Is today's rampant pessimism about the stock market justified?

Although the future looks pretty bleak economically, there are those who aren't passing this opportunity to add some great stock deals to their portfolios
March 08, 2009
DAVID OLIVE
BUSINESS COLUMNIST
Is today's rampant pessimism about the stock market justified?

Of course it is, in the short term. Every day brings news of more layoffs, falling corporate profits, dividend cuts, and, in the U.S. and Europe, government bailouts of financial institutions. It's enough to give the most stoic investor the shivers.

But the long-term outlook – say, the next five to 10 years – is much brighter. And that's the minimum time frame a nest egg-building investor should be concerned with.

Granted, there's no overstating the speed and severity of the current downturn. In just 16 months, the benchmark Dow Jones industrial average has lost a little more than half its value from the all-time peak set in October 2007.

Economic downturns are drearily similar, but each has its unique twist. This time it's the effective failure of the global financial system, which is heavily complicit in the stock market collapse. It has deprived households and businesses of life-sustaining credit. And there is no sign of when banking stability will return.

Making matters worse, stocks were overpriced prior to a market meltdown that has done most of its damage since late last summer, when the magnitude of the banking crisis first became widely apparent. Stocks were more expensive, in fact, than at almost any time over the past century, save the Great Depression and the dot-com and tech bubble of the late 1990s.

Stocks were overvalued because money was so cheap earlier this decade. That drove investors out of fixed-income securities, with their paltry returns. Punters instead crowded into equities, forcing up stock prices to unsustainable levels.

Even blue-chip stocks had lots of room to drop. That they have fallen so hard, so quickly, surprised even Warren Buffett. The world's most successful stockpicker last weekend released his widely read chair's letter to shareholders of his Berkshire Hathaway Inc. conglomerate. He described a "free fall in business activity ... accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative feedback cycle. Fear led to business contraction, and that in turn led to even greater fear."

It makes one nostalgic for investors who once advised to "buy on dips." Where are they in our hour of need?

Actually, while thinner on the ground than usual, they're out there. Buffett, who's sticking by his investing adage that "pessimism is your friend, euphoria the enemy," has been bargain shopping at a rather ferocious pace. He has snapped up stakes in everything from Tiffany & Co. to General Electric Co. (down a stunning 82 per cent from its five-year high).

It's tough to argue with a stockpicker who has suffered just two modest declines in per-share book value since launching Berkshire in 1965. Over 44 years, Berkshire has increased its value by 362,319 per cent, against a 4,276 per cent gain in the Standard & Poor's 500.

If you accept that we are enduring a Wall Street crisis, not a Main Street meltdown, it's easier to feel confident about long-term share values. One could even argue that a resolution to the global banking crisis, given its huge complicity in the current woes, could trigger a surprisingly swift recovery.

In contrast to the overvaluation prior to the market implosion, stocks now are reasonably priced. The 10-year average price-earnings ratio of the S&P 500 has slid to about 12.3, below its average of 16 over the past century. Warning that the ratio fell as low as six or seven in the super-bear markets of the Great Depression and the 1970s period of stagflation, veteran market analyst David Leonhardt of the New York Times says stocks may continue to drop, perhaps by a considerable amount.

"But long-term investors – and that describes most of us – should start to feel perfectly fine about buying stocks," he wrote earlier this week.

There are other comforters.

With the collapse in stock prices, yields have soared. For blue-chips with a record of maintaining dividends through thick and thin – Bank of Montreal just marked its 180th year of uninterrupted dividend payouts – yields often exceed, say the 4 per cent return on U.S. Treasury bonds. Even after GE slashed its dividend by 68 per cent late last month, its stock still sports a 4.7 per cent yield. Stock in Buffalo-based M&T Bank Corp., a Buffett favourite, yields 8 per cent. So do shares in Caterpillar Inc. Cat is sure to benefit from the coming hike in government-funded infrastructure spending in the U.S. and abroad.

Most blue chips came into this recession with healthier balance sheets than is usually the case. And many have been loading up on cash by slashing expenses to ride out the storm. GE has a $48 billion (U.S.) cash hoard. DuPont Corp., IBM Corp., Cisco Systems Inc., Google Inc. and Apple Inc. also boast swollen treasuries.

For those not yet brave enough to venture into a still uncertain market, there are some firms you might at least not want to part with. Just avert your eyes as they shed a bit more value before a North American economic recovery expected next year at the latest.

At a time when corporate losses or sharp declines in profit appear to be the norm, these 15 companies I arbitrarily selected posted an average increase in profits last year of 27 per cent: Cisco, Loblaw Cos., Bank of Montreal, Procter & Gamble Co., Johnson & Johnson, Bombardier Inc., Exxon Mobil Corp., Chevron Corp., EnCana Corp., Alimentation Couche-Tard Inc., United Technologies Corp., Kraft Foods Inc., Shoppers Drug Mart Corp., CVS Caremark Corp. and Kellogg Co.

As a group, these well-run companies with sectoral dominance – as close as one gets to stocks you can buy and safely neglect – are trading at a whopping 46 per cent average discount to their five-year highs.

And here are 15 masters of top-line growth that have managed to increase sales in each of the past four years: Cisco, Kellogg, Shoppers Drug Mart, Caterpillar, EnCana, Kraft Foods, CVS, Loblaw, GE, P&G, Chevron, J&J, Finning Equipment Inc., Suncor Energy Inc., and PepsiCo Inc. This group trades at an average discount of 51 per cent to the firms' five-year highs.

No responsible investment adviser would counsel you to file your financial statements unopened, as so many of us do. But if Martha Stewart, who knows a thing or two about comebacks, can adopt a casual regard for her net worth in the short term, so might you. She has a business to run.

And you have kids waiting to be read their bedtime stories.


Full disclosure: The writer holds shares in Exxon Mobil.