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Equity Valuations

equity-valuations
Chart is courtesy of Northern Trust

You may need to click on the chart above to see the detail, but what this chart is demonstrating is that equity valuations – how expensive or how cheap stocks are in the aggregate – for the four major categories of stocks (Large Cap, Foreign, Emerging Markets, and Small/Mid Cap), those stocks are in general trading below their 15 year average valuation.

But, that does not mean they can’t get cheaper from here.

The current economic situation in the US and abroad seems to justify valuation levels that are below recent-historic averages.

Valuations come from investors willingness to put their hard earned money to work in a long-dated asset. If the investment environment is murky, then it is tough for investors to get excited about committing to an equity investment.

Additionally, investors require a higher cash return in the aggregate since they are less convinced that the capital gain return component will be as significant as it has been at other times when the world’s economy was on better footing.

The average yield on Large Cap stocks is at 2.2% compared to 1.7% for the 15 year average. It may not seem like that is a big difference, but that one-half percent differential between 1.7% and 2.2% represents a 30% premium in dividends over the average, which is significant.

I often get questions along the lines of “Is this a good time to be a buyer?” The real answer is whether you are looking to buy for the long-term (maybe a retirement in 15 years) or the near-term (your kid’s college tuition in three years).

For the long-term, I think it is a decent time to be a buyer – but if the European problems do not get adequately addressed and they spread to the rest of the world, then obviously valuations can get a lot cheaper.

For the short-term, I think you have to be really aware of the issues that are facing the world and understand that if valuations get a lot cheaper, you have a lot less time to recover in the short-term than in the long-term.

Secular bear markets and secular bull markets run in roughly 18 year cycles.

long-term-trading-range

This graph shows you our current Secular Bear Market and how the stock market has moved since the beginning of it in 2000. As is typical in these Secular market situations, whether Bear or Bull, you have significant cyclical movement up and down. We have a pretty clearly defined top around 1550 on the S&P 500 Index. This Secular Bear Market will not end until we are able to break through the 1550 level and stay above it.

You can see where we are today, we have made more than a 100% move from the low at 666 on the S&P 500 Index in 2009 post-crash.

Unfortunately, there are people that stayed out of the stock market for most of that move and have only recently begun to get back in simply because the yield on the stock market is more (and sometimes much more) than the yield they are getting on bonds and certificates of deposit.

If their time horizon is long-term, they understand that stocks can go up and down, and they are mentally capable of riding the stock they own up and down, then in my opinion, they can look at a stock for yield. And as long as the dividend is safe – meaning the company can pay it even if the stock price goes down due to a poor economic situation – and they are able to buy more shares of the company when the price goes down, then those people will be OK as stockholders.

The people I worry about are those that got out of the market somewhere near the bottom, waited until most of the recovery has been experienced, and now want to own a stock for its 4% yield – those are not people with long-term horizons. Those are people that should stay in CD’s because they are likely to see their stock pull back 10% or more, and instead of buying additional shares, they sell and lose significantly more in capital losses than they collected in dividends during their short-term holding period.

Pfizer

This is the same graph as the earlier one, except I’ve over-layed a graph of Pfizer (the green line). This is one of the companies that is paying an over 4% dividend yield. You can see that it has tracked the stock market fairly closely over the past 20 years. When the market was near its lows, Pfizer was paying an above 7% dividend yield, now that the market is nearing the highs, it is paying above 4%.

For the the investor with the long-term horizon, understanding that markets move up and down allows them to buy additional shares if their holding goes down in price. Wouldn’t it have been great for all these folks that are now getting 0.5% on their CD’s to have locked in a 7% yield when the market was at a low? That’s a much better deal than the 4% you get today.

The real key is to have the conviction of your beliefs and to buy more shares of your holding if your 4% yielding company turns into a 5% or 6% or even a 7% yielder. You just have to make sure that the underlying business is still in tact no matter what the stock price is doing. Will the holding still be selling its product if the stock price is at 20 instead of at 35? Will its sales continue to support its dividend?

If you can answer “yes” to these questions, and your horizon is long-term, then you buy more shares. If one of these questions cannot be answered satisfactorily, you are better off swapping into a company with a similar yield to support your lifestyle, but whose sales and dividend stream are solid.

If you perform a self-assessment and you believe that your first reaction is to sell your stock if it goes down 5% – or if you have a past history of doing just that – then you need to stay in your CD’s and bonds and adjust your lifestyle to the cash flow you are receiving.

Investing is a process, and you have to have a plan going into it to be successful, remembering that we are only 12 years into what is typically an 18 year cycle. Sometimes its less than 18 sometimes its more than 18, but you have to be prepared for the market to move lower during the cycle until it can finally break above 1550, particularly since we have moved up so much in the past three years.

If you think overall that stock valuations are cheap and that you can mentally withstand any pull back that might occur in this current Secular Bear Market, then maybe buying a company with a good dividend yield is a plan for you – particularly if you have done your research and understand the company. Also, part of your plan will need to be having some cash available to buy more shares if the company’s stock price falls (and it almost always falls at some point during your holding period – particularly as we are working our way through a Secular Bear Market).

If you think you will be a seller as soon as you experience a loss, stay away from stocks – even if you need the 4% yield to support your lifestyle. You are better off adjusting your spending habits than adopting a plan that ensures you lose money.

And, stay away from junk bonds if you don’t have a long-term plan. The advice is the same for these securities since they trade much like equity investments – the 6% yield that has you salivating just is not worth it if you can’t stomach a pullback and don’t have the cash to buy more when the price goes down. And pull backs in junk bonds (or their more marketing friendly name “high yield” bonds) can be severe.


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Mark