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Another one of the many old adages in the stock market (our ‘paraphrasing’) claims that ‘bear markets don’t completely end until every last bull has thrown in the towel’. The stock market psychology in 2011 seems very close to that as strategists, investors and market commentators have become more bearish as the year has gone on, issuing negative outlooks for global growth, stock and commodity prices. If on any particular day we see 3 pieces of positive financial news and 1 piece of bad news, it seems a given that investors will focus only on the negative news. In fact, even with the plethora of better economic news coming out of North America over the past few months, more of the commentary seems now to question the legitimacy or accuracy of those numbers, suggesting that ‘if it’s good news it has to be wrong.’ And if the data can’t be challenged, then the commentary quickly revolves back to the ‘financial crisis in Europe’.
While the 1990’s became a decade-long embrace of the emotion of ‘greed’, the period since 2008 can clearly be defined as a similar period of ‘fear’, where investors have driven up the prices of ‘non-risk assets’ (i.e. U.S. Treasury bonds, defensive stocks and, until the last few weeks, gold). In much the same way as the ‘decade of greed’ in the 1990’s ultimately created an environment where it was better off being out of stocks altogether, we continue to believe that the current environment is creating a similar opportunity on the buy side. Stocks, in our view, are exceptionally under-valued and the underlying economic environment not nearly as dire as most investors are ready to believe. This could set us up for a multi-year rally in stocks (both economically sensitive and growth stocks) supported by the continued expansion of the global economy, low interest rates, strong corporate profitability and record low stock valuations.
The ‘rush to safety’ by investors has lead to a period of unprecedented outperformance of bonds versus stocks. The chart below shows the spread (difference) between the yield on 10-year U.S. government bonds and the earnings yield of the S&P500 stock index. The long-term average for this spread is zero. At today’s level of -6.3% the spread is at the widest level since the stock market lows seen in 1975! Either stocks are severely under-valued, corporate earnings are about to collapse or interest rates and bond yields are about to head dramatically higher. Our view is that stocks are exceptionally under-valued.
Investors are showing their wariness about stocks in the way various sectors of the market are being priced. They are paying a huge premium to avoid risk and are driving up the prices of defensive investments to illogical levels compared to growth stocks. The table below outlines some of the differences in stock valuations and performance for a sampling of defensive versus cyclical stocks. We took a random selection of large defensive stocks in different industries and compared them to a group of larger, cyclical stocks on the basis of the current price-earnings ratios (P-E), their 5-year earnings growth rate (2007-2011) and their stock returns thus far in 2011.
| Defensive Stocks | P-E Ratio | 5-year Growth | 2011 Return | Cyclical Stocks | P-E Ratio | 5-year Growth | 2011 Return |
| Shoppers Drug |
14.8 |
6.1% |
+6.6% |
Magna Int. |
8.2 |
9.3% |
-36.3% |
| Tim Horton’s |
22.1 |
13.7% |
+19.3% |
Teck Corp |
9.2 |
16.1% |
-46.5% |
| TransCanada |
19.2 |
6.5% |
+14.7% |
Bombardier |
7.5 |
12.5% |
-29.5% |
| Bell Canada |
12.9 |
8.1% |
+14.8% |
Cliffs Inc. |
4.9 |
57.0% |
-21.2% |
What can be seen clearly is that investors are putting a premium on safety versus growth as the cyclical stocks have actually shown some stronger earnings growth over the past five years but trade at substantially lower earnings multiples. The lower P-E’s have of course come from the fact that the stocks have fallen so much in 2011 while their earnings have continued to grow. Investors are paying more for earnings stability and dividend yield which they expect will do better in a slower growth environment. On the other side, cyclical stocks are being priced as if their earnings are about to collapse. Obviously the difference in the pricing and performance of those stock groups is related to the expected earnings growth rate, which is in turn determined by global economic growth, particularly for the big industrial companies such as Magna, Teck, Bombardier and Cliffs. We don’t see the logic in paying mid-teens earnings multiples for single-digit earnings growth when you can buy companies with strong long-term earnings growth at much lower relative prices. We understand that investors are worried about the global economy, particularly since the global financial crisis in 2008 is still so fresh in every investors memories. But this is not “2008 Part 2!” While the sovereign debt crisis in Europe is reminding everyone of the banking crisis in the US in 2008, the impact on the global economy is nowhere near as dire. By the 4th quarter of 2008, the global economy was contracting, lead by a 6% decline in the US. As we go through the 4th quarter of 2011, the global economy is still growing at an annual rate of almost 4% while US growth is starting to increase again.