5 Stocks to Beat the Permabull

I want to be perfectly bullish on the stock market. I really do. But sometimes you have to accept the reality that's staring you in the face and accept that a full-on bullish charge is not the right move.

Don't tell that to stock permabull Jeremy Siegel. On Friday he was featured on Yahoo!'s Daily Ticker talking about why it's not too late to be bullish on the stock market as a whole. Siegel believes that stocks are cheap and that investors can expect attractive returns buying at today's prices.

But I'd be very careful following that advice.

Here's the problem
Don't get me wrong. I dig Siegel, and he's delivered a lot of good wisdom over the years. He's also simply a very sharp guy -- he's a professor at my alma matter, The University of Pennsylvania, and holds a Ph.D. from MIT. But he's made a name for himself largely through his bullishness on stocks and his book Stocks for the Long Run.

In this particular case, I'm concerned that his always-on bullishness is causing him to dismiss a warning flag way too lightly.

During the appearance on Daily Ticker, host Aaron Task asked Siegel about the fact that Yale professor Robert Shiller's cyclically adjusted price-to-earnings (CAPE) ratio -- which measures the market's current price against average earnings over the past 10 years -- suggests that stocks are expensive. Siegel responded by saying that the measure is misleading because financial companies such as Bank of America, Citigroup (NYSE: C  ) , and AIG (NYSE: AIG  ) registered massive losses during the financial meltdown that dragged total index earnings down an almost unprecedented amount during that stretch. The implication was that if earnings had fallen more in line with a "normal" recession that today's CAPE would look much more attractive.

The tale the numbers tell
The idea that Siegel is floating is easy enough to test. What I did was simply grab Shiller's spreadsheet (which he's kind enough to provide on his website) and replace those disastrous crash-era earnings numbers. During the post-dot-com recession, earnings fell a bit more than 50% from peak to trough, so I chopped peak 2007 earnings in half and replaced all of the 2008-2009 earnings results that were below that level with the new, higher floor.

In simple terms, this makes it as if, instead of a hellish, sky-is-falling earnings crash, we had a relatively average recession.

Directionally, the result is right in line with Siegel's view. That is, the CAPE multiple falls. The problem, though, is that it doesn't fall all that much. Based on the actual numbers, the current CAPE is 20.1, or 23% above the long-term average of 16.4. When using my hypothetical numbers, the CAPE drops to 19, which is still 16% above the long-term average.

So in other words, if we plug the gaping earnings hole in 2008 and 2009, the S&P 500 index as a whole is still expensive.

Heck, even if I go absolutely crazy and plug in 2007 peak-level earnings for the entire time since then -- making it as if the recession and financial meltdown never happened at all -- the CAPE measure would still show the S&P 500 as only fairly priced.

Much love, Jeremy
Even if I don't agree with him on this one, I'm still a fan of Siegel. One big reason for that is that he's an avid supporter of high-quality, dividend-paying stocks -- and I think there is still a lot of opportunity in that corner of the market.

That's right -- even though the stock market broadly isn't terribly attractive to me, there are quite a few individual stocks that I think are worth considering right now. The five that follow are great examples of exactly what I mean.

Company

Current Trailing Price-to-Earnings Ratio

Price-to-Average 10-Year Earnings

Dividend Yield

ExxonMobil (NYSE: XOM  ) 9.5 11.2 2.6%
General Electric (NYSE: GE  ) 12.2 10.4 3.8%
Intel (Nasdaq: INTC  ) 9 14.7 4.3%
Cisco (Nasdaq: CSCO  ) 13.2 14.2 1.6%
AstraZeneca (NYSE: AZN  ) 7.8 10.3 5.9%

Source: Capital IQ, a division of Standard & Poor's.

Why are these stocks so cheap when the rest of the market isn't? Is it because the computing infrastructure around the world will suddenly stop using Intel chips? Is it because the massive dividend-adjusted performance of ExxonMobil's stock has been a fluke? Is it because AstraZeneca will never develop another blockbuster drug ever again?

I'm sure that you'll find some people that will answer "yes" to some of those questions. But the real truth is that the market moves in cycles, and at times investors want nothing but large-cap stocks, while at other times they want nothing to do with the big guys. During the decade ending in 2000, the advantage went to large caps as the Dow Jones Industrial Average (INDEX: ^DJI) significantly outperformed the small-cap Russell 2000. Over the past decade, though, the opposite has been true, as the Russell 2000 has outrun the Dow.

That has created some good news for investors. To find cheap, high-quality, dividend-paying stocks today they don't have to dig through small, relatively unknown companies because large, well-known companies are very attractively priced. Not quite convinced? Here are 13 more examples from my fellow Fools who think these are a bunch of stocks that you can buy today.

