Tuesday, April 6, 2010

Stocks for the Long Yawn

From the beginning of 1994, when the economic recovery from the 1990 recession was more or less complete and the Fed began hiking rates, till now, the stock market as judged by the S&P 500 has risen from 446 to 1187.

Value Line maintains a different index, in which all stocks are weighted equally, so that a small company counts the same as IBM. This reflects the fact that for a small investor, $1000 or $10,000 can just as well go into a small cap as a mega-cap. Institutions of course lack that freedom.

In the same time period, the overall Value Line Index ("Geometric") is unchanged. I also suspect that dividend payouts were higher from the '500', given the greater maturity of those companies.

The Value Line Industrials are actually down a bit, as are the Utilities (though with much higher yields); only the Rails are up (6 times!).

In these past 16 years, the country has been out of recession all but about 2 1/2 years. Thus overall the climate for small companies and their stocks could have been good. It is difficult to explain this observation. Large-cap stocks had been moving up substantially since the 1982 bottom, so they were not "depressed". Did smaller companies' stocks suffer from chronic overpricing?

I suspect that was and remains so. This flies in the face of the standard line that research shows that since 1927, small caps have noticeably outperformed large caps.

Most investors who choose their own individual stocks are best off ignoring market cap and focus on financial strength, track record of the company and the stock, presence or absence of dividends or dividend-paying ability, and other fundamental and also technical factors. When in doubt, financial strength and the absence of a stretched valuation vis-a-vis the underlying assets of the company take away much of the downside risk to a stock.

In the here and now, stocks are either cheap or expensive, depending to whom one listens. Monetary and fiscal stimulus, AKA easy money, are working their magic. Overcapacity is allowing ultra-low short-term rates to persist. Small investors who have patiently held stocks but not bought more over the last few years are increasingly reaching the break-even point. As their perceptions of the overall economy remain downbeat, many will wish to get out even. I for one am sticking either with fundamentally cheap stocks that are going nowhere fast-- RE, RNR, CB; or stocks that are either already at all-time highs or multi-year highs such as TJX, DLTR, MCD and WPI. All the above have P/E's lower than the market and have substantial free cash flows.

Nonetheless, overall yours truly remains of the view that stocks are fundamentally overpriced as a whole and that the current cyclical upturn in the economy is so unbalanced that we need to fear the next cyclical downturn, when investor psychology will allow stocks to return to a valuation which offers a more attractive entry point for the market as a whole.

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