Name Large Caps Still a Buy

By: Henry To | Wed, Mar 28, 2007
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Dear Subscribers,

Just like in the stock market, if one wants to panic in everything else in life, the best time to do it would be to do it early, or ahead of almost everyone else. Worried about a mass layoff at your company? Declining morale? No problem - get a job somewhere else, and do it quickly. Once your coworkers have done the same, the supply/demand pendulum would have already shifted to the side of other employers in the same industry, and you will no longer have bargaining power in terms of your salary, benefits, job position, etc. If you had waited that long, you may as well stay with your company and hope or try to go for a raise or promotion, as many of your peers and talent would longer be there to compete with you. The best scenario is if your boss has also left the company. Assuming you don't get laid off (in stock market lingo, this would mean either 1) you are not leveraged or that you are not leveraged enough to get a margin call during a crash, or 2) the companies that you are holding don't go bankrupt during an economic recession), this would probably be your best chance to get promoted, as it is always much easier to promote within, especially for a company that is unattractive to many others in the same labor pool.

Bottom line: The "deer in the headlights and then panic" approach does not work in the stock market, and neither does it work anywhere else in life. It is amazing how much trading or investing in the stock market can teach you about life in general.

Before we begin our commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,096.01 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 976.01 points

In the short-run, the market is still relatively overbought - as both the Dow Industrials and the S&P 500 are still approximately 5% higher than their respective 200-day moving averages. Given this short-term overbought condition, any further upside in the market during this upcoming week is probably not sustainable in nature, and should not be chased. That being said, I am still bullish on the U.S. stock market in the longer-term, and after a brief consolidation phase (and hopefully more pessimistic sentiment readings and some kind of washout in margin debt levels), I expect the U.S. stock market to be higher three to six months from now.

Over the weekend, I reviewed the August 2006 edition of Outstanding Investor Digest featuring an interview with Arnold Van Den Berg of Century Management - a value investor who have strung together an annualized return (after fees) of 15.6% for his clients over the last 30 years (as of mid 2006) vs. an annualized return of 13.5% for the S&P 500. Moreover, this performance was achieved while his clients were holding cash and bonds in their portfolios. If we count the equities portion of his clients' portfolio, the annualized return (after fees) would have jumped to 19.9% instead, an enviable record by any measure. I highly recommend the interview with Mr. Van Den Berg. It is available for free on the Outstanding Investor Digest website, if you are interested.

In his August 2006 interview, Mr. Van Den Berg recommends a buy-and-hold strategy in many of the U.S. mega-cap stocks, such as WMT, MSFT, and PFE. Just for the record, this author has been doing the same thing over the last six to nine months, and I continue to recommend such a strategy going forward. Quoting Arnold: "... today, the average P/E of the biggest of big-cap stocks has fallen from 25.5 to 18.6. But that's not the whole story. And here's why I say that: Since 2000, the yield on the 10-year Treasury has declined from an average of 6.03% to 4.29% [Henry's note: It closed at 4.61% last Friday]. So the average P/E should actually be higher. However, there's always a psychological reason why valuations temporarily get out of line - and this time is no different. Only in the stock market does the best merchandise occasionally sell cheaper than the lower-grade merchandise. And it just so happens that we're at one of those points in history right now. In fact, I'd say that such an opportunity only comes along about once every 10 or 12 years - in fact, it may come along only once every 20 years. It's very, very rare..."

The discount of U.S. large caps vs. U.S. small caps can also be witnessed in the following chart showing the relative P/E ratio (12-week moving average) of the S&P 500 vs. the S&P 600 from April 1993 to the present:

Relative P/E Ratio (12-Week Moving Average) of S&P 500 vs. S&P 600 (April 1993 to Present)

As Arnold discussed in his August 2006 interview - not only is U.S. large caps trading at a discount to U.S. small caps, but also to U.S. treasury notes and bonds as well. More importantly, the discount gets wider as one move further up the market cap spectrum. According to Yahoo Finance, WMT is now trading at a P/E of 17.7, PFE 9.7, HD 13.7, MO 15.0, MCD 15.9, GE 17.9, DELL 17.8, and so forth. This discount is even more pronounced if one compares the valuation of U.S. mega-caps with the valuation of REITs, the popular emerging market securities, and so forth.

