Comparing real earnings against market valuation finds that this market clearly still has legs, says Dan Wiener of the Independent Adviser for Vanguard Investors.
Nancy Zambell: Thanks for joining me. My guest today is Dan Wiener, and he is the editor of The Independent Adviser, and an expert on mutual funds and bonds.
Dan, we've seen a lot of talk about the great rotation from the bond market into the stock market, but you don't necessarily agree with that. Is that correct?
Dan Wiener: Yes. I don't think that there has been a great rotation. I think that at best, what we've seen is the beginning of some money moving into stock mutual funds, equity funds. But at the same time, we're still seeing much more money continuing to flow into fixed income funds and to bond funds.
So there isn't a great rotation. I think there might be just a minor awakening for some people who have stayed away from the stock market while it's more than doubled from its bottom.
Nancy Zambell: Right; and that's what usually happens with investors. They get in fairly late, don't they?
Dan Wiener: Well, some do, unfortunately.
Nancy Zambell: And certainly, we've seen the market reach record highs. That keeps a lot of those investors who have not come in off the sidelines still out there, and also makes the investors who have participated wonder whether they should get out now. What do you think?
Dan Wiener: I really think that the worry about hitting new nominal highs is a little overdone.
First of all, I think you have to remember that we hit a nominal high back in October 2007, and we've been working toward a new high ever since. Last month, we finally got there. So over that 5-1/2 year period, stock prices were simply recovering to their prior peak.
Meanwhile, corporate earnings were growing quite dramatically. If you want to look at operating earnings on the S&P 500 companies, they're up about 22% since the quarter ending in September 2007.
If you look at overall corporate earnings that are reported by the Bureau of Economic Analysis after taxes, they're up about 46% through the end of 2012, and we haven't even seen the first quarter's numbers yet. Still, earnings are up a lot, and prices have essentially gone back to where they were.
The index numbers may be hitting new highs, but it really doesn't have anything to do with how investors are doing. Actually, on a total return basis, we've been seeing new highs in the stock market, when you incorporate dividends into the calculation, for a long, long time-more than a year.
I've heard some arguments about inflation. Inflation's a factor. If you want to look at an inflation-adjusted Dow average, the index hit a high back in January 2000. That's over 13 years ago. To match that high today, we'd have to see the Dow up around 16,100. And as you noted, we haven't even hit 15,000 yet.
Nancy Zambell: Right, and so there are still some legs left in this market?
Dan Wiener: I think there is. There are some great stocks out there that are undervalued, and there are some stocks that may be sort of close to the average valuation, or relative valuation, that we've seen historically.
I think that whether you look at year-over-year earnings, or you look at year-over-year, normalized earnings, over the last five or ten years, small stocks look the most expensive to me, and large stocks actually look the most inexpensive to me.
Nancy Zambell: Yes, the small- and mid-cap stocks have had quite a run.
Dan Wiener: They have, and the large-caps have done well too. But the small- and mid-caps-as you note-have done even better.
Even if you look at the trend in earnings and a normalized basis for P/Es over the last five or ten years, what you don't see in those numbers is that in low interest rate environments-like the one we're in right now-typically investors will put an even higher P/E on stocks than they would when interest rates are a lot higher.
And we haven't really seen that. P/Es are really not at the kind of low interest rate levels you might expect to see. So I don't worry about the stock market overall right now, but really I'm much more interested in finding managers who aren't going to be fools about what they're buying, who aren't going to be jumping all over the most expensive stocks.
As you know, I focus a lot on Vanguard. There're three sets of managers there that I think run funds that are some of the best in the business.
Don Kilbride, who runs Vanguard Dividend Growth (VDIGX), is certainly not going to pay up for earnings. He buys companies with battleship balance sheets, very large-cap companies with the potential to grow their yields and grow their dividends over time.
Jim Barrow and Mark Giambrone at Vanguard Selected Value (VASVX) are classic value investors. You're not going to see them paying up for the most expensive fare in the market. They run Vanguard Selected Value as a mid-cap value fund.
And then you have the team at PRIMECAP Management. They run several funds at Vanguard. I prefer their private label, PRIMECAP Odyssey Funds-Stock (POSKX), Growth (POGRX), and Aggressive Growth (POAGX), but Vanguard just opened PRIMECAP Capital Opportunity (VHCOX) fund.
That's a good fund. It's a large-cap growth fund that's worth getting into, and they're growth at a reasonable price-type investors, which means they're taking a value approach to buying growth companies.
And then finally, if you look at Vanguard's Healthcare Fund (VGHCX), Jean Hines, who sort of runs the team that runs that fund, is no fool. She is not going to pay up for pricey stocks in the health-care arena, and over time the team that runs that fund has outpaced the health-care index by leaps and bounds. So I don't lose sleep over new highs when I've got managers like this in my portfolio.
Nancy Zambell: Regarding the health-care fund. Do they concentrate on one specific sector in health care, or are they pretty broad-based?
Dan Wiener: No. That's the beauty of the Vanguard Healthcare Fund and the matching fund out of Hartford, the Hartford Global Health Fund (HGHAX). They take a very broad view of the health sector.
They're in the pharmaceuticals, biotechs, device makers, and service providers. United Healthcare (UNH) has been one of their big holdings. So you get a really broad look at the whole health-care sector. Also, they typically run about 20% of the portfolio in companies based overseas.
Nancy Zambell: How interesting.
Dan Wiener: Yes. You're getting a lot of Japanese pharma companies. You are also seeing that even though most of the big pharma companies are global in nature, having boots on the ground overseas means that they can get more quickly into the emerging markets where we're seeing tremendous growth in a middle class that is demanding higher quality, better health care in all aspects.
So it's a growth business, and it doesn't hurt that the pharmas pay a nice yield to boot.
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