The laundry list of worries continued to grow in November, thanks to the flare up in the Middle East and the fear that the U.S. economy will go tumbling over the “Fiscal Cliff”. When added to concerns about rising deficits in the U.S., a slowdown in China, a complete mess in Europe and a possible housing bubble in Canada, it should be no surprise that investors have flocked to the safety of cash. With the market currently pricing in all the things that could go wrong, our feeling is that investors also need to prepare their portfolios for what could happen if things start to go right.
It is our belief that all of the bad news is already priced in to this market. Corporate profits on the S&P 500 are expected to deliver another year of record performance. Analysts are also expecting more growth in 2013. Yet, stocks are generally priced for an imminent recession. Since World War II, the S&P 500 has averaged about 16 times its current year earnings. At its current price, the S&P 500 is priced at about 13.5 its current year earnings, or about 15% below its historical average. The market is pricing in a decline in profits, yet profits continue to grow, profit margins are near record levels, dividend payments from S&P 500 are at a 13 year high and the earnings yield on stocks is almost five times greater than the interest yield on the U.S. 10-year bond.
Instead of paying attention to all the troubles that are talked about daily on CNBC and BNN, investors need tune in to a revival that is happening in U.S. housing and auto sales. Housing starts are finally coming to life in the U.S. on the back of decreasing inventory, low mortgage rates and housing affordability. Car sales are also recovering dramatically, for similar reasons. While a full recovery to pre-recession levels for housing and auto sales are still a long way off, the current improvement will have a much needed positive impact on U.S. GDP.
In our minds, the market has over-reacted to potential downside and has not focused on events that actually matter to corporate profits. Corporate profits that are delivered to shareholders through a rising dividend stream is the only reason to buy stocks. If some of the current gloom that is surrounding the market starts to lift, investors need to focus less on the downside and more on how to participate in the upside. That should start with a return of cash on the sidelines to quality stocks.