Bill Miller, the legendary investor who beat market averages for 15 years straight, recently sent investors an unequivocal message: Now is the time to buy large-cap stocks. In fact, this is the buying opportunity of a lifetime.
As he puts it:
U.S. large capitalization stocks represent a once in a lifetime opportunity in my opinion to buy the best quality companies in the world at bargain prices. The last time they were this cheap relative to bonds was 1951. I was 1 year old then, but did not have then sufficient sentience or capital to invest. I do now, and if you are reading this, so do you.
It's important to emphasize that Miller thinks large caps are cheap not only by stand-alone metrics like P/E ratios, but relative to bonds. James Paulsen, chief economist at Wells Capital Management, has a nice chart illustrating this:
The wide gap at the far right of this chart is what Miller's referring to when declaring stocks cheap relative to bonds. Notice that this "undervaluation" gap is more extreme than the "overvaluation" gap that occurred in the late '90s. In a similar vein, I recently showed that the Dow's average dividend yield was briefly higher than the yield on 10-year Treasury bonds. Barron's points out how rare this is: "Over the past 50 years the Dow's yield has exceeded that of the 10-year Treasury for only one period -- the end of 2008 into early 2009, as the financial crisis climaxed."
Does all this mean large-cap stocks are a buy? I think it does. More on that in a second. First, though, here's what I imagine the bears' rebuttal will be.
If you could ask Mr. Market why there's such a chasm between stock and bond prices, his answer would be clear: looming deflation. If prices fall, thought goes, fixed income will protect your purchasing power, while corporate profits will be eaten away and stock prices will disintegrate. That's why investors are willing to pay a premium for bonds while eschewing stocks.
Viewed this way, the valuation gap between stocks and bonds isn't bullish at all. It's among the most bearish signs imaginable, predicting deflation that could crush the economy.
Picky bull rebuttal
Problem is, it's hard to refer to "the economy" as a unified body these days. Thanks to the recession's dirty work, "the economy" is almost perfectly bifurcated: one part is doing really well, and another is gasping for air. There's very little in between.
You see this in the job market. Obtaining a job today seems split between "easy" and "completely impossible" depending on your marketable skills. Reuters blogger Felix Salmon sums this nicely: "most Americans [are] actually doing OK, with an unemployable underclass bearing the brunt of the recession."
The average result of this shows an economy that's plodding along at a frighteningly slow pace, but the individual components of that average couldn't be more polarized, tell far different stories, and will have wildly varying futures.
The same holds true for companies. Viewed as a whole, the S&P 500 average might look dicey given the specter of deflation. But the 500 individual components of that average are anything but equal.
For example, I pulled up data on all S&P 500 companies and found that:
- 242 (48%) reported higher earnings per share (EPS) over the past 12 months than they did in 2007, when the economy and market last peaked. The median EPS growth for these companies was a solid 33%.
- The remaining 258 companies saw EPS fall during the same period, with a median decline of 35%.
I think that's remarkable. With few exceptions, the S&P 500 is split almost perfectly between companies that are either doing extremely well, or extremely badly.
What's more, and here's where Miller's call comes back into play, the average market cap of the companies that grew earnings during this period was 25% larger than those that saw earnings fall. All S&P 500 companies are fairly big, but it's predominantly the really huge ones that have done well over the past few years.
There could be several explanations for this, not least of which is lobbying power. But a big one I'd focus on is that larger companies tend to have their footprints all over the globe. In fact, you can find several megacap stocks like ExxonMobil (NYSE: XOM ) , Intel (Nasdaq: INTC ) , and Coca-Cola (NYSE: KO ) that do the overwhelming majority of their business overseas. This is seriously important, since diversification helps offset deflationary pressures in the U.S. with strong growth from regions like Asia and Latin America. Large-cap stocks, in other words, are relatively detached from the U.S. deflation that our bond market seems to foretell.
Large-cap companies also have access to credit in ways smaller companies can't dream of. IBM (NYSE: IBM ) , for example, just sold three-year debt with a 1% interest rate. Johnson & Johnson (NYSE: JNJ ) sold 10-year notes for 2.95%. These numbers are borderline absurd. Smaller companies can also raise debt thanks to investors' insatiable appetite for fixed income, but the interest rate advantage that large companies hold over smaller rivals is truly huge.
In many ways, it's never been a better time to be a big multinational company. But at the same time, their stock valuations will hear nothing of it.
It's Miller time
To tie this all together, large caps are generally faring much, much better than the economy as a whole, yet valuation-wise they're still lumped into a broad group we call "the market" as if they were merely average. Why? Perhaps it's the explosion of index-based ETF trading. High-quality large caps are indiscriminately bought and sold alongside lower-quality names, as if the merits of all companies are equal at a time when, in fact, inequality is running wild. My Foolish colleague Alex Dumortier has a few other possibilities. Whatever the reason, Bill Miller sees this disconnect as the opportunity of a lifetime, and I can't disagree.
How about you? Sound off in the comments section below.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.