Why carry stocks?
Correction is always bears’ show, with bulls on trial.
Bears’ prosecuting question: why carry stocks?
Bulls’ answer (mostly from briefings.com):
Growth
Real GDP growth was revised lower to a 2.2% annual rate for the fourth quarter. That follows a 2.0% growth rate in the third quarter. Consumer spending remains steady while housing remains a drag. Business investment should pick up as 2007 proceeds. Real growth will probably continue in the 2% to 2.5% range for the first half of 2007.
Earnings
Earnings growth expectations are down to 5% to 7% from our previous 7% to 10%.
Inflation
News has been good. The core rate on CPI has actually risen to 2.7% on a year-over-year basis from 2.6% in our last report, but it will soon start downward. January posted a 0.3% increase. Before that, there were three straight 0.1% monthly gains. As large numbers drop off the back end, the year-over-year rate will ease. It had appeared that inflation was moderating significantly, but now it appears that only a modest improvement is occurring. Inflation will not ease enough to allow the Fed to lower rates even as economic growth softens.
Long-term rates
The 10-year note yield has held in its range of recent months. It is now at the low end of that range at 4.53% but this is the day after a stock market plunge which precipitated a flight to bonds. As long as it holds between 4.50% and 5.00% (which may be a long time), it will not be a major factor on stock prices.
Valuations
Valuations are very reasonable. The operating earnings P/E on the S&P 500 is just 15.9 through fourth quarter earnings (almost complete).
, valuations are very reasonable. The operating earnings P/E on the S&P 500 is just 15.9 through fourth quarter earnings (almost complete). That is down a bit from 16.0 at the start of the year.
The stock market plunge on February 27 took the excessive optimism out of the market, but it was not based on new bearish conditions.
Valuation metric
There is a long-term relationship that the 10-year yield runs approximately equal to the forward earnings yield. (The earnings yield is the inverse of the P/E). The expected operating earnings yield for the next four quarters is 6.9%. With the 10-year note currently at 4.53%, this simple model suggests that stocks are undervalued by almost 30%.
Bears’ criticism:
1. Even assuming your macro view is reasonable, my earnings yield of carrying S&P 500 is only 6.9%, and my cost of capital is already 5.25%, not very bullish;
2. “Real growth will probably continue in the 2% to 2.5% range for the first half of 2007”. This is too optimistic:
Economy is now at the end of cycle, and more importantly slowing down of housing is going to drag down economy further. Therefore, the growth is going to be lower than 2% to 2.5% range, if not becoming negative. So earnings yield of S&P 500 is going to be a lot of lower than 6.9%. Then, why carry it?
It’s hard for traders to push up Dow this morning while bulls are on trial, and they just managed to go above 12300 by 2 points, as of 2:00ET.
On downside, I guess traders will try 12250 again before closing.
