Corrections go down long enough to scare everybody out and make sure they give up, and then they turn around.”
— Jim Rogers
Stocks: A Relatively Great Buy
Over the last week or so the U.S. stock market has dropped an astonishing 13%. The stock market is a voting machine where investor confidence and expectations are always driving price movements—sometimes quickly and dramatically in the opposite direction. The headline fear is the Coronavirus, but some insightful investors have mentioned that a communist leading the Democratic race for the White Race could also be a factor. In the long run, the latter would be far more damaging. I will leave this paragraph with a riddle that I will not answer: Who is old and grey whom only kids believe in for what they hope he will bring for them? (hint: its not Santa Claus)
There are lot of things that could be said about the markets right now but I am taking the time to right this letter to focus on only one thing: interest rates versus stocks. The following chart compares the S&P 500 stock market index (blue line) and the 10-year U.S. Government bond or “10-year” (red line). Before I get into this chart, it is important to understand that in the financial world, the 10-year is used as a sort of foundational measuring stick for all other asset classes. It is viewed as very safe because of its backing by the U.S. government and the fact that the U.S. has the strongest economy in the world. Regulators consider it to be Tier 1 capital for the banking industry so banks will hold lots of U.S. government bonds as capital to fortify their lending operations.
Back in 2018, the Federal Reserve was raising short-term interest rates and this was driving bond yields higher across the spectrum. For a little while, the 10-year yielded above 3%. It was around this time that the U.S. stock market experienced its just about almost 20% decline in the 4th quarter of that year. There were other market factors at play at that time, but clearly for once the 10-year started to become attractive to investors looking for some yield in a safe package. In 2018 I was able to buy some short-term corporate bonds for clients that were yielding 3.5% to 4% (quality corporate bonds tend to yield a little more than government bonds). Those days are now gone as the 10-year plummeted to an all-time low yesterday of 1.13%.
Despite the recent stock market panic attack, the longer-term trend still remains rising stock prices as bond yields decline. This chart makes this clear:
Chart courtesy of barchart.com; Blue Line = S&P 500 Stock Index and Red Line = 10-year U.S. Treasury Bond
This week, as the 10-year has been racing toward a measly 1%, I was able to buy stocks for you that pay 4% to 7% dividend yields. Exxon Mobil is trading at something like a 15-year low and now yields about 7%. Not only do you get a bargain, but you also get a dividend yield that is literally about 5 times greater than what you can get from bonds.
In my last update letter, I mentioned that I had some spending money on the sidelines in your portfolios. I used roughly half of it this past week. The good news is that there were 2 stocks, in particular, that I really wanted to buy more of but the valuations were way to high. Needless to say, they came down a lot and I was able to build positions in both of them this week for you.
In the short-term, speculative traders can and will swing markets in directions that in hindsight clearly didn’t make any sense. Can the stock market go lower? It sure can. But a few news story could also send the elevator right back up. Just look at blue line right after Christmas 2018.
We have reached the point where there is simply no alternative to stocks for anyone looking to get a return on their money that exceeds inflation. If you are an insurance company selling annuities, what do you do now? Can you have your salespeople out there offering 3% to 4% fixed annuities when you can only get 1.5% on the investments that fund them? What this means is that as things settle down and the true economic impact of the Coronavirus and all the monetary and fiscal actions that are taken because of it become clear, the pressure is going to be on stock prices to rise—potentially very fast.
Sometimes markets will move like a “sling-shot.” They will move quickly in one direction but it is really just a setup for a stronger move in the opposite direction. The current stock market environment holds this potential because (1) most of the current decline is associated with wild speculation on economic outcomes and (2) stocks have become dramatically more attractive relative to bonds. A sling-shot in the near future to new all-time highs would not surprise me.
Just How Relatively Overvalued are Bonds?
Companies earn income and this is divided by the number of shares outstanding to calculate earnings per share. Most stocks tend to trade at a price that is 10 to 20 times their earnings. Investors will pay more for companies that they believe can grow earnings faster. One way to look at it is that if you are paying 10 times earnings for a stock you are paying for 10 years worth of earnings. Theoretically, you could double your money in 10 years if the company generated the same earnings each year, didn’t grow earnings, and just paid out all its earnings to shareholders as dividends. This is the equivalent of a bond paying 10% interest (annually). You would double your money in 10 years.
I was listening to an interview with Warren Buffett this week and he mentioned that buying the 10-year at 2% is like paying 50 times earnings for a stock which is way too high of a price to pay for any stock. With the 10-year closing in on 1%, this is like paying 100 times earnings for a stock which in my previous example means it would theoretically take you 100 years to double your money. This is what investors are paying for the perceived safety of bonds and they are setting themselves up to be devoured by inflation. As I have heard some insightful investors recently comment: bonds are no longer an investment. I am certainly not putting any of your long-term money in them. Instead I am choosing stocks like Exxon at 10 times earnings with a 7% dividend yield or JPMorgan, the best bank in the world, at 10 times earnings with a 3% dividend yield.
Return Pressure Points to Higher Stock Prices
To conclude, I have tried to convey the fact that I think pressure is actually building in the current market environment for higher stock prices. I have been positioning your portfolios accordingly.
Depending upon what strategy you are invested in, your total portfolio is generally yielding 3% to 4% from interest & dividends and includes a lineup of stocks with strong growth potential as well. This is far better than bond alternatives and especially now that many stocks are on sale. I expect this dynamic to get stocks moving higher again at some point in the near future.
Sincerely,
Joshua S. Hall, ChFC
Disclosure:
The True Vine Letter is a publication of True Vine Investments, the investment advisory business of Joshua S. Hall, ChFC, and a Registered Investment Advisor in the U.S.A. The information presented is for educational purposes only and should not be regarded as specific financial or investment advice nor a recommendation to buy or sell securities or other investments. It does not have regard to the investment objectives, financial situation, and the particular needs of any person who may read this Letter. In no way should it be construed as personalized investment advice. True Vine Investments will not be held responsible for the independent financial or investment actions taken by readers. All data presented by the author is regarded as factual, however, its accuracy is not guaranteed. Investors are encouraged to conduct their own comprehensive evaluation of financial strategies or specific investments and consult a professional before making any decisions. Positive comments made regarding this Letter should not be construed by readers to be an endorsement of Joshua Hall’s abilities to act as an investment advisor.