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October 16, 2006
But while late-year rallies in each of the last 2-years brought the Dow to the cusp of 11,000, today’s rally has pushed the average to 12,000. If this rally can be sustained it would be the first real up-leg in the Dow since the big bounce in 2003.
Valuations Not Holding Dow Back Many Dow components are not overvalued based upon some very basic valuation measures (excel). For example, Wal-Mart trades at 0.61-times sales and 18-times earnings. If it wasn’t for the very real threat of a consumer led recession in America, Wal-Mart would probably be worth accumulating at current prices. And while it is often argued that if you always wait for the perfect opportunity to buy a quality company that such an opportunity may never arrive, with WMT the question must be asked: what is the big rush? WMT’s 1.4% dividend yield does not offer any downside protection if things turn bad for the U.S. economy, and – lets be honest - a lot of things are going to have to remain just right for times to stay good.
P/E Speculations Assuming companies with higher P/Es are poised for stronger growth and companies with lower multiples are in for rough times (i.e. many homebuilders have ‘low’ P/E’s of <5 because the housing boom has turned to bust), Dow components are sending out some conflicting signals insofar as the future direction of the U.S. economy is concerned. For example, companies like Citigroup (PE of 11), Caterpillar (12), Exxon (10) and Home Depot (13) are trading at historically low multiples, which suggests that investors are pricing in a consumer spending slow down, negative repercussions from an inverted yield curve (JPM, C), and the death of energy as a growth investment. But what is not clear in light of these low multiples is why a company like Dupont trades at more than 22-times earnings and why Disney, which yields less than 1%, trades at 21-times earnings. In short, although some Dow components are attractively priced if goldilocks remains the theme, on the average no absolute valuation measure sees the Dow as undervalued based upon long-term historical valuation averages. Dow may be breaking records, but not in bull market style The 1990s stock bull lasted longer than most thought possible because there was a constant flow of new money entering the markets and chasing stocks higher. In the context of a financial world awash in excess liquidity, the Dow’s record rally today is, in part, being fueled by real estate/commodities investors seeking refuge in stocks. "Money that a year ago would have been invested in Miami condos and six months ago would have been invested in crude oil futures is now looking for a home” John Skjervem, Northern Trust (AP) While large capital movements between asset classes is not always a red flag, there is cause for concern if today’s movements are being made by investors and managers whose investment horizons stretch to next weeks Fed meeting, or next months election. To be sure, whereas a long-term bull market can engender a ‘buy the dips’ mentality among market participants, a rotationally driven rally can sometimes create the conditions that make sharp market declines possible. For example, in 2000 when money temporarily rotated out of ‘new economy’ stocks and into ‘old economy’ stalwarts many analysts applauded the safety that traditional blue chips offered the investor compared to tech. In hindsight, market rotation in 2000 was simply a sign that the bull market was exhausted. Question is, does rotation in the marketplace today mark the end of the good times? Although a difficult question to answer in a timely manner, that large cap U.S. stocks are being touted for their ‘safe’ qualities today is eerily familiar to rational given to buy blue chips in 2000/01. For that matter, that JNJ – a recession resistant company - is the top choice among stock newsletters at a time when the Dow is supposedly kicking off another bull leg is, well, just plane eerie. Of equal concern to the rotational forces at work in the markets is the fact that - based upon P/E disparities - many Dow components are already pricing in a peak to the corporate earnings cycle. With economists (Bloomberg) recently cutting GDP estimates to 2.6% in 2007 – the weakest since 2003 – labor costs rising, and CEO confidence slumping to a 5-year low (conference board), evidence is mounting that the historic streak of double digit increases in U.S. corporate earnings is in jeopardy. But alas, we are told not to fear: the Dow is relatively undervalued compared to other markets both global and domestic (i.e. small/mid caps), big capital shifts simply prove that large cap U.S. stocks have been out of favor far too long, and the earnings hawks are wrong again. As for the U.S. economy, it is growing! and as one M&A analyst recently put it, “Low interest rates mean “it's cheaper to borrow money than go bankrupt””. Growth today may well cost the U.S. consumer dearly tomorrow, but who really cares… In summary, although July 14, 2006 has definitely usurped May 11, 2006 as the most important ‘transition’ day this year, it is nonetheless difficult to conclude that this transition was into a sustainable stock market bull. The Dow’s rally may simply be the handiwork of the hot money crowd in search of a temporarily sanctuary. That this crowd previously parked capital in skyrocketing real estate, natural gas, and (still) perfectly priced emerging markets doesn’t worry the Dow cheerleaders. It should. |
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