5 Reasons You Should Be Optimistic

01/03/2013 10:00 am EST

Focus: MARKETS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

Sure, there's a lot of fear-based talk coming out of Washington and Brussels (and Tokyo for that matter), but things are definitely looking up if you care to look beyond the headlines, observes John Reese of Validea Hot List.

While the fiscal cliff talks drag on, the US economy is continuing to make gains in several key areas.

In November, for example, the private sector added 147,000 jobs, according to the Labor Department. That was enough to lower the unemployment rate to 7.7%, the lowest it has been since December 2008.

The so-called "U-6" unemployment rate, which unlike the headline figure takes into account workers who have given up looking for a job or those working part-time who want full-time work, also fell to 14.4%. That's still significantly higher than historical averages, but it's the lowest the figure has been since January 2009.

Industrial production, meanwhile, increased 1.1% in November, according to a new Federal Reserve report. Part of the reason for the big gain was a rebound in production in the aftermath of Superstorm Sandy, which had limited production in some areas the previous month. Still, November's gains wiped out all of October's losses, and more-overall production for November was about 0.4% higher than it was in September, before Sandy's arrival.

The housing market also continues to improve. Existing home sales rose 5.9% in November, according to the National Association of Realtors, reaching the highest level in three years. Construction starts, meanwhile, dipped a bit in November, falling 3%, according to the Commerce Department, but they remain more than 20% above year-ago levels. Permit issuance for new home construction rose 3.6%.

Big news also came from the Federal Reserve. The Fed last week said that, starting in January, it will begin buying $45 billion of Treasury securities per month to support financial markets and bolster the economy. It will continue its ongoing plan of buying $40 billion in mortgage-backed securities per month.

The Fed also took the unusual step of linking its interest rate policy to hard economic data. It said it will keep rates low at least as long as the unemployment rate stays above 6.5%, so long as the projected inflation rate a year or two out doesn't exceed 2.5%. The Fed is thus again expanding its balance sheet in an attempt to boost the economic recovery.

Since our last newsletter, the S&P 500 returned 2.1%, while the Hot List returned 4.1%. So far in 2012, the portfolio has returned 20.2% vs. 14.8% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 171.6% vs. the S&P's 44.3% gain.

Five Reasons for Optimism
As 2012 winds down, the general mood surrounding the market and the economy remains one of fear. The fiscal cliff, unresolved debt problems in Europe, and the lingering scars of the financial crisis and Great Recession seem to be giving pessimism the upper hand over optimism, and keeping investors lukewarm (at best) on stocks.

But as we head into 2013, I think there are several reasons to be optimistic about where we stand. That doesn't mean we aren't facing some serious problems...there is no doubt that the US and much of the developed world indeed have a lot on their plates.

But what it does mean is that overall, a number of factors are combining to make stocks look like attractive investments right now for long-term investors. Here's a handful of those reasons:

The Housing Rebound: It's hard to believe that six years have passed since the housing bubble began to burst, but it's true. And while the nascent rebound hasn't been as dramatic as the decline was, it is significant.

Housing starts are up 21.9% since a year ago. Permit issuance for new home construction is up 28.1% in that period. Existing-home sales have risen 15.5% in the last 12 months, meanwhile, and pending home sales are up 18%.

Home prices are on the rise, too, having jumped 3.6% in the year ending September 30 (the most recent data available), according to the S&P/Case-Shiller Home Price Indices.

That's a big deal. Housing is usually a big part of economic recoveries, but until recently it's been absent from this one. The sector's impacts are so wide-ranging-impacting everything from construction companies to carpet manufacturers to home-furnishing stores-that housing market improvements can lead to the creation of thousands and thousands of jobs.

Employment: It's no surprise, then, that the housing recovery has been accompanied by a significant improvement in the jobs market. Yes, unemployment is still far too high, but we've seen real progress lately. The headline unemployment number (7.7%) is down a full percentage point from a year ago, and more than two full percentage points from where it was two years ago.

The broader "U-6" measure (which also includes workers who have given up looking for a job or those working part-time who want full-time work) is down 1.2 percentage points in the past year, and 2.5 points in the past two years.

