The Sky Isn’t Falling — Here’s why Stocks are Cheap

For the third straight year, the stock market is slumping badly as we head into summer. It’s as if every rally eventually hits a wall and is knocked back to the ground. And every time it happens, investors become further convinced that owning stocks is simply too scary.

In fact, investors have another reason to think stock investing is a losing game: The S&P 500, after approaching the 1,500 level in 2006, eventually found itself in a tumble — and even today, nearly six years later, is roughly 200 points lower.

Yet it’s important to dissect what this means. So much has changed in the U.S. economy in the past six years, so it’s instructive to see what S&P 1,300 really means.

#-ad_banner-#Then and now…
If you compare 2006 and 2012, then a clear contrast emerges. Consumer spending was robust and a wide range of industries saw steadily rising sales. The U.S. government was running up big deficits but few seemed to mind. Meanwhile, many corporations took inspiration from the solid economy and added workers — and debt.

Six years later, the converse is true. The economy feels a lot less inspired, and demand for many goods and services is weak. Yet corporations have since shed massive amounts of expenses — especially in terms of labor costs. This has led to a remarkably robust phase of profits. Indeed, profit margins are at all-time highs in many industries and show no signs of weakening, if recent first quarter results are any indication. And companies have used those robust profits to build cash reserves.

Moreover, the sharp drop in interest rates during  the past few years has enabled many companies to roll over — and extend — their debt at historically low interest rates. Net debt-to-assets of companies in the S&P 500 stood at 17.2% at the end of 2006, and is now 15.6%. And since that debt is at lower rates, interest expense is much lower than back in 2006.

Simply put, many companies are better prepared for a tough economic climate than they were back in 2006. At the time, few saw a major economic slowdown coming, and stocks got hammered in 2008 largely because so many companies were ill-equipped to handle the tough times.

Offsetting risks
Make no mistake, these feel like precarious times. Back in 2006, the U.S. economy looked set to keep growing at a 3% to 4% pace. These days, we’ll be lucky to eke out 2% growth, at least for 2012 and 2013. It will likely be the middle of the decade before a robust pace of economic activity returns. Offsetting this, corporations are so lean that they will likely sustain decent profits, even if the economy dipped below the forecasted 2% growth rate in 2012 and 2013.

By the numbers
To get a better sense of the market’s value, you can look at where we stand by several key measures, starting with the big picture. It may feel as if the U.S. economy has struggled since late 2006, but the numbers paint a different picture. The economy contracted for three straight quarters in late 2008 and early 2009, but has expanded every quarter ever since. Assuming the U.S. economy grows 2% this year, it will be 5.6% larger at the end of 2012 than it was at the end of 2006.

The picture for corporate profits plays out in a similar fashion. The aggregated earnings per share of all companies in the S&P 500 rose 14% in 2006 to $87.72. Though that figure subsequently plunged in 2008, it is now expected to be above $100 in 2012, nearly 20% higher than in 2006. Moreover, book value, on average, is roughly 15% higher in the S&P 500 than it was in 2006.

A little simple math regarding earnings also tells you this market is cheap (using rounded numbers):

Of course, many argue that stocks deserve a much lower price to earnings (P/E) ratio today, as recently summed up by Morgan Stanley’s market strategists:

“Companies have wrung as much savings as possible from their cost structure — through debt refinancing, a leaner workforce, and technology, and that robust revenue growth will ultimately be needed to drive higher future earnings growth. Given the tepid pace of current economic growth, as well as fiscal and regulatory headwinds, high revenue growth is far from certain. Thus, while investors are paying a lower multiple for equities today, they are receiving lower future earnings growth in exchange,” they say.

Yet it’s not clear that this is really the case. Although economic activity is likely to remain muted over the next 12 to 18 months, there remain powerful catalysts for eventual profit growth. Let’s look at two sectors for insights…

Housing. A wide range of industries benefited in 2006 from a solid pace of new home construction, from raw materials producers to pick-up truck manufacturers to building supply chains. These days, the entire housing complex is barely breathing, contributing little or nothing to S&P 500 earnings. Yet when you consider the ongoing expansion of the U.S. population and the five-year run of little new construction, you can make the case that there is a lot of pent-up demand and that housing construction activity will be a little better in 2013, somewhat better in 2014 and perhaps quite healthy by 2015.

Banks. Low interest rates have crushed the profit spreads that banks typically garner. Moreover, lending to both consumers and small businesses remains anemic. Yet slowly rising employment trends (and yes employment trends still appear positive even with the recent cooling) foretell a rising level of economic activity that should eventually help jumpstart banking activity. Bank profits were a large component of S&P 500 profits in 2006 and are a much smaller component today. A reversion to normalized banking activity could add $10 or even $15 a share to aggregated S&P 500 profits.

It’s important that you distinguish a weak economy (which we have right now) from a recessionary economy.  The U.S. economy continues to expand in the face of robust headwinds, and as those headwinds abate, the stage may be set for more solid economic growth as we head toward the middle of the decade.

Risks to Consider: Investors won’t fully embrace the “stocks are cheap” thesis until they are certain that the European crisis won’t spiral out of control.

Action to Take –> It’s very hard to call the next move for the broader market, but many individual stocks are extremely inexpensive. They are out of favor now because of fears of a broader U.S. economic slowdown, yet their valuations don’t even begin to account for the eventual strengthening of the U.S. economy. Now is the time to load up on these stocks for the long haul (or at the very least, start building your wish list).