Stocks are still undervalued in spite of benefiting from the strongest September since 1939. Clearly, the market became overly pessimistic about the prospects of a new recession. It appears now that the economic recovery is intact but much slower than the majority of post-World War II recoveries.
Outside of the six months surrounding the Lehman bankruptcy, stock valuations are the cheapest since 1988 in terms of the ratio of the price to next year’s earnings. Dividend yields for many stocks are higher than the yield on ten-year Treasury bonds. Typically, Treasury holders require a much higher interest rate than the dividend yields on AAA stocks due to the fact that the Treasury coupon payment is fixed, while the dividend payment will grow over the next ten years.
At the risk of giving too much information, the math works like this: Owning one ten-year Treasury bond ensures that you will receive an annual interest payment of approximately $25 each year until 2020. If you invested the same amount in the stock of the four companies whose debt is rated AAA by Standard and Poor’s (Johnson and Johnson, ADP, Microsoft, Exxon) you’d expect a dividend yield of about 3% or about $30 from your $1,000 investment.
The average annual dividend growth rate for the four AAA rated companies over the last five years is about 12%. If this keeps up, in 2020 the AAA stock owner would receive $93.18 in dividends while the Treasury bond owner would still only receive $25. Assuming that dividends only grow half as fast over the next ten years, in 2020 the investor who owns stock in the four AAA rated companies will receive more than twice the payment of the Treasury bond holder ($53.73).
It’s hard to imagine dividend yields getting much higher relative to treasuries. So, as dividend payments grow, the stock price should move higher as well. Without stock price appreciation that is in line with the growth of dividends, yields that are already at a nearly unprecedented premium to Treasuries would go even higher. In other words, bond-holders will likely underperform stock owners over the next ten years in one of two ways. Either they lose their shirts while interest rates go much higher, or they break even while stocks go much higher.
Given the extraordinarily high levels of cash on corporate balance sheets (Microsoft has $27 billion in the bank); it’s unlikely that the growth of corporate dividends will slow down any time soon. If overall economic weakness leads to a shortage of corporate growth opportunities, companies will likely increase dividends. If growth opportunities are widespread, dividends will stay lower but the growth rate of corporate earnings would be more robust.
The biggest strategic decision that stock investors have to make today is whether to favor the stocks that would do best during a sparkling economic recovery, or own the higher rated, stable dividend payers whose financial fortresses will support them through an uncertain economic environment.
The smartest investors I know tend to believe that growth opportunities will be more limited over the next ten years for all of the usual reasons. The consumer is saddled with huge debt loads, government deficits will limit fiscal policy, and banks are just trying to survive this period of foreclosure and regulatory uncertainty. This economic view seems to support a more defensive, low-earnings growth, high dividend yield strategy.
But, if we let the market speak for itself, this type of strategy has substantially lagged the strategies that emphasize smaller, higher growth companies that are less likely to pay dividends. In 2010 our strategy has been to emphasize higher quality companies, and it has been somewhat of a struggle to keep up with the S&P 500 this year.
The S&P 500 and the market in general have been led by lower quality companies. The market seems to be saying something different than the experts. Specifically, that growth prospects are more robust than what investors currently perceive, and the more risk you are willing to take on, the greater reward you will receive. Subsequently, our recent trades have increased our exposure to economically sensitive companies like DirecTV, Siemens, & BASF.
I’m not normally a big proponent of seasonal trading patterns, but one historic pattern that seems to be proceeding according to script is the mid-term election cycle. Historically, the second year of a presidential term experiences a volatile trading range during the first nine months of the year. On average, after the turbulence, the market benefits from an eight to ten percent rally in the final months of the year.
So far, 2010 is experiencing a volatile trading range. If the fourth quarter holds true to historic performance, we could see a nice finish to this rocky year. Surprisingly, this pattern seems to occur regardless of whether the majority
retains control. Maybe the cause of the outperformance after the midterm elections is that investors are relieved to no longer have to think about politics.
Whatever the reason, hopefully the pattern will persist again this year. Most of our portfolios are up four or five percent for the year. If the fourth quarter is decent, 2010 will end up as a better than average year for stocks. Right now it looks like everyone who isn’t short is doing pretty well. It hasn’t mattered whether you’re in bonds, gold or stocks. Investors’ accounts should end 2010 up substantially from the beginning of the year, which is probably the best indication that the economic recovery will continue.