For well over a year I have been bullish on stocks, arguing it made little sense to own a bond yielding 2% instead of well-managed blue chip stocks yielding 2-5% with dividend growth of 5-12%. If all went well, I argued, a “valuation levitation” was likely. With the S&P 500 up 11.7% in the first half of this year, it has happened. To coin a cliché, the easy money has been made. What now? Over the next couple of years the public, with apologies to Dr. Strangelove, will stop worrying and learn to love equities. This process has already started and will push up PE ratios at least modestly, making stocks a good investment over the next 2-3 years.
Since March 2009 the S&P 500 has more than doubled even as investors ran away from stocks; there were net outflows of $258 billion from equity mutual funds and $654 billion net inflows into bond funds. Individuals particularly hated U.S. equities, selling $353 billion in domestic equity funds, but they loved gold. Investors didn’t worry about missing the bull market in stocks because they were making good money in bonds and gold. But now the “safe haven” status of bonds and gold has been shattered, necessitating a rethink. Over the next couple of years stocks will become respectable again as we shift to a new investment regime.
The ABEI Regime (2001-2013) . . .
Abei is not a city in the Middle East; it stands for Anything But Equity Investing. The bursting of the tech bubble, 2000-2002, discredited long-term investing in equities — a view that was confirmed by the 2008 crash. So investors flocked to:
- Residential real estate (until 2008).
- Commercial real estate.
- Bonds.
- Gold (Remind me again—is it a hedge against inflation or deflation?)
- Other commodities, ranging from platinum to timber land.
- Private Equity
- Hedge funds. To avoid the risk of long only investing, most funds actively trade—long / short pair trades; distressed debt; risk arb; macro bets on gold, currencies, etc.; and (it turns out) quite a bit of insider trading.
ABEI has driven a cultural shift in the markets that younger investors don’t appreciate. There is today an absurd fixation on macro issues, such as Wall Street’s current “taper tantrum.” ETFs facilitate aggressive trades in obscure macro variables that were out of reach of most investors a few years ago. Brokerage firms have shifted their focus from researching long-term growth opportunities to spotting short-term trades. At the morning meeting, salesmen are less interested in Starbucks’ growth rate than how SBUX options will trade when the company reports same store sales on Wednesday. The Street’s new short-term ethos is nicely captured in the entertaining book Buy Side by former hedge fund trader Turney Duff, a man of many vices (cigarettes, booze, coke, pot, hookers, porn) and considerable literary talent. Duff describes the often zany interaction between traders at “buy side” money management companies and the “sell side” (brokerage firm) salesmen and sales traders who help them make money for their investors—or at least live well in Manhattan while failing to do so.
During the ABEI regime influential institutions, such as Ivy League endowment funds, shifted from U.S. equities to the above-named alternatives, particularly hedge funds and private equity. For example, Harvard’s allocation to domestic stocks fell from 38% in 1995 to 11% in 2013. The current allocation of Yale and Princeton to domestic equities is even lower at around 7%. Stuck in illiquid assets, they are missing out on the rally in U.S. equities.
. . . and Four Reasons Why ABEI is Fading
Reason Number 1. Investing is about the future, not the past. If I look at the stocks I own – CAT, PM, SBUX, whatever – it is not their fault that stocks collapsed in 2000-2002 because they became overvalued. Nor is it their fault that in 2008 the financial system almost collapsed due to a housing bubble created by Washington with ample help from Wall Street and Main Street. Stocks may be volatile, but with everyone on the lookout for the next bubble, they are actually less risky than before 2000. And if you own stocks for long-term dividend growth, price volatility doesn’t matter much. Even during the 2008-2009 crash, more S&P 500 firms raised than cut dividends.
