The #1 question
The most basic question for any individual investor to answer as he constructs an equity investment strategy for the new year is whether stocks are likely to go up or down over the twelve months.
My answer for 2011 is that stocks will be up, modestly. Ask me what “modestly” means and I would reply “around 10%,” based on the idea that the earnings growth for the S&P in 2011 will be of about that magnitude. In rough terms, a quarter each of the earnings of the S&P 500 come from emerging markets and from Europe (including the UK). If we say that emerging markets profits will be up by 20% this year, the US by 8% and Europe by 4%, we get one percentage point of aggregate profit growth from Europe, five from emerging markets and four from the US.
The reality is, I think, that no one can forecast earnings even one year forward with great accuracy. Perhaps a more persuasive justification for thinking that 2011 will be an average year for equities would be that the US economic growth appears to have begun to accelerate last September. Industrial production is rising, consumer confidence is improving, companies seem to be rehiring at a faster rate and, in consequence, consumer spending has a firmer tone. This implies to me that 2011will be a much better year economically than 2010 was.
In addition, I don’t think this better news is fully discounted in today’s stock prices. Earnings for the S&P 500 will likely come in at about $90 for 2010. A 10% earnings gain would imply eps for the index of around $100 for 2011. If so, that would mean the index is now trading on about 12.5x forward earnings. This is a modest multiple, considering the 30-year Treasury is yielding 4.5%. Historically, a 12.5x multiple would be more in keeping with an 8% long bond yield. Relative to bonds, their closest competitor among liquid investments, and even factoring in 150 basis points in increased interest rates, stocks look cheap.
easy money and caveats
Commentators are very fond of saying that “the easy money has already been made.” In hindsight that’s often an appropriate comment. But it ignores the considerable angst that an investor always faces when trying to predict future events, rather than analyze the past.
The reason this hackneyed phrase—one I dislike intensely–nevertheless comes to mind as I’m writing this is that the markets have begun to hoist two potential red flags about the current bull market. I don’t think they’re immediate concerns, but they weren’t evident at all a year ago. They are:
—time. On March 9, about two months from now, we’ll enter year three of rising stock prices. A typical inventory-driven market cycle consists of two and a half years of up and a year and a half of down. Under normal circumstances, then, this means that at the two year waypoint one should be at least considering becoming more defensive.
I think it’s too early to do so during this cycle, because the downturn wasn’t an inventory issue. It wasn’t a minor one engineered by the money authority to take some excess steam out of a booming economy. Instead, it was a full-blown, train-wreck, shoot-yourself-in-the-foot financial disaster. As we can see from the two oil crises (1973-74 and 1981-82) and the internet meltdown (2000-2003), severe recessions take longer to recover from. So the post-recession bull market should last more than two and a half years.
I think we have to put the end of the bull on our checklist of stuff to watch out for, in a way we didn’t need to last year. But I don’t think it’s a burning issue today. And I think it’s way too soon to assume a defensive portfolio posture.
—the consensus of Wall Street pundits is now bullish, and more so than I am. This fact is a bit more troubling because buying high is so seductive and because you typically make money be betting against the consensus. Also, I’m a growth investor, so I find it particularly difficult to be bearish. Still, my reading of the market is that investors are still overly cautious. Two factors make me think this:
a. in the first half of an up cycle, value stocks tend to outperform. During the second half, that is, for well over a year in an inventory cycle, growth stocks do better. In this cycle, growth stocks as a group have only been outperforming for about four months.
b. as a bull market matures, the discounting mechanism changes. Investors go from paying attention only to bad news to incorporating good news into prices as well. That has clearly already happened. But as time passes without new disasters striking, investors go from discounting good news as it’s being announced to anticipating future positive developments. At the top, market participants aretypically discounting at least a year, and often more, in advance. I don’t think we’re at all close to doing that now.
The #2 question
The second question an investor, even in the US, should ask himself is whether economic strength will be greater in the home country or abroad. To the extent that you invest in foreign stocks, you should pose this question for each country where you’re going to buy a listed stock.
This doesn’t mean you should necessarily avoid countries where there’s poor economic growth. I think, that you should have a preference for stocks whose revenues come from fast-growing areas and be skeptical of those main businesses are situated in slumping regions. So the answer to this question tells you whether to concentrate your efforts on studying domestic or foreign-oriented companies.
My thumbnail sketch for 2011:
US: better growth abroad, but not by as great a margin as last year
Europe: weakest region in the world. Much better growth abroad
Emerging markets (investable ones): better growth internally, but not by as great a margin as 2010
Japan: hopeless. As for the past twenty years, much better growth abroad
That’s it for today. Next post: what can go really right/wrong.