12/22/2010 1:00 AM ET|
10 picks for the epic bull market
Evidence is mounting that an epic bull market has already begun. But there are still ways to position your portfolio to take advantage in 2011.
Back in September, I wrote that we were on the cusp of an "epic bull market" as corporations used ultracheap financing to transfer wealth to shareholders. This was an out-of-consensus idea at a time when fear and uncertainty were so high. In other words, more than a few of you thought I was crazy.
Since then, the major indices have been on the move and are now trading at multiyear highs.
I'm convinced as we roll into 2011 that this bull is on. And if you've been on the fence, unsure about the economy's strength and the longevity of the stock market's strength, know that there is still time to cash in.
After the worst decade for stocks in a generation, things are turning around. Businesses have been taking advantage of the massive flow of investors' cash into bonds to issue new debt and pad their balance sheets. In turn, this cash is being used to engage in share buybacks, mergers and acquisitions. This is providing the critical element -- demand for stocks -- that will continue to drive equity prices higher and ultimately reignite investor interest in 2011.
In fact, this may already be happening: The fund flow experts at EPFR Global note that in five market days that ended Dec. 15, bond funds posted their biggest outflow since October 2008, while equity funds took in more than $10 billion for the second such period running. The shift from bonds to equities is accelerating as the economy strengthens and the epic bull market picks up steam.
Like the consumer-driven housing boom and bust we just went through, the new upturn is being driven by cheap borrowing. But businesses are driving the trend this time. Before we look at the areas of the market poised for outperformance in 2011, let's review the forces at work here -- because they are key to understanding where investors should focus their attention.
Debt deliverance, again
While households continue to pay down debts, businesses are ramping up their borrowing in a big way: Over the past two years, consumer credit market liabilities are down 3.5% while corporate indebtedness is up nearly 4% and has reached a new record high.
With the banks only now loosening their lending standards, the majority of this increase has been new debt issuance. Through the end of October, companies had issued more than $570 billion in new bonds, according to Société Générale, on pace to challenge 2009's record-setting full year total of nearly $800 billion and already coming in higher than the end-of-year totals for 2000 through 2008.
Much of this has been at very low cost. Microsoft (MSFT, news) issued a three-year bond note carrying an annual interest rate of just 0.875%. Wal-Mart Stores (WMT, news) and Coca-Cola (KO, news) borrowed at 0.75% a year for three years.
As a result, corporations are sitting on a cash pile worth $1.9 trillion -- the largest, as a percentage of total assets, since 1959. Slowly, the money is finding its way into stocks. Without getting technical, the reason is simple: Stocks are offering a higher earnings yield -- a higher implied return -- than bonds.
You can see just how rare a situation this is in the chart above, which illustrates the recent rise in the equity risk premium -- a measure of how richly stock investors are being compensated relative to bond investors. For most of the past 30 years, the equity risk premium has been negative. This is because stocks offer the potential for capital gains and have built-in inflation protection. Bonds don't.
But now that's changed, and bond yields are lower than equity yields. So it makes sense to borrow cheaply (via corporate bonds) and invest. After all, stocks haven't offered this kind of premium since 1980, when Kenny Rogers topped the charts and "The Empire Strikes Back" first hit theaters. By other measures, such as free cash flow yield versus corporate bond yields, stocks haven't been priced so attractively compared to bonds since the early 1960s.
Borrowing to invest
And borrowing to invest is exactly what the suits in the corporate suites are doing. Not in property, equipment or new workers (although this is slowly beginning to turn) but in stocks. During the third quarter, American companies spent $92 billion on stock buybacks -- a 71% increase from the previous quarter and the highest result since early 2008.
By reducing the number of shares outstanding, company executives provide a boost to the all-important earnings-per-share measure of a stock's value. And that makes the stocks of these companies instantly more valuable.
Merger and acquisition activity, or the buying of another company's stock, is also on the rise and is growing for the first time since 2007. Thomson Reuters reports that M&A grew nearly 20% this year to $2.3 trillion globally. As deal activity increases, an M&A "premium" gets priced into the market as everyone tries to anticipate where the next big deal will take place.
And we've already seen a number of big transactions. CenturyLink (CTL, news) bought Qwest Communications for $22 billion. Coca-Cola bought Coca-Cola Enterprises for $13 billion. And we've seen some big deal premiums. Burger King got taken out by a private equity firm back in September for a 46% premium to its pre-deal closing price. And just last week, Canadian bank BMO Financial (BMO, news) announced its intention to buy regional bank Marshall and Illsley (MI, news) for a 34% premium to its pre-deal stock price.
The key to success in 2011 will be identifying the sectors and stocks that are poised to benefit most from the rise in share repurchase and M&A activity -- or at least offer a more compelling investment proposition than bonds. For cautious investors taking their first steps back into stocks, here are a few defensive, high-yield ideas. For the risk takers, a collection of M&A/buyback ideas follows.
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