Anthony Mirhaydari
It's been a rough run for investors. Stocks have settled back to summer 2010's trading range. Job growth has stalled. The economy is on the precipice. Europe's banks are a mess. U.S. consumers are too scared to spend.
But there's more than just a slow economy at work. This is a continuation of a malaise that goes back more than a decade. The Standard & Poor's 500 Index ($INX)is trading at prices first reached in 1998 -- a run of poor performance on a scale not seen since the Great Depression. No wonder so many investors, fearing a future of despair and decay, have been flocking to the safety of gold and U.S. Treasury bonds.
The thing is, despair is the wrong emotion to have. Things are bad, but we're going to get through this patch.
Investors need to end their paralysis and beat back the bear market in fear. Money can still be made in turbulent, hair-raising, risky environments like this. It will take a lot of effort, a little hope and a little greed.
This week, I'll go over the reasons I'm hopeful as an investor. Then I'll give you a strategy and some stocks and exchange-traded funds to consider if you're ready to join the market fight.
Think of it as a strategy for the worst of times that will hold up as things start getting better.
Hope, not despair
As I outlined last week in "This is not a 'Max Max' economy," while today's economy is weak, the bottom isn't falling out. We're not fated to a dystopian future of scarcity and conflict.
In fact, a new recession is still unlikely given the strength of corporate balance sheets, ultralow interest rates and the lack of traditional drivers like overinvestment and bulging inventories.
Moreover, safe havens like Treasurys and precious metals are becoming increasingly less attractive than stocks, based on interest rates and earnings -- a situation that has marked the beginning of long, generational bull markets in stocks. Last week I showed how the earnings yield -- profits dividend by price -- on the S&P 500 is beating the pants off of Treasury bonds and corporate bonds on a scale not seen since the 1970s.
This is a reflection of the fact that stocks have been flat-lining since the '90s (and delivering weak returns, as the chart above shows) despite a huge increase in corporate profits over the same period. Second-quarter profits this year totaled an annualized $1.47 trillion in the second quarter, up from $478 billion in the second quarter of 1998.
To put it simply: Companies have been making more and more money, thanks in large part to rapid growth in foreign markets, so stock prices should be higher. Instead, they've been flat, because people just aren't interested in buying shares and taking risks.
Indeed, Citigroup analysts find that stocks should be trading at least 15% higher than they are now, assuming that current earnings continue into the future. In other words, even assuming that the 500 largest companies in the United States don't make a dime more than they are now, their stocks are still undervalued.
But a deeply rooted fear that another recession or financial crisis that will crush those profits has convinced investors that T-bonds offering 1.9% annual return, or a shiny yellow metal valued mainly as a historical relic and for its ability to resist rust, are better investments than stocks offering an earnings yield of 6.3%. That yield -- combined with solid cash flow and solid balance sheets -- means far better returns than those of bonds, in the form of higher stock prices, dividends, share repurchases and more.
Here's why I'm hopeful this is going to change.
Greed, not fear
First, the fear is going to fade. It's the latest form of the dynamic that pushed home prices well above justifiable levels during the housing bubble. And that dynamic is raw, unadulterated emotion. It was greed then. It's fear now. It will go back to good-old-fashioned greed soon enough.
After all, policymakers are showing increased inclination to support fragile growth, including President Barack Obama's new jobs proposal, an easing of the European Central Bank's rigid anti-inflation stance, and a Federal Reserve preparing new ways to push down long-term interest rates at next week's policy meeting. (For more on the Fed, review my Aug. 24 column, "Can the Fed chief calm our fears?") That should ease investors' fears.
Likewise, the eurozone debt crisis will be with us for a while, but leaders there have no choice but to continue the current strategy -- a combination of imposed losses on bondholders, forced austerity, and bailout funding -- and wait it out. But the worst fears won't come true. We aren't likely to see the euro fall or the European Union break up. According to UBS estimates, Germany would lose 25% its gross domestic product if it left the European Union; Greece would lose 50% or more.
I'm not hopeful because I think these problems will be resolved quickly and painlessly. I just think investors' fears will fade, because dwelling on low-probability disaster scenarios doesn't do anyone any good. They'll get back to the business of making money. Greed.
History suggests exactly this. Citigroup's Tobias Levkovich notes that over the past 40 years there have been only 61 weeks during which stocks were as attractively priced compared with bonds as they are now. In every single instance, stocks pushed higher in the year that followed -- by an average gain of nearly 25%.
