The Bull Market Turns 2; How to Invest Now

On March 9, 2009, both the S&P 500 and the small-cap Russell 2000 hit their crisis lows. The rebound in stock values since then has been stunning. With the S&P 500 having nearly doubled and individual investors returning to U.S. stocks, this anniversary is an excellent opportunity to ask: How should we invest today?

The catalyst: The banking system puts its house in order
Do you remember what triggered the market panic in March 2009? Investors were concerned that the banking system was insolvent and they were confused by the response of the administration and regulators. At the beginning of May, the authorities released the results of the banking stress tests, and the process of shoring up bank balance sheets gathered speed. If we consider the current components of the S&P 500, financials were responsible for nearly two-thirds of all the equity issued during the four quarters that followed the March 2009 meltdown.

Today, financials are back to being the second largest sector in the S&P 500, behind technology. Not all banks are healthy: Expect to see significant further consolidation among local banks and a failure rate that remains well above average. However, there are no longer any fears about the insolvency of the banking system.

Stocks were manifestly cheap in March 2009; today, the margin of safety has evaporated
The following table breaks down the forward price-to-earnings multiples for the S&P 500 at the market low and at yesterday's closing price:

 

March 9, 2009

March 8, 2011

S&P 500 676.53 1,321.82
Forward Operating EPS Estimate $64.36 (2010) $96.19 (2011)
P/E Multiple 10.5 13.7

Source: Author's calculations based on data from Standard & Poor's.

On the face of it, a 13.7 price-to-earnings multiple doesn't look expensive, but watch the denominator -- the "E" in P/E. With corporate profit margins near the top of their historical range, a downward revision in the earnings estimate looks a lot more likely than an upward one. The productivity of U.S. companies is excellent, but there is only so much juice you can squeeze out of workers. With energy costs rising, stoking fears of inflation, companies will be doing well to maintain margins at current levels.

I'm not going to trot out Shiller's cyclically adjusted P/E multiple for the umpteenth time; I'll simply say that the valuation risk in this market is a lot more elevated than the figures in the table would suggest.

As stock correlations fall and valuations increase, stock picking becomes critical
In this bull market, a rising tide has certainly lifted most boats. The broad market Russell 3000 index has risen 100% through Monday. Sixty percent of the stocks in the index beat that figure.

However, as valuations increase and the market refocuses on companies' individual characteristics instead of the macro environment, this sets the stage for differentiated returns going forward. Certain stocks still sport reasonable valuations; but in many cases, the numbers will become increasingly difficult to justify. Here are some examples of stocks in the top and bottom quintiles of their sectors in terms of forward P/E multiples:

Sector

Looks cheap/ reasonably priced

Looks expensive

Consumer staples Molson Coors (NYSE: TAP  ) Mead Johnson Nutrition (NYSE: MJN  )
Health care Covidien (NYSE: COV  ) , Medtronic (NYSE: MDT  ) , Baxter International (NYSE: BAX  ) Intuitive Surgical* (Nasdaq: ISRG  )

Source: Capital IQ, a division of Standard & Poor's; *The folks on our Rule Breakers service may disagree since Intuitive Surgical is an active four-time recommendation (last rec in November 2008).

The worst of the crisis is over and the country didn't collapse. That was enough to lift stock prices from their 2009 low, but we are well past this stage. We have gone from stock valuations that simply require we avoid a complete disaster to earn very good returns to valuations that require the absolute best-case scenario in order to earn middling returns (or even avoid capital losses!). That's very problematic in an environment in which ...

... plenty of risks remain
In March 2009, fears centered on the banking system. That risk is no longer, but there are plenty of others that have come along to replace it: higher commodities prices including higher oil prices, increased political risk, an unresolved sovereign debt crisis in Europe -- the list is extensive. In that regard, it's maddening to witness that individual investors are choosing to get back into U.S. stocks only now after bailing out at much lower prices. It's still possible to put money into U.S. equities today with the expectation of earning an acceptable return, but investors need to be discriminating to achieve that.

To track those stocks that look cheap, click on Molson Coors, Covidien, Medtronic, and Baxter International to add them to your watchlist, or start a new watchlist and add any company you want. You'll get valuable updates as well as immediate access to a new special report, "6 Stocks to Watch From David and Tom Gardner." Click here to get started.

Fool contributor Alex Dumortier, CFA, has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. Covidien and Molson Coors Brewing are Motley Fool Inside Value picks. Intuitive Surgical is a Motley Fool Rule Breakers selection. The Fool owns shares of Medtronic, and Molson Coors Brewing. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On March 09, 2011, at 9:57 PM, jmadden76 wrote:

    There is never a perfect time to invest in the market and every single day you can find good reasons not to be in the market as well as good reasons to invest in the market.

    Imagine being alive in 1942 shortly after our country was attacked at Pearl Harbor and we had become fully involved in World War 2. Sounds like a great reason NOT to be in the market, but if you had the courage to invest you would have enjoyed a 24-year secular bull market that returned approx 1,000%.

    I'm sure you would point out that the CAPE in 1942 was 10. Unfortunately during my entire adult life the CAPE has only been below average once and that was for a very short time before our current rally. How do you propose I invest for retirement during all those other years when the CAPE is above average?

  • Report this Comment On March 09, 2011, at 11:59 PM, TMFAleph1 wrote:

    <<How do you propose I invest for retirement during all those other years when the CAPE is above average?>>

    Very selectively!

    Alex Dumortier

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