Relax, He Only Looks Scary
Keep today's economic problems in perspective, and good stocks seem like great buys
(MONEY Magazine) – HAS A BEAR MARKET ALREADY STARTED? It's sure beginning to look that way. After advancing for the first four months of the year, the S&P 500 has more than given back its gains. And the Nasdaq is down 10% from its mid-April high. There are substantive reasons for the rise in investor anxiety. High oil prices, resurgent inflation and rapidly climbing interest rates recall the stagflation of the 1970s. And a return to '70s-style valuations would depress stocks by 40% or more. Scary, indeed. But in my view, the pessimists are mistaking a 20-pound cub for an 800-pound grizzly. Or, to be less fanciful, they're confusing minor short-term problems with crushing long-term trends. And that confusion is creating an opportunity to buy topnotch stocks at below-average prices.
The chief cause of all the unease out there today is the notion that the economic expansion, now in its fifth year, is about to come to a screeching halt. "Today's economy is on a collision course with a recession," says market forecaster Jim Stack, editor of the newsletter InvesTech. "And the most probable starting point is the fourth quarter of this year or early 2007." Based on past periods of rising interest rates, he puts the chance of a recession at seven in eight and thinks the main culprit will be the recent run-up in the price of oil and other commodities. To head off higher inflation, says Stack, the Federal Reserve has been raising interest rates, taking a toll on the housing market that will likely spread through the entire economy.
That outlook may not be baked in the cake, but economist David Rosenberg at Merrill Lynch still sees a 40% risk of a recession. The economy is already slowing because of past interest-rate hikes by the Fed, according to Rosenberg, while inflation still appears to be rising. Even if it's theoretically possible to manage rates in a way that stops inflation without hurting the economy, Rosenberg argues, it would be easy for the Fed to miscalculate and raise rates too far.
Even some who don't expect a recession see lots of risk. Pimco's Bill Gross, a leading bond fund manager, expects further increases in interest rates and subpar economic growth that could lead to a drop of at least 10% for the S&P 500.
Why Things Aren't So Bad It's hard to argue with the view that oil prices, inflation and interest rates are causes for concern--but for the next six months or so, not the next six years. Are the severity of today's problems really dire enough to depress the economy for most of a decade, as they did in the '70s? I don't think so.
Oil will doubtless be more expensive over the next 20 years than it has been in the past. Demand from countries like China and India will outpace new supply. But that doesn't mean that today's super-high oil prices have to continue--they're the result of international turmoil and temporary imbalances. Lord Browne, CEO of BP, recently predicted that as the oil market comes into better balance, the price would ease to around $40 a barrel within the next five years.
It's also noteworthy that the recent upsurge in inflation hasn't triggered the kind of rising labor costs that you see in a true inflation spiral. While the total consumer price index has risen 4.1% over the past 12 months, the core rate (excluding food and energy) is up only 2.4%. If oil prices stabilize or go down even a little, inflation could drop below 3% within a couple of quarters.
And as for interest-rate policy, it's debatable whether Fed chairman Ben Bernanke has made any mistakes yet. The question is whether the Fed will go too far in the future.
Moreover, while the pessimists are getting most of the attention, the majority of forecasters remain optimistic about the long-term outlook. Consensus projections are for slightly above-average economic growth over the next three years. Stock analysts expect the typical blue chip to post 11.4% earnings gains this year, with a pickup to 12.9% in 2007, according to Zacks Investment Research. And more analysts are raising earnings projections than cutting them.
Whatever your outlook, you don't want to make decisions about whether to buy stocks solely according to which forecasts you agree with. It's tough to win that guessing game. What you can do is make prudent judgments about the level of stock prices. Stocks were fundamentally cheap after the 1973-74 bear market. Even though the economy stayed bad, had you bought a cross section of blue chips anytime between then and 1980, your money would have multiplied tenfold by today.
Finding the Real Bargains Today's greatest bargains are giant growth and growth and income stocks, many of which are at least 15% below their historical norms. So almost any no-load large-cap growth fund with below-average annual expenses is a reasonable choice. Examples among the MONEY 65 are Fidelity Dividend Growth and T. Rowe Price Blue Chip Growth.