Reason Number 2. Macro bets are little more than gambling because no one except George Soros can make money anticipating macro trends and investor psychology. Even the Fed, with its platoons of economists and unlimited access to financial information, has failed to anticipate the last three recessions. Currently some big-name fund managers, such as John Paulson and David Einhorn, are losing big money in gold. And the crown is slipping from the brow of “Bond King” Bill Gross, who proclaimed nearly a year ago that the “cult of equities” was dead because stocks are a “Ponzi scheme.” Stocks are up 18% since Bill shared his insights with the public. (For why Bill was wrong, see our Aug. 3, 2012 post, “Another Stock Market Buy Signal from Bill Gross?“)
Reason Number 3. From the point of view of shareholders, large U.S. companies have rarely been better managed. Companies cleaned up their corporate governance act after Sarbanes Oxley was passed in 2002, and they became even leaner and meaner after the 2008 liquidity scare. Margins have never been higher and firms are judiciously allocating free cash flow toward capex, M&A, dividends and buy-backs in a very shareholder friendly manner. Corporate tax reform that liberated overseas cash would further enhance this theme.
Reason Number 4. Hedge funds have several serious flaws that are gradually becoming recognized. They are tax inefficient because gains are taxed annually as ordinary income, not eventually at a lower capital gains rate. Second, trading strategies that try to exploit short-term market inefficiencies fail to benefit from the fact that stock prices really do rise over time – for example, at a 6.7% annual rate since 1966 (not including dividend yield, which averaged 3.0% since 1966). Hedge funds are also illiquid and expensive.
Bottom line: As the alternatives lose their luster stocks will become more popular with investors and, assuming inflation and rates stay low, the PE ratio will trend higher. Rising PE on rising EPS is a potent combination; it is multiplicative, not additive. (Eg., if PE rises 10% and EPS 20%, price rises 32%, not 30%). If the S&P 500 earned $124 in 2015 and the trailing PE rose from the current 15.2x to a very reasonable 17x, the year-end 2015 price would be 2111, up 32% from the current level. Throw in dividends and you’re looking at a total return of nearly 40% in two and a half years.
Historical Perspective: Stock Market Regimes Since 1950
1950s: A Hedge Against Inflation. With bond yields very low in the 1950s investors—still scarred by the 1929 crash—cautiously crept back into stocks, which rose 258% as the trailing PE on GAAP EPS rose from 7x to 17x. The market mantra was that you had to be in stocks as a “hedge against inflation” (which is mostly true as long as inflation is not too high).
1962-1972: Stocks a Go-Go In the sixties, stocks went from necessary to sexy. Financiers started to create what the media called “high-flying conglomerates” that flattered their earnings by using their high-PE shares to acquire companies with lower PEs. Conglomerates’ glamour was tarnished by poor performance during the 1970 recession, but investors moved on to “one decision growth stocks” in 1971 and 1972. The “nifty fifty” were mostly tech, healthcare, and consumer growth issues that were, in many cases, excellent companies. But they became too expensive (median PE: 41x) and collapsed when inflation spiked in 1973.
1970s: Inflation and the “Death of Equities.” Stocks were a terrible investment during the inflationary 1970s; the S&P 500 was no higher in 1982 than 1972, meaning its inflation-adjusted price fell 57%. Corporate America was over-regulated and poorly managed (why bother cutting costs when you can raise prices?), and risk capital nearly dried up as capital gains taxes soared. With investors fleeing equities in favor of real estate, gold, industrial commodities, and collectibles, Business Week flashed an early “buy” signal with its 1979 cover story, the “Death of Equities.”
1980s: Rebirth of Equities The collapse of inflation in 1981-83, and a surge in corporate takeovers (many financed with new-issue junk bonds invented by Michael Milken) drove stock prices up 227%. But high real interest, stock market volatility caused by program trading, and the 1987 stock market crash kept the public on the sidelines.
1990s: Stock Market Mania Very low interest rates after the 1990-91 recession pushed individual investors back into stocks, and by the late 1990s they were enthralled by the Internet and TMT (tech, media, telecom) stocks. As money poured into index funds valuations of large-cap stocks hit excessive heights; by March, 2000 the S&P 500 trailing PE was 26x. The ensuing crash was arguably worse than the 1930s or 1970s, because many Internet companies and widely held large-cap issues – such as Nortel, Lucent, Worldcom, Enron, Sun Micro, and Global Crossing – did not merely decline in price; the companies crashed and burned.
2001-13: ABEI (Anything But Equity Investing)—see above.
2013-20??: Stay Tuned
Copyright 2013 Thomas Doerflinger. All Rights Reserved.
