Stocks went on an extraordinary ride last week, as the Dow Jones Industrial Average ($INDU) swung more than 400 points in four straight sessions. But the net result was modest, with major averages ending with losses of less than 2% over the five trading sessions.
Barron's remains bullish, because U.S. stocks, as measured by the Standard & Poor's 500 Index ($INX), are valued at around 12 times this year's earnings. The current S&P forward price-earnings ratio is back to 1980s levels, save for the brief period around the market low in early 2009. But back in the '80s, interest rates were much higher, so stocks arguably are a better relative value now.
The S&P 500 closed Friday at 1,179, off 1.7% for the week and 6.3% for the year. And the Dow finished at 11,269, down 1.5% in the five sessions and off 2.7% this year. The S&P 500 now yields 2.2%; the Dow, 2.7%.
A range of blue-chip stocks, including Microsoft (MSFT, news), Merck (MRK, news), Intel (INTC, news), Exxon Mobil (XOM, news) and JPMorgan Chase (JPM, news) trade for less than 10 times estimated 2011 profits, and most have dividend yields that exceed the puny 2.26% on the Treasury's 10-year note. (Microsoft owns and publishes MSN Money.) With the Federal Reserve pledging to hold short-term rates near zero for the next two years, the dividend yields on stocks look appealing, especially since many companies should be capable of increasing their payouts each year.
"Investors have a great opportunity to build a defensive portfolio that will throw off a good income stream," says Michael Jamison, portfolio manager at Barrett Asset Management in New York. He cites stocks like IBM (IBM, news), Procter & Gamble (PG, news), Kraft Foods (KFT, news), ConocoPhillips (COP, news) and Kimberly-Clark (KMB, news).
Other fans of quality stocks include Jeremy Grantham, a founder of Boston investment manager GMO. Grantham noted in his recent investment commentary that quality stocks have bested lesser peers globally since April and that the trend could continue.
With the economy weakening in recent quarters, investors worry that corporate profits may be headed lower, which would remove a key underpinning for the stock market. Barclays Capital strategist Barry Knapp is optimistic, arguing that profits will hold up in the coming quarters. He cites good earnings reports in recent days from the likes of Macy's (M, news), Kohl's (KSS, news), Nordstrom (JWN, news) and Cisco Systems (CSCO, news).
"I don't see any data points that suggest the economy is going to roll over," he says.
Knapp looked at the profit picture during recessions since World War II and found that S&P 500 profits dropped an average of 15.7%. The biggest declines came during the past two downturns, including a profit collapse of more than 50% in the 2008-2009 recession.
Knapp thinks the economy will avoid a recession, but even if there is one, he figures that the profit drop will be modest at 10% or so. The huge earnings decline in 2008-2009 was largely a result of deep losses in the financial sector, which accounted for 64% of the earnings decline from the peak in 2007 to the bottom in early 2009. The energy sector also was hit hard as oil dropped from a high of $140 a barrel to a low of $40.
"If we get a recession in 2012, I would expect S&P 500 earnings to fall to something like $90" from around $96 this year, Knapp says. That would hardly be catastrophic, given that the S&P 500 now would be valued at 13 times that bearish earnings level, rather than 11 times the current consensus for about $105 in S&P profits next year.
A replay of 2008-2009 seems unlikely from an economic standpoint, and American nonfinancial corporations are much healthier than they were then, sitting on more than $1 trillion of cash.
Banks have been a focus of investor worries lately, with financial stocks the worst performers in the S&P 500 so far this month -- and during 2011 -- given debt problems in Europe and ongoing domestic mortgage woes. But the industry is far better capitalized than it was before the financial crisis in 2007, reducing the risk of anything close to a repeat of the '08-'09 crisis.
Barclays credit analyst Jonathan Glionna wrote in an Aug. 12 note to clients that the country's four largest banks -- Citigroup (C, news), Bank of America (BAC, news), JPMorgan Chase and Wells Fargo (WFC, news) -- have $471 billion of tangible common equity, nearly double their total in June 2007, reflecting retained profits since then and the sales of common stock and other capital-raising efforts.
Big bankers may grumble about regulatory overkill and excessive capital requirements that are dampening returns and stock-market valuations, but higher capital levels should enable big banks -- with the possible exception of Bank of America -- to avoid any dilutive equity sales. The capital cushions also reassure investors and creditors. American banks are much better capitalized than most of their European brethren, whose shares were crunched last week.
