Discovering Opportunity Amidst Investor Fear
Looking at the current debate about the economy, one cannot help but be reminded of how the discussion can lurch from one extreme to another. A little over a year ago, consensus revolved around the notion that inflation would be a real threat to the economy. Today, the dreaded d-word -“deflation” – has captured investors’ collective attention.
As expressed in previous comments before, if inflation is to make its presence felt in the global economy, it would take much longer than many expected. To see just how full circle the economy has come, investors have been confronted with economic growth rates that have come in below expectations in Canada and the US.
All of the talk about deflation has caused equity investors to flee the stock market and rush into bonds. This flight from equities has resulted in many world class companies seeing their share prices crushed to single digit price-to-earnings (P/E) ratios. In other words, investors are paying less than $10 for each dollar of earnings these companies produce.
For example, if we look at the 30 stocks making up the Dow Jones Industrial Average, it can be seen that half of the members of this elite circle have dividend yields of over 3% and many of them are trading for the lowest P/E ratios since the 1980s. In all, 17of the 30 have P/E ratios less than 15. This is remarkable in that the last time P/E ratios were this low and dividends were even close to being this attractive was in the early 1980s – when interest rates were in their mid teens – not in the low single digits.
Therefore, it can be seen that stocks are pricing in the impact of an economic slowdown to a fair extent. Many of the companies in the Dow Jones Industrial Average dominate their respective industries. In the event that deflation does set in, they should be able to maintain their pricing power and ride out adverse economic events.
At the end of the 1990s, as the last great secular bull market was concluding, many of these companies had dividend yields less than half of current levels and P/E ratios closer to 30 or more. In other words, investors were paying more than $30 for each dollar of earnings. Bull markets do that to otherwise rational people.
As history has shown before, bull markets tend to end with investors paying substantial premiums for stocks and bear markets begin their conclusion with stocks driven to bargain basement levels. Part of the reason that stocks get driven down to these levels is that investors lose their affinity for stocks as an asset class. History shows that investors too often throw in the towel just as stocks begin to offer favorable risk to reward ratios.
That is not to say that the markets are putting in their final bottom. That remains to be seen as the broader macroeconomic landscape takes shape. What it does mean is that choosing to rush into bonds as so many are doing right now is a decision fraught with its own risks.
This report is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. The information contained in this report has been compiled from sources we believe to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information’s accuracy or completeness. All opinions and estimates contained in this report, whether or not our own, are based on assumptions we believe to be reasonable as of the date of the report and are subject to change without notice. Past performance is not indicative of future performance. Please note that, as at the date of this report, our firm may hold positions in some of the companies mentioned.