2007 Outlook: Bet on Stocks
This bull market can't get any respect. Since the market bottomed more than four years ago, Standard and Poor's 500-stock index has returned 89%. But ordinary investors could hardly be less excited. Indeed, many seem scared of stocks. "People are still nervous," says Sam Stovall, chief market strategist with Standard Poor's. My advice: Get over it; stocks are cheap.
During most bull markets, price-earnings ratios expand as the market rises. That makes sense: As stocks rise in price, investors become increasingly optimistic, bidding their prices up ever higher.
But that hasn't happened this time. Instead, the market has become cheaper even as stock prices have climbed. The price-earnings ratio of the SP 500 was a lofty 27 on October 9, 2002, when the market hit bottom. A year later, the P/E had fallen to 26. By October 2004, it was down to 19, and by October 2005, it had slipped to 18. Today, the market is trading at a bit less than 18 times trailing earnings -- and less than 16 times analysts' projected earnings for 2007.
As stock prices have risen, corporate earnings have climbed even higher. Thus, price-earnings ratios have contracted. Put another way, investors have been willing to pay continually less for a dollar in earnings even as the market -- and the economy -- has strengthened.
Why? I think there's one huge reason: Most investors got clobbered in the 2000-02 bear market, and many haven't gotten over it. Indeed, many haven't broken even yet. The Dow Jones industrial average has topped its 2000 high, but the SP 500 still hasn't, and Nasdaq stands at less half of its 2000 peak of over 5000.
Many investors still worry about another devastating bear market. But history tells us that the 2000-02 downturn -- during which the SP lost nearly half its value and Nasdaq lost four-fifths of its value -- was likely a once-in-a-generation event. A similar market catastrophe hit in 1973-74, but before that, you have to go back to the Great Depression to find such awful losses. In most bear markets, which usually occur every four or five years, the major averages shed 20% to 30% of their value -- and set new highs within two years of the bottom.
Price-earnings ratios don't tell you everything, but they make a bear market less likely -- and, if one does hit, they make a severe bear market very unlikely. When the 2000-02 bear market began, the SP was trading at about 32 times earnings -- and many tech stocks sported triple-digit P/Es (if they had P/Es at all, since many of the young tech companies with obscene share prices had no profits).
Today's market environment offers a lot of positives. Yes, economic growth is slowing, but a recession seems unlikely. Corporate profits are growing, unemployment is falling, the Federal Reserve has stopped raising rates. The merger mania on Wall Street shows that corporate chieftains and private investors find stocks attractive.
Not that things can't go wrong. The Middle East is a geopolitical mess -- and that could lead to even higher oil prices as well as terrorist attacks. Housing prices are falling, which makes consumers less willing to spend. The dollar's fall could get out of hand. The U.S. suffers from huge budget and trade deficits.
But there are always things that can go wrong, and investors have usually been better off betting on the economy to muddle through. SP's Stovall predicts an 8% return for stocks next year. I think that's conservative.
What should you buy? Any of the funds in the Kiplinger 25 are worth considering. Among my favorites are Bridgeway Aggressive Investors 2 (BRAIX), Dodge Cox International (DODFX), Excelsior Value Restructuring (UMBIX) Legg Mason Opportunity (LMOPX), Marsico Growth (MGRIX) Muhlenkamp (MUHLX) and Selected American Shares (SLASX).
In short, I think investors would be wise to take a long view of bull and bear markets. Sure, bad things can and will still happen. But there is ample evidence that P/E ratios are historically low.
Steven T. Goldberg is an investment adviser and freelance writer.