3 Reasons to Keep Your Hopes Up in 2012

01/05/2012 8:15 am EST


John Reese

Founder and CEO, Validea.com And Validea Capital Management

The light at the end of 2011 is not likely to be an oncoming train, as many investors fear, writes John Reese of the Validea Hot List.

2011 has been a tough year for stock investors. The market put investors through some major ups and downs over the course of the past 12 months. And most investors continue to shy away from equities.

But while many investors remain skittish as we head into 2012, I see a number of reasons to be optimistic. Here are a few of the main factors that make me feel good about the coming year.

There are, of course, a number of ways to value the broader market. But of the myriad of valuation metrics that my models use, the vast majority are showing the market to be either cheap or fairly valued. The exception to that is the ten-year P/E ratio, which for the S&P 500 remains between 20 and 21, higher than its long-term average of about 16.

Other than that, however, a variety of metrics paint a positive picture. Trailing 12-month P/E ratios for the S&P 500 are 13.1 using operating earnings, and 14.3 using as-reported earnings, based on S&P data and Wednesday's closing price. Forward-looking P/Es are even better.

The S&P's price-to-sales ratio, meanwhile, is 1.2, according to Morningstar.com. That's below the 1.5 target that my James O'Shaughnessy-based model uses to identify bargains, and it's within the "good value" range (0.75 to 1.5) that my Kenneth Fisher-inspired model uses.

The stock market-to-GDP ratio is also quite reasonable. According to GuruFocus.com, it's at 86.4% (as of December 21), which is within the "fair value" range that was determined by examination of historical data. (Note: for this metric, the site uses the Wilshire Total Market Index as a proxy for "the market".)

This ratio is of particular interest to me, because Warren Buffett has cited the stock market-to-Gross National Product ratio (which runs very similar to the stock market/GDP ratio) as possibly being the best measure of where valuations stand at a given moment.

Finally, the market's dividend yield is very attractive, particularly when compared to the near record-low Treasury bond yields currently available. As of December 20, the S&P's dividend yield was 2.53%. Compare that to the 1.94% yield on the ten-year Treasury bond, and stocks look very attractive.

Corporate Turnaround
Heading into the financial crisis of 2008 and the accompanying recession, American companies—especially banks—were stretched too thin. Financial companies were way overleveraged, and many non-financials had left themselves little wiggle room in the event of a major downturn.

Today, that's much different. Yes, banks are still working off some bad debt, and low interest rates are decreasing lending spreads and hampering earnings. But overall it appears that they are in far better shape than they were in 2008 (thanks in no small measure to the federal government's assistance).

In fact, according to Deutsche Bank, the ratio of total US bank assets to cash—a measure of liquidity—is near all-time lows. It had climbed to nearly 40:1leading up to the financial crisis; now it is below 10:1, levels not seen since the early 1980s.

Non-financials, meanwhile, have been stockpiling cash, not wanting to get hit by another major downturn. Cash at companies excluding banks, utilities, truckers, and automakers was a record $998.9 billion last quarter, according to Bloomberg.

And there are indications that more companies may be putting their cash to work. This year, shares of the 40 S&P 500 companies that bought back the most of their own stock or offered the biggest dividends climbed an average of 5.7%, Bloomberg reports; the 20 that hoarded the most cash fell an average of 15%.

If the laggards are taking notice, that could mean more companies up their buybacks and dividends in 2012, which should help the market.

Improving Economy, Gloomy Sentiment
While many pundits spent most of 2011 predicting recession—and worse—for the US economy, positive data has continued to flow in over the last several months. In fact, it appears that growth really accelerated toward the end of the year.

But despite that, and despite Corporate America continuing to post strong profits and streamline operations, a sense of doom certainly seems to be hanging over the market.

Some of the fear is merited, with the European debt crisis being a legitimate, serious problem that needs to be dealt with. Still, given the solid, if unspectacular, performance of the US economy and the stellar growth that continues in other parts of the world, Europe and its problems are probably getting a bit more attention than they really deserve. Why?

A big reason, no doubt, involves the lingering scars of the 2008 financial crisis, and Great Recession. After going through a crisis and recession that may have been the worst the US has seen since the Great Depression, investors and Americans in general understandably have been left with a sense of foreboding.

For many the crisis came on so swiftly and unexpectedly that it has left them with a sort of financial post-traumatic stress disorder. Not wanting to be burned so badly again, investors head for the hills and sell off stocks at the first sign or hint that another crisis is upon us.

All you need to do is read the headlines to get an idea of the fear that is still out there. Recently, I read an article entitled "Five Reasons Why Investing is Dead". The article was rife with short-term thinking, but for now I don't want to get into all the specifics as to why I think it was misguided.

Instead, the important point for this discussion is the hyperbole in the headline. Stock investing has been proclaimed dead on several other occasions by prominent news sources, perhaps most notably in 1979, when BusinessWeek ran a cover story entitled "The Death of Equities".

The article came at the tail end of a very weak period for stocks, one that lasted over a decade. But within just a few years the market began to surge, remaining in bull-market mode for most of the next two decades.

These sorts of articles always come out when things have been going bad for an extended period, because people by nature are inclined to extrapolate the recent past out into the future—it's what behavioral finance terms "recency bias".

But as any investor worth their salt knows, the best time to invest in something usually isn't when the asset has been rising in price for an extended period; it's when prices are cheap and expectations are low. Given that, the current gloom hanging over the market is a positive if you're buying stocks now.

Do I think that the current doom and gloom mindset will change completely in 2012? No.

Frankly, I think it will take more than another year for investors and Americans to really feel like they have their feet on solid ground again. But I do think that we'll see gradual improvement in confidence in the coming year; the further and further we get from 2008, the more the pain will fade.

What the lingering fears do seem to be doing, however, is putting something of a floor under stock prices. With many investors not only fearing but expecting the worst, some very bad scenarios are already baked into stock prices.

That certainly doesn't mean that stocks can't go lower; but it does mean that the downside should be somewhat limited, while the upside should be great. And for value investors, that's a climate that is very attractive.

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