Bulls See Lower Stock Prices as Gift
Jim Paulsen’s frustration with the stock market translates to something like this:
“Yo, what’s wrong with you people?”
Paulsen, the chief investment strategist at Wells Capital Management in Minneapolis, believes that U.S. stocks in general are great buys right now, particularly compared with the usual alternatives.
Yet many investors, he says, can only find reasons to avoid equities. In fact, he says, some people seem to draw the same negative conclusion about the market from either side of a single vantage point.
Rising interest rates, for example, are always a big fear factor for stocks. But lately, falling rates -- as in the case of long-term bond yields -- also have been seen as a potentially bad omen for share prices because of concern that the bond market is foretelling an economic slump.
Paulsen’s view is that the economy is fine, stocks are attractive and investors should lighten up already.
He was arguing the same thing a year ago, when the Federal Reserve began tightening credit. And as it turned out, sticking with the stock market over the last 12 months was a smart idea, even as the Fed raised short-term interest rates.
You would have earned a 6.3% total return in the Standard & Poor’s 500 index in the 12 months ended Thursday, the one-year anniversary of the first Fed rate hike.
By contrast, your average yield on three-month Treasury bills would have been about 2.2% over the last year if you had bought one on June 30, 2004, and rolled it over every quarter.
Nearly every category of stock mutual funds also beat cash returns over the last year, according to Morningstar Inc. For that matter, so did almost every category of bond funds. The Pimco Total Return fund, the world’s biggest bond fund, earned 7.2% in the period.
So staying committed to longer-term assets was the right decision, even in a period when the justification for holding cash seemed quite strong.
Now, what about the next 12 months?
Many of the same issues that dogged markets a year ago still loom: How high will the Fed go with short-term rates before it’s done? How much will it slow the economy and corporate earnings? Could inflation accelerate despite the Fed’s credit-tightening campaign? Could long-term interest rates surge as the Fed tightens further?
Then there are the risks that have nothing to do with the Fed -- oil prices, for example.
In other words, there’s a lot that could go wrong for financial markets, as usual. If enough goes wrong, cash might come to look very appealing indeed as a hiding place, especially if the Fed keeps raising short-term rates.
If you measure only since Dec. 31, cash already is winning compared with the blue-chip S&P; 500: The index was down 1.7% in the first half of this year. Including dividends, the total return was a negative 0.8%.
But if you’re bullish, you ought to view lower stock prices as a gift. That’s how Paulsen sees it.
As corporate earnings have soared over the last three years, they have sharply outpaced the average gain in share prices, he notes. The result is that price-to-earnings ratios (P/Es) have come down significantly for the typical blue-chip stock.
By Standard & Poor’s calculations, the average S&P; 500 stock is priced at about 16 times this year’s estimated operating earnings per share. The P/E has dropped from 18 at the end of last year and 24 in 2000.
At 16, the P/E is back to where it was in 1995. Paulsen believes that is a very compelling valuation, particularly compared with the alternatives.
Investors traditionally are willing to pay higher P/Es for stocks when long-term bond yields are low, because bonds then look less attractive, in theory. The 10-year Treasury note yield was at 5.5% at the end of 1995, the last time the S&P; 500 P/E was 16. Now the T-note yield is 4.04%. Shouldn’t that make stocks worth a higher P/E than in 1995? Paulsen asks.
Instead, some investors put falling P/Es in the same category as falling bond yields, he says: They think it’s a sign that something’s wrong with the market.
“People see stock P/E multiples coming down, and they say it’s a bad thing,” Paulsen says. “I think it should get people excited about stocks -- not the other way around.”
The bear case is that P/Es are dropping because corporate earnings soon will be declining instead of rising. So it’s an article of faith for the bulls that, as Paulsen insists, the economy is healthy and earnings will continue to grow, albeit probably at a slower pace than the last few years.
Doug Sandler, chief equity strategist at Wachovia Securities in Richmond, Va., also is upbeat on stocks. The market, he says, hasn’t been as dismal this year as investors might suspect from the drop in the S&P; 500.
“I think Main Street is missing that there are some great things going on in the market,” Sandler said.
That’s what you might expect a brokerage investment strategist to say. Still, even if it sounds like cheerleading to put it that way, Sandler is right that there have been plenty of stocks that have risen this year even as the headline indexes have slipped.
It’s a good reminder because it’s possible that the next few years in the market could look much like the last one: a lot of back and forth in the well-known indexes, but not much net progress in those gauges, or perhaps modest losses.
Under those circumstances, the headlines might encourage you to heavily favor cash, in part out of sheer boredom with stocks. But that might cause you to miss out on some rewarding ideas that could spice up returns in a diversified portfolio.
This year, for example, smaller stocks have beaten bigger stocks -- again. The S&P; 400 index of mid-size stocks was up nearly 4% in the first half, including dividends. The S&P; 600 index of small stocks was up 1.8%.
That continues the trend that has been in place since 2000 as investors generally have favored smaller issues over blue chips.
Sandler, for one, thinks that the better growth opportunities still are in the stocks of companies that are smaller and less well known than the Coca-Colas, Citigroups and Wal-Marts of the marketplace.
The healthcare business has provided a prime example of the danger of focusing exclusively on big-name stocks, Sandler said. While drug giants like Pfizer Inc. have stumbled in recent years, smaller firms such as Barr Pharmaceuticals Inc., a maker of generic drugs and birth control pills, have shined. Barr’s shares have jumped 45% in the last year while Pfizer’s have fallen 20%.
Apart from smaller stocks, many U.S. investors have found another profitable market niche in recent years: foreign shares. The dollar’s plunge from 2002 through last year helped produce hefty gains for Americans in overseas markets as stronger foreign currencies translated into more dollars.
This year, foreign stocks have been red-hot again in their local currencies. France’s main stock index zoomed 10.7% in the first half; the Danish market was up 20%; the South Korean market jumped 12.5%.
But the dollar’s rebound this year has slashed those returns for Americans, to the point where there has been no net advantage in having money overseas versus keeping it at home. The average U.S. stock mutual fund is up 0.3% year to date, according to Morningstar. The average foreign fund is up 0.2%.
That isn’t an argument for giving up on foreign stocks. But Paulsen wonders what the message is, when the U.S. market stalls while most foreign markets surge. “If you look anywhere else in the world ... markets have continued to go up,” he says.
Are things really that much better overseas -- or that much worse at home?
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(BEGIN TEXT OF INFOBOX)
Broad gains despite tighter credit
How major categories of stock mutual funds have gained or lost over the last 12 months as the Fed has raised its key short-term interest rate nine times.
Fund category / 1-year total return
Emerging markets: +33.4%
European shares: +17.6%
Small-cap value: +14.6%
Large-cap value: +10.9%
Small-cap growth: +8.0%
Healthcare: +5.0%
Large-cap growth: +4.5%
Technology: -0.2%
Average U.S. stock fund: +9.3%
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Source: Morningstar Inc.
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Tom Petruno can be reached at tom.petruno@latimes.com.