Over the long-run, I sincerely believe that the only way an individual investor can beat the professionals (including guys like Bill Miller, hedge funds, private equity funds, etc.) is to employ a buy-and-hold strategy and only buy on 1) valuations, and 2) fundamentals. When buying individual stocks, capital preservation is the game, and buying based on valuations can cover a lot of mistakes. In fact, I would go one step further: Buying U.S. large caps such as WMT at good prices is close to a no-brainer, as companies like WMT usually come with high-quality management and a brand name that attracts the best talent - luxuries that many small cap and mid cap companies do not typically have. Finally, as the U.S. economy continues to grow below its potential (this is short-term in nature) and as the U.S. Dollar continues its secular decline against many of the Asian currencies (this is more secular in nature) - U.S. large caps, with its much more geographically diversified earnings stream - should experience higher earnings growth than U.S. small caps going forward.

Let's now move on to a discussion of margin debt. We last discussed margin debt in our February 22, 2007 commentary ("Is the Rise of Margin Debt a Danger?") and concluded that while rising margin debt in bull market is very normal, the fact that it was rising so quickly signaled a red flag nonetheless. In retrospect, however, I was wrong nonetheless as I also stated: "That being said - for those that are already long and are in stocks that have good fundamentals and earning power - I would not consider selling here. Records are meant to be broken, especially during a bull market. Moreover, many things I have read suggest that most of the increase in margin debt has been due to speculation in foreign stocks and ETFs - as opposed to the concentration in domestic technology stocks back in late 1999 and early 2000. In past times, I would have slapped an emphatic "sell" on international stocks and on emerging markets - but given the much cleaner balance sheets and economic/earnings growth in emerging markets in recent years, I now believe margin debt can continue to increase from current levels before we see any kind of significant correction. Readers please stay tuned." Five short days later, the Dow Industrials would decline over 500 points in an intraday swoon resulting in a NYSE Arms Index reading not seen since the aftermath of the Eisenhower heart attack in late September 1955.

Given the February 27, 2007 decline, one would think that the amount of margin debt outstanding on both the NYSE and the NASD would have experienced some kind of washout, but alas, it was not to be. Margin debt outstanding actually increased again (for the sixth consecutive month) during the month of February. In fact, the rate of ascent in the margin debt outstanding has been nothing short of phenomenal over the last six months - as shown on the following chart showing the Wilshire 5000 vs. the 3, 6, and 12-month changes in margin debt from January 1998 to February 2007:

Wilshire 5000 vs. Change in Margin Debt (January 1998 to February 2007) - As shown on this chart, while the three-month increase in margin debt has corrected somewhat during the month of February, both the 6- and 12-month increase has continued to rise, with both the former and the latter at their highest levels since April 2000. The fact that leverage still remains high is disturbing, especially coming after the February 27, 2007 decline in the stock market. In the short run, this probably means more consolidation ahead. We will continue to watch the behavior of margin debt levels in the coming weeks.

The total amount of margin debt outstanding on both the NYSE and the NASD increased $10.3 billion (assuming that NASD margin debt remained the same, as February NASD data isn't released until the end of this month) to $321.8 billion - a new record high. As mentioned on the above chart, both the 6-month ($72.4 billion) and 12-month ($72.2 billion) change in margin debt are now at their highest levels since April 2000! Because of this latest increase, margin debt continues to be a red flag. While I believe the U.S. stock market is still in a long-term uptrend, investors who want to go long should generally adopt a "wait and see" approach before buying. This is also one reason why I believe the U.S. stock market should experience a further consolidation period before we see higher highs over the next three to six months.

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Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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