More employed workers means more people with money to spend. More people with money to spend means more profits for consumer-related businesses, which drive our economy. More money for them is leading to more jobs, which leads to more people with money to spend-and so on goes the cycle.

As the fiscal cliff mess gets resolved, the hiring may well increase even more. Many companies have been staying in a holding pattern until they get clarity on tax policy and government spending plans. They want to know the rules of the game-whatever the rules may be-before they start to really play.

If Congress and the President can reach some sort of agreement that lays the tax and policy rules out for them-whatever it involves-businesses may have the clarity they need to start spending their cash on new employees, and capital improvements.

|pagebreak|

Global Monetary Conditions: Yes, the Federal Reserve has been sharply criticized by some for its loose money policies in recent years. And, to be sure the Fed has been far from perfect in its decisions.

But whether you're pro-Fed or anti-Fed, the reality is that the central bank-and other central banks around the globe-are doing what they can to push investors toward riskier assets by keeping interest rates so low. And while that hasn't resulted in a deluge of cash flowing into stocks, it has no doubt helped increase demand for stocks somewhat, and it should continue to do so in 2013.

Of course, there are unintended repercussions of loose monetary policy. One is that, if conditions were right, encouraging investors away from bonds and toward stocks could lead to a bubble, with stocks becoming highly overvalued. But that brings me to my next point...

Valuations Are Reasonable: As I noted in a recent Hot List, the broader market seems to be priced somewhere near fair value. Sure, there are some valuation metrics that are flashing warning signals, like the ten-year P/E ratio and Tobin's Q. But there are many more that are indicating the market is in the range of fair value or undervalued.

  • Trailing 12-month P/E ratios are in the low- to mid-teens.
  • The market's price-to-book ratio is lower than its long-term average.
  • The price-to-sales ratio is a reasonable 1.3 or so.
  • And the stock market-to-GDP ratio has been hovering around the high end of the fair-value range/low end of the modestly overvalued range.

In addition, dividend yields are significantly higher than the yields on long-term treasury bonds, a historical rarity and a bullish sign for stocks.

Also keep in mind that those figures are for the broader market. When it comes to individual stocks, there are a myriad of good companies with strong track records whose shares are trading at extremely attractive valuations, the type of stocks that the Hot List continues to target.

And, as Charles Schwab's Chief Investment Strategist Liz Ann Sonders recently noted, even if the US does go off the fiscal cliff and a recession results, the reasonable valuations should help provide a cushion that would keep a bear market relatively mild.

Time: It takes time-a lot of it-to recover from financial crises. It may sound obvious, but it's very important to remember. Every year further out we get from the epicenter of the crisis, the more bad debt gets worked off, and the more the nation's collective bearish psyche heals.

Professors Kenneth Rogoff and Carmen Reinhart have done perhaps the most extensive research on past financial crises. In examining about 15 pre-2007 financial crises across the globe, Reinhart and Rogoff said in a 2008 paper that on average, real house prices fell for six years before rebounding. In very few cases did the declines last less than five years.

Unemployment, meanwhile, increased on average for nearly five years by an average of 7 percentage points. Real public debt jumped 86% on average in the three years after the crises.

In other words, the tepid recovery we've seen in the past few years isn't a sign that we're headed for disaster, or that America will never grow the way it used to. It is instead a sign that we are experiencing a typical recovery from a financial crisis. (In fact, in a recent piece for Bloomberg.com, the professors said that the economy has in some key ways actually performed better than the average country has in the aftermath of past financial crises).

These five factors are, I believe, creating an environment that is pretty supportive for stocks overall, and very attractive for long-term investment strategies that can identify cheap shares of good companies. That doesn't mean 2013 will be an easy, upward climb for the market, or the Hot List portfolio. In the short term, emotions drive the market, and right now there are still a lot of strong emotions out there on the negative side.

But good investing is about looking past the short term and focusing on where the best long-term opportunities lie. Right now, I think the stock market is home to plenty excellent opportunities.

Subscribe to Validea Hot List here...

Related Reading:

2013 Outlook for Global Growth

The Fiscal Cliff and Hyperinflation

The Law of Unintended Consequences

Related Articles on MARKETS

Keyword Image
11 Reasons to Buy Microsoft
18 hours ago

For our latest recommendation, we revisit one of the world's most prominent technology companies, Mi...