I’ve Found a Signal for Stocks You MUST Know About

Growing up, I spent most of the summer at the neighborhood tennis and swim club. July 4th was a special day and featured the club’s summer tennis tournament, a cookout and fresh watermelon giveaway. There were also pool games. For me, the highlight of the day was what I called the “penny dive.” Basically, the supervisory grown-up threw a handful of pennies in the pool. The object of the game was to dive to the bottom and pick up as many coins and possible. This was a daring feat, testing all sorts of skills. The divers able to get to the bottom first could pick up the most and had the best shot at the prize.

This was 33 years ago and, ironically, U.S. equities were in a bear market. The S&P 500 hovered around 96. I’ll say this again: the S&P 500 was at 96. The price-to-earnings (P/E) ratio for the index wavered between 9 and 10.
It’s often said that bear markets end in single-digit P/Es. By 1982, the multiple had shrunk to 7 or 8. Shortly thereafter, the market was off to the races and didn’t look back until the end of the 20th century.

Today, 10 years into the 21st century, many market observers — including myself — would classify the current scenario as a structural bear market. But we may be seeing a bull showing up in the horizon soon. Here’s why…

Are we there yet? Are we there yet?
If you spent the past week on vacation and you happen to be the “owner” of small children, the questions above are probably still echoing all around your skull. Investors have been asking the same thing about the market turnaround. Correct me if I’m wrong, but the market has kind of been on a tear since mid-2009. However, looking at the past decade, a chart of the S&P 500 shows that stocks have basically gone nowhere.

So while we’ve had a nice run lately, save for two 7% pullbacks so far this year (thanks to the Arab Spring, Japanese earthquake and eurozone troubles), nothing much has changed in the past 10 years. P/E ratios aren’t nearly as high as they were circa 1999-2000.

But many value investors will argue that stocks aren’t that great of a bargain based on where multiples are now. Analysts project 2012 earnings per share (EPS) for the S&P 500 at $106. This would put the forward P/E right at around 12.6 times 2012 earnings. So how do we get to a single-digit P/E? Mathematically, it’s fairly easy: a 25% pullback to the 1014-990 range would take the 2012 P/E down to about 9.5.

Most investors don’t want to see a 25% correction. But we have seen worse.

What’s the catalyst? That’s the 64-billion euro question. Oil shock? Open hostilities with Iran? Greece pulling out of the euro zone and hitting the Argentinean-style reset button? Maybe a combination of all of the above. Maybe an outlier. Who knows? 

Just like whenever the grown-up would throw money into the pool, if you look at the historical chart and see when the S&P 500 hits single-digit P/E land, it’s a decent sign it’s time to dive into the pool. Some of the kids have already made it there and have been picking up their single-digit pennies. These are big, well known, blue-chip kids such as:

Eli Lilly (NYSE: LLY) — With a forward P/E of less than 10, this pharmaceutical giant sports a 5% yield and a promising pipeline.

Intel (Nasdaq: INTC) — This tech titan’s forward P/E is a shade under 10 times 2012 earnings. It controls the semiconductor market and pays an un-tech-like dividend yield of 3.6%.

Conoco Phillips (NYSE: COP) — Investors can be comfortable holding this big integrated oiler. A forward P/E of about 9, a dividend yield of 3.4% and a focus on the North Sea rather than the more controversial Gulf of Mexico or Persian Gulf provides investors with low-cost, well-managed energy exposure.

JP Morgan Chase (NYSE: JPM)
— Psychologically, it’s hard to hold the big bank stocks these days. If you listen to closely to the news, you’d think there was no hope for the sector ever recovering. But smart investors know better. JP Morgan is one of the biggest of big banks and trades with a forward P/E of about 8, which is pretty cheap for a huge franchise with such a superb CEO like Jamie Dimon. The yield isn’t bad either. At 2.4%, it’s much more generous than its peers and could rise once the cloud over bank stocks dissipates.

Action To Take –> These are just a few stocks, but they make a diverse basket of holdings with compelling dividend income. There a handful of other large-cap, blue-chip names with single-digit forward P/Es worth looking into as well.

The fact that widely-held names across multiple sectors share the same trait makes me stop and take notice. If bear markets truly end in single-digit P/Es, then these bellwethers may be part of the first wave of a market recovery. We may not be there yet. However, if you look at the whole process as if we were driving on an interstate highway, then we could be just a few exits away.