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4 Things You Must Know About Buying Stocks Now

By Tim McAleenan
Published on July 2nd, 2015

With the stock market recording its largest day of losses during the June 29th trading day, investors may be wondering whether the current stock market offers a fair entry point for buying blue-chip stocks.

Many cautious investors have been pointing out that stock prices have almost tripled since the March 2009 lows, and even a modest pullback today would not be enough to burn off the general overvaluation of the S&P 500.

That worldview certainly tells us that stocks are nowhere near as cheap as they have been at various points over the past six years, but it does not give us enough information to determine whether investors are getting a fair shake for most purchases they make today.

I choose to keep the following things in mind:

#1: Stocks Are Not Terribly Overvalued

Stock today trade at a valuation of 18x expected earnings over the course of 2015. That is not terrible overvaluation—for most of the 20th century, stocks traded at 15x earnings and have traded at over 16.5x earnings during the past twenty-five years.

This gradual, gently sloping uptick in the S&P 500 ratio is not something to get worried about because technology advances have enabled “owner earnings” to shoot through the roof.

I’ll give an example of what I mean. In 1960, Maxwell House employed tens of thousands of people to make coffee and generate the inflation-adjusted equivalent of $100 million in revenue. After paying the employees and performing factory maintenance, there was about $40 million left over that could be distributed to shareholders or grow the business. By 2010, that same amount of revenue could be generated by 2,500 people and only required about $25 million in costs. Technological progress ensured that $75 million would be able to trickle back to shareholders net of expenses.

Now that 3G Capital is planning to take over the operations of Kraft Food Groups (KRFT), the company plans to open a Latin American Maxwell House factory that will only cost 13.5% of revenues. In other words, a few dozen people will be able to generate $100 million in revenue while the company only has to pay $13.5 million factory and employee expenses. Certainly, the P/E ratio of Kraft should increase over time as technology gains occur, and this Maxwell House story has been playing out all across America for the past fifty years.

This is not a positive trend for the nation’s employment rate nor does it enhance the general cohesiveness of communities, but it does make it more lucrative to be on the owner side of the equation.

Don’t lament the trends that take place in the world.  Instead do your best to respond intelligently by making decisions that maximize your happiness.

This likely involves being on the owner, rather than employee, side of these relationships.

#2: Low Interest Rates Create Higher Stock Valuation

Higher stock-market valuations should be expected when the S&P 500 is trading at low interest rates. I know what you are thinking, “Yeah, but how long will that last?” When you exclude periods where the ten-year Treasury offered yields above 6.5%, the average P/E ratio for the stock market as a whole is 19.5. By that gauge, the current valuation of 18x earnings is on the low side of fair value. Right now, the ten-year bond yields 2.3%.

The relevant question is not really whether rates will increase, but rather, how much. If interest rates for the ten-year U.S. bond stay below 6.5%, the current valuation is right in line with historical norms. Unless you think interest rates will exceed 6.5% within the next five years, I would not worry about significant, meaningful harm striking the S&P 500 as a whole due to the interest rate dilemma (day-to-day swings in response to interest rate projections are of course fair game.)

#3: Oil Industry Profits are at Cyclical Lows

The fall in oil prices have greatly reduced the contributions of energy companies to the S&P 500. In aggregate, Exxon (XOM), Chevron (CVX), Conoco (COP), and Phillips 66 (PSX) are expected to report 40% lower profits in 2015 compared to 2014. And that isn’t even the entire oil sector.

The fact is that many oil companies are trading at 25x or so this year’s expected profits, and that information is not useful to the long-term investor because it is not cyclically adjusted. A reversion to the mean in the commodities sector could send Exxon’s profits from $18 billion to $35 billion within a year, and that is why the current earnings per share of the S&P 500 as a whole may be understated right now.

#4: The Strong Dollar is Reducing Profits

The earnings of the S&P 500 components are actually 3.8% higher if you manually adjust for currency fluctuations. Almost 42% of the S&P 500’s annual earnings come from overseas, and the United States dollar has outperformed the global basket of currencies index by almost 25% in the past year. The strength of the dollar has weighed down to the international component of corporate profits, and that is why long-term investors buying now are in a better position than they might initially think.

Where to Look for Value

If you are looking to make a purchase right now, pay special attention to large companies in the banking sector like Bank of America (BAC), JP Morgan (JPM), and Wells Fargo (WFC). In aggregate, they trade at 17x earnings which is slightly cheaper than the market as a whole. Bank of America’s payout ratio is only about a third of its historical average, and JP Morgan and Wells Fargo stand to experience $3.5 billion profit gains each for every one percentage point increase in U.S. interest rates.

You may also want to check out the tech and oil sectors. Companies like Apple (AAPL) and Microsoft (MSFT) are expected to grow profits at 8-12% annually in the coming three years, and their valuations trade at less than the market as a whole.

And lastly, you may want to check out oil companies. Exxon and Chevron yield 3.5% and 4.5%, respectively. That is not something that has happened for an entire year of trading for either company at any point in the past twenty-five years. Oil is one of the few areas where the deals today bear some resemblance to the deals available during the financial crisis during 2008 and 2009, and could prove to be a source of lucrative long-term investing if you have a deep understanding of fluctuations in the commodities markets that enable you to ride out the storm.

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