Market Watch - September 29, 2005

Measuring Future Stock Returns

Last month, Market Watch published a chart that mathematically reviewed past stock market returns produced since 1965. These are returns that occurred after the ten year Treasury bond produced certain yields. Take a look.

This chart is telling us the opposite of what we might expect. Logic dictates that when the ten year treasury bond yield is low, the cost to corporations of doing business is much less, and therefore, during a period of ten years after low treasury bond yields, the return on the S & P index of 500 stocks should be excellent. But that is not how the market works, and this is why:

1. Ten year bond interest rates set the rates on almost all variable rate bank loans and variable rate mortgages. Interest rates are driven down by the Federal Reserve System when it appears the economy is becoming sluggish. The theory is that lower interest rates will stimulate borrowing for consumer spending and for corporate capital investment. The borrowing will create jobs and increase cash flow in the economy. What happens, however, is that during times of lower interest rates, the stock market is driven to unrealistic values. The market becomes so overpriced that it takes several years to readjust to average values. That period of adjustment is either a sideways movement, like we have been experiencing the last few years, or a big decrease in value, which we experienced earlier in this decade, or, since the year 2000, a combination of the two. The consequence is that stock market growth in the years following extremely low interest rates is modest.

2. In periods of high interest rates, the cost of consumer and corporate borrowing is high. High interest rates induce consumers and corporate borrowers to forego spending until such time as rates make economic sense to spend borrowed money. During that period of waiting for interest rates to become more economically feasible, the government, corporations and consumers must continue to pay interest on already existing outstanding debt. Those interest payments are high and require a higher percentage of individual and corporate income. High interest rates frustrate individual disposable income, as well as corporate earnings, which lead to a depressed stock market (early 1980s). A depressed stock market will rebound over a period of time when interest rates are lowered, as we witness from 1982 to 2000. Stock market returns during the years subsequent to very high interest rates are unusually high because, as interest rates go down, the cost of borrowing is cheaper, which requires a smaller percentage of income for interest payments. Those lower interest payments are transferred into superior corporate earnings. Superior earnings inspire corporations to increase dividends. Because corporate earnings have increased, the net result is that values in the stock market increase, pushing the whole market into an upward trend.

What is this chart telling us? This chart is telling us that the odds of our making good returns in the stock market over the next several years are substantially diminished. Our economy has piled up debts in historically unparalleled volumes over the last several years. That burden of debt, with interest rates now increasing, is going to require a higher percentage of disposable income for interest payments alone. These statistics are saying that to the extent increased interest burdens curtail the spending habits of the public, corporate earnings will not be able to meet expectations. The market will go sideways, or down, likely resulting in little or no growth in the Standard and Poor Index of 500 stocks over the next several years.

What to do?

Retail buyers make good returns in the stock market by purchasing quality stocks when they are cheap. Right now, the stock market, and the bond and real estate markets are all overpriced. They bear what economists call “little or no risk premium”. Mutual funds have the lowest cash position they have had in years because they are fully invested. Yet the market still hasn’t gone anywhere for years. One only has to look at the above chart, and understand the logic, to figure out why the market has gone nowhere. THERE ARE NO FURTHER VALUES ON THE UPSIDE FOR THE MARKET AS A WHOLE.

There are, however, some good opportunities becoming available for investors with cash. Bank of America (BAC) is selling at 11 times earnings and yielding almost 5% with a dividend payout equal to less than 50% of earnings. BAC has a monster growth rate of both dividends and earnings per share. It is hard to imagine BAC not performing extremely well over the next 10 years, yet if it does not, it’s nice to collect the 5% per annum. With good dividends, after several years, one has a considerable percentage of their investment back. Citigroup (C) yields 4%, sells at eleven times earnings and is another monster. US Tobacco (UST) pays a dividend of 5.5%. UST sells at 13 times earnings, it’s an A rated stock, and it virtually has a corner on the smokeless tobacco market

If it is the desire of investors to be in markets when bargains are available, a few of these bargains are becoming available. A very good service that delineates excellent buying opportunities based upon dividend yield, price earnings ratios, book value, and a host of other important variables, is Investment Quality Trends (www.iqtrends.com).

The astute and patient investor can keep cash available for good stock buying opportunities that will occur over the next several years. While the return on cash is not great, the investor has reduced their risk substantially by holding cash. Investors sometimes hypothecate that since inflation appears to be higher than the yield paid on cash, they are “losing money”. The truth is that when great buying opportunities begin to become available, they must be capitalized upon quickly, which one can do with cash. Subsequent increases in earnings, dividend increases and stock appreciation for those securities found on the bargain table more than make up for any losses suffered from the payment of low interest rates from investments in cash or cash equivalents.

Question: What happens if those bargain basement stocks I buy go down?
Answer: One buys any stock because the company is well managed and has a proprietary niche in the market. When good stocks go down, if an investor still has confidence in the company, add to your position.

Conclusion:

We live in an economy constructed of debt, liabilities, credit and negative savings. We borrow 80% of the world’s annual savings, and 70% of our GDP is a result of consumer spending, much of which comes from consumer borrowing. We have a growing net negative investment position in the world (we owe more than we are owed) from two decades of persistent U. S. current account deficits. We consume more than we produce, which is simply unsustainable.

The U. S. economy remains in a vulnerable and dangerous position as reflected in the poor performance of the stock market over the last several years. A quote from last months article is appropriate and instructive: “the way to make money in the stock market over time is to purchase stocks when they are a bargain. Historically that means, on the Dow, purchasing stocks selling at less than their average price earnings ratios of 14.2 times earnings, and paying a dividend with yields in excess of 4%”.

Overall, the market is still very risky. But, the good news is that a few decent buying opportunities are becoming available.

Caveat Emptor.
George Rauch
September 29, 2005