individual investors back into stocks, and by the late 1990s they were enthralled by the Internet and TMT (tech, media, telecom) stocks.\u00a0 As money poured into index funds valuations of large-cap stocks hit excessive heights; by March, 2000 the S&P 500 trailing PE was 26x.\u00a0 The ensuing crash was arguably worse than the 1930s or 1970s, because many Internet companies and widely held large-cap issues \u2013 such as Nortel, Lucent, Worldcom, Enron, Sun Micro, and Global Crossing \u2013 did not merely decline in price; the companies crashed and burned.<\/p>\n 2001-13:\u00a0 ABEI\u00a0 (Anything But Equity Investing<\/b>)\u2014see above.<\/p>\n 2013-20??:<\/b>\u00a0 Stay Tuned<\/p>\n Copyright 2013 Thomas Doerflinger.\u00a0 All Rights Reserved.<\/p>\n","protected":false},"excerpt":{"rendered":" For well over a year I have been bullish on stocks, arguing it made little sense to own a bond yielding 2% instead of well-managed blue chip stocks yielding 2-5% with dividend growth of 5-12%. If all went well, I … Continue reading \n