Sluggish Growth Not All Bad

1/14/2013


On Jan. 4, after the U.S. Labor Department issued a December employment report in line with expectations — and commentators rightly and widely noted that much faster growth was needed to reduce unemployment substantially — the broad S&P 500 Index closed above 1,466 for the first time in more than five years. The cyclical Dow Transports closed at a fresh 52-week high, less than 2% from an all-time high.

The Dow Industrials have not confirmed the move to significant highs in the Dow Transports, and that is one reason we are keeping some cash on the sidelines. But we disagree with the skeptics who argue that five-year highs in the S&P 500 are inconsistent with today's sluggish economic growth, partly because we don't think valuations for S&P 500 stocks reflect expectations of robust earnings growth. Also, an environment of slow-and-steady growth would not be all bad for equities.

Valuation comparisons

The nearby below compares today's valuation numbers for the S&P 500 to those from March 2000 and October 2007, the two other times the index was near current levels. Today the S&P 500 trades at roughly 13 times expected year-ahead earnings, versus forward P/Es of 15 in October 2007 and nearly 26 in March 2000.

S&P VALUATION SNAPSHOTS
March
2000
October
2007
January
2013
S&P 500 Index level
1,527
1,565
1,457
Forward price/earnings ratio of index
25.6
15.2
13.1
Median price/earnings ratio of 500 stocks
17.4
17.9
16.4
Average price/earnings ratio of 500 stocks
22
20
18.3
Median price/earnings ratio of 50 largest stocks
28.5
18.1
15.4
Average price/earnings ratio of 50 largest stocks
36.3
19
15.9
Dividend yield of S&P 500 Index (%)
1.1
1.8
2.2
Yield on 10-year Treasury bond (%)
6.2
4.7
1.9

Those numbers are distorted by the massive compression in P/E ratios for the index's largest stocks. The largest 50 stocks in the S&P 500, which traded at a huge premium in 2000, had P/Es in line with the broad market by 2007. Today the largest 50 stocks trade at a discount, depressing the composite valuation numbers for the capitalization-weighted index.

Still, even on an equal-weighted basis, valuations are not consistent with the euphoria often seen at market tops. Today's median trailing P/E of 16.4 for S&P 500 stocks is more than 8% below the norm since January 1992. Only 26% of month-ends since January 1992 had a lower median P/E than 16.4.

Consensus forecasts

Both the Federal Reserve and consensus forecasts see about 2% real growth in the U.S. economy this year, and the Fed expects fairly sluggish growth through at least 2015, when it expects the U.S. unemployment rate to reach its target of 6.5%. The Fed has pledged to keep short-term interest rates extremely low until the unemployment rate reaches 6.5% or inflation expectations move substantially above its 2% target.

In such an environment, U.S. stocks are likely to remain attractive relative to bonds and cash — assuming overseas economies improve as expected and corporate profit margins hold up. One concern is that consensus forecasts still project 10% growth in profits for the S&P 500 Index this year. And while few may believe that forecast, it's not clear what it will take to satisfy investors.

Conclusion

With December-quarter reporting season about to heat up, the reaction to earnings news could prove telling. A breakout above 13,610.15 in the Dow Industrials would reconfirm the bullish primary trend under the Dow Theory. While we are still holding some cash in reserve, we intend to take advantage of opportunities. This week's addition of Magna International ($52; MGA) means our Buy List has 93.8% in stocks, versus 89% for our Long-Term Buy List.


DOW INDUSTRIALS AND TRANSPORTS


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