Moreover, since the S&P 500 is a good proxy for the stocks in question, you can minimize expenses with an index fund such as Vanguard 500 Index or an ETF like the iShares S&P 500 Index.
Lots of individual stocks are attractive too. Bank and drug stocks are cheap across the board. In other sectors, look for projected earnings growth of at least 10% a year, a bit of dividend yield and a P/E that's low compared with the company's growth rate and its historical average P/E. Here's a quick look at four Sivy 70 stocks (see page 80) that qualify.
• Applied Materials. The chief producer of semiconductor-manufacturing equipment has been suffering from so-so capital spending by chipmakers. As a result, shares are down a third from their high of three years ago. Earnings can swing dramatically with the health of the tech sector, but over the long run growth is way above average. Over the past five years, for instance, earnings have increased at an annual compound rate of 24% despite the blah market for Applied Materials' gear. Recently, analysts have upgraded the stock, partly because it looks like a bargain at the current low P/E (based on earnings for the coming year) and partly because they see an upturn in global demand for chipmaking equipment that could last a couple of years and really rev up profits.
• Burlington Northern. The second largest railroad in North America is a double play on high energy prices. First, railroads are up to nine times more fuel efficient than trucks for long hauls. Not surprisingly, in the most recent quarter, demand was up by 14% to 19% in all four of Burlington's major business groups. Second, one of those businesses is the shipment of low-sulfur coal, which will keep growing as long as oil prices stay high. Railroads in general have been mediocre performers for some time, and Burlington still trades at a below-market P/E despite projected earnings growth in the mid-teens. With both trucking firms and air carriers likely to be hurt by oil prices, this undervalued railroad seems like a great choice for the transportation stock in a portfolio.
• General Electric. The stock of America's most admired company has gone nowhere for two years. Now the P/E (based on projected 2007 results) is below 15, a level rarely seen when Jack Welch was running the company. CEO Jeff Immelt continues to follow Welch's strategy of putting resources behind the strongest businesses, and several, including aerospace and broadcasting, are on the upswing. Despite GE's enormous size, earnings are projected to grow at a 10% annual rate over the next five years. The shares yield a hefty 3%.
• Procter & Gamble. With an extensive array of brands such as Tide, Crest, Head & Shoulders, Pampers, Pringles and Gillette, P&G is what the Wall Street crowd calls a defensive stock. After all, people don't stop washing their hair just because the economy turns sluggish. You might expect that the stock would do well in the current uncertain climate. But the share price is down 10% from its March high because P&G's 2005 acquisition of Gillette has been a drag on earnings. Within a couple of years, however, the merger should start producing pretax cost savings of around $1 billion a year, which would contribute significantly to the bottom line. Otherwise, P&G is a powerhouse, generating $10 billion in cash a year. And you can't get much more predictable: The company has raised its dividend for 50 years in a row.
Near-Term Pain, Long-Term Gain Rising interest rates are disrupting the market, but the long-term outlook offers opportunities.
Bears vs. Bulls
[Bears] The Fed has raised interest rates more than four points over the past three years...
...but that still hasn't been enough to keep inflation below the key 3% mark.
[Bulls] The economy is solid, and analysts are raising earnings estimates more than lowering them...
...while growth stocks still look relatively cheap compared with their historical P/Es.
NOTE: Data as of June 29. SOURCES: Federal Reserve Bank of St. Louis, U.S. Bureau of Labor Statistics, Zacks Investment Research, the Leuthold Group.
Bullish Prospects Undervalued blue chips and the funds that hold them look like the best bargains for long-term investors.
NOTES: Data as of June 26. P/E ratios based on projected earnings for 2007. Earnings growth is annual rate projected for five years. SOURSES: Morningstar, Thomson/Baseline.
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Read editor-at-large Michael Sivy online every Tuesday at cnnmoney.com/sivy. E-mail him at firstname.lastname@example.org.