How to Play the Market Sell-Off by Jeremy Siegel, Ph.D.
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Posted on Monday, July 30, 2007, 12:00AM
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["CONCEPT"] ,"context": " headlines, the underpinnings of our economy and stock
market remain strong. Rotate to quality stocks and"} }; It doesn't take
much when you're near the tipping point. Last week Countrywide Financial said
it had increased defaults on some of its home equity loans and several banks
took unexpected charges against potential credit defaults. Suddenly investors
reacted as if the whole world had changed. Their fears sent the popular stock
averages to their biggest loss in almost five years and the bears proclaimed
that the days of easy credit that has fed the bull market over the past 4 ½
years were finally over.
Valuations are Sound
But the purveyors of doom and gloom are wrong. It's true that over the past
few years the interest rate spreads between the high and low-rated debt became
extremely low by historical standards. Then tremors developed last February
when the sub-prime mortgage crisis surfaced. These tremors turned into an
earthquake last week when the private equity firms and banks wanting to acquire
Chrysler and Alliance Boots failed to attract the lenders needed to finance
their $20 billion buyout. All of a sudden, the stock market bears emerged from
hibernation to yelp "I told you so!"
But the bull market in equities did not depend on these low spreads or on the
rising tide of leveraged buyouts. Despite the fizz in a few stocks, the overall
level of the stock market never became overpriced relative to the most
fundamental metric of firm value - corporate earnings.
Based on the S&P 500 Index, which constitutes 80% of the total market value
of U.S. stocks, these stocks are now selling at 16.5 times a conservative
estimate of 2007 earnings. In a world where government rates are below 5% and
inflation is below 3%, stocks are not only reasonably priced, but cheap on a
historical basis.
Positives for the Equity Market
But valuation is not the only reason to stay invested in stocks. The
following facts are also very positive for equities:
(1) Although there was a sharp increase in the interest rate on low-grade
debt securities, there was little if any increase in interest rates on
investment grade securities, which constitute the vast majority stocks in S&P
500. This is because the increase in the spread between investment-grade bonds
and the Treasury yields was more than offset by the drop in U.S. treasury
yields, so credit costs for quality stocks have not increased.
(2) Although the housing market remains in the tank - and will stay there
for quite a while - there is still no convincing evidence that the rest of the
economy is headed for a significant slowdown and certainly there are no signs
of a recession. Second quarter GDP grew at 3.4% rate despite a lousy housing
market. Early estimates for this quarter are for 2.5% to 3% growth. This
would be greater than the slow growth of the first half of the year during
which time corporate earnings still rose briskly.
(3) In a worst-case scenario where the tightening of credit standards does
lead to a substantial economic slowdown, the Fed has ample room to ease
interest rates from the current 5.25% level. With the sharp drop in treasury
yields across the board, the term structure of interest rates has once again
become inverted, with the ten-year bond falling to 4.75%. This puts the
central bank on alert that the market thinks that short term rates may be too
high. In fact, the Federal funds futures market now expects two 25 basis point
reductions in the Federal funds rate by next summer. Although I think the
economy will stay strong enough so that the Fed will not have to lower rates,
if the Fed does act, this will be very positive for stocks.
(4) A large part of the stock decline last week was due to portfolio
managers establishing defensive positions by buying index puts to protect
themselves against market declines. The VIX index, which measures the premium
that investors pay for such puts reached 24, the highest level since the start
of the Iraq war 4 ½ years ago. Spikes in this index have historically been
great times for investors to buy stocks.
(5) It will be several months before we find out how hedge funds faired
during this turmoil. If their returns suffered, this could ultimately be very
good for stocks. Hundreds of billions of dollars have migrated from the equity
markets to "alternative investments" in recent years. If these alternatives
fail, it is very likely that much of this money will return to the equity
market.
What Should Investors Do?
The strategy for investors is clear. The cost of credit has not gone up to
the top credit companies - such as those rated A and B by Standard and Poor's.
It is the lower-rated firms, as well as many smaller stocks that have do not
have a ready access to the credit markets that will be hurt the most if spreads
remain wider. Those lower rated stocks have had a wonderful ride for the last
several years, but that ride is over. Quality stocks are set to outperform the
market and withstand the credit storms.
Is there anything to worry about? Sure. Oil prices continue to rise in spite
of the declarations of Kuwaiti officials who said they would like to see crude
oil back in the $60 range. If oil and its derivatives - gasoline and heating
oil - keep marching upward, this will crimp consumer spending and slow the
economy.
But, history tells us that the worst time to buy is when there are no clouds
on the horizon and everyone is optimistic. On the other hand, the best times
for stocks are when there are mountains of worries. Despite the scary
headlines, the underpinnings of our economy and stock market remain strong.
Rotate to quality stocks and you will weather the storm well.