The Motley Fool owns shares of Yahoo, Cisco Systems, Citigroup, Intel, American International Group, and Bank of America, has created a bull call spread position on Cisco Systems, and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Yahoo, Cisco Systems, and Intel and creating a diagonal call position in Intel. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Bank of America and Intel but has no financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter, where he goes by @KoppTheFool, or on Facebook. The Fool’s disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (7) | Recommend This Article (19)

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  • Report this Comment On September 06, 2011, at 5:36 PM, 123spot wrote:

    Nice analysis. I wondered that same thing as I read Siegal's interview. But you actually put the pencil to it and gave me an answer. I think we'll get our 16, and must buy below it to profit from any later regression to the mean. I've also wondered about the logic of extrapolating the market's P/E to individual stock's valuations. I see that you think it is logical with the large-caps at least, and that helps too. Cheers. Spot

  • Report this Comment On September 06, 2011, at 8:18 PM, TMFKopp wrote:

    @123spot

    "I've also wondered about the logic of extrapolating the market's P/E to individual stock's valuations."

    Whether or not you're comparing the individual stock valuations to the rest of the market, it can still be instructive to look at the price-to-10-year earnings for individual stocks. Graham liked to do this and I'm pretty sure his "good buy" threshold was a multiple of 10.

    Matt

  • Report this Comment On September 07, 2011, at 10:38 AM, Franky102 wrote:

    I like your idea about "certain stocks" rather than stocks as a whole. It's always the case that some stocks are a great buy at any given time. Given how much money Apple is making and how fast they are growing, it shocks me why more people don't push this stock a lot higher. They have about $80 per share just sitting in their piggy bank and are dominating all over the world. I'm living in China and I guarantee they will beat analysts expectations a lot again next quarter and the stock will be over $400. It will be over $500 after the Iphone 5 takes hold and starts making inroads in RIM's former business market. It is super cheap regardless of looking at numbers like CAPE.

    Google the phrase, "why apple is still an amazing buy" and you'll see what I mean. You'll find a great finance blog with that as a title at the top of the search results. Very forward thinking and international.

  • Report this Comment On September 07, 2011, at 12:52 PM, Hamiltionian wrote:

    I still agree with Siegel on this one. I agree that changing the recession earnings changes the CAPE very little and by that measure the stock market is still close to fairly valued. However, the more important factor is the current equity risk premium which is at levels we have not seen in decades due to the insanely low interest rates on bonds. Most of the stocks mentioned above have yields greater than 10yr treasuries, which is crazy given our modern understanding of the drivers of return on equities.

  • Report this Comment On September 07, 2011, at 1:28 PM, dctodd27 wrote:

    Well-written Matt, nicely done. Very interesting analysis.

    @Franky102...If earnings growth was all that was needed to push a stock's price higher, MSFT would have had a much better decade than it just did. If the price gets too far ahead of normalized earnings, all the growth in the world won't push the stock price higher. If investors aren't careful they WILL turn AAPL into the next MSFT (and not in a good way), regardless of quarterly earnings or the next 5 iterations of the iPhone .....

  • Report this Comment On September 07, 2011, at 1:47 PM, TMFKopp wrote:

    @Hamiltonian

    "However, the more important factor is the current equity risk premium which is at levels we have not seen in decades due to the insanely low interest rates on bonds."

    Here's the important thing to remember about that... Theory says that stocks should be valued much higher because of the low rates on bonds. However, we need to remember that returns are returns in the end, meaning that if we say "Ok, 5-year Treasuries are yielding 0.88%, so with a 5% equity risk premium, the market should have a P/E closer to 17" then we've just argued our way into 6% annual returns. I'm not sure what your equity-return targets are, but mine are a fair deal higher than that.

    Bond yields are exceedingly low. Low enough to call them a bubble of historic proportions. As a result, trying to say that stocks should be priced at X because bonds are priced at Y is basically saying that because bonds are in a bubble, stocks should be as well.

    Some might argue that that's precisely what the Fed is trying to do by keeping rates so low. I don't really care about that. What I care about is the actual returns that I can expect -- just because theory tells me that I should be happy with a 6% return right now doesn't mean that I'm going to be ecstatic about getting 8%.

    It's a really interesting thought though and obviously mine is only one perspective. Thanks for the comment.

    Matt

  • Report this Comment On September 08, 2011, at 6:03 PM, Hamiltionian wrote:

    Yes, bonds are clearly in a bubble. Thus, I think this leaves the potential long term investor with two reasonable options. First, buy equities, or second, hold on to cash and hope that the market will get cheaper and thus offer a better return. While the market certainly could get cheaper, I think that is a risky bet to be taking. There is nothing that says that the market will have to offer a better than 8% return any time in the near future. So yes, 8% from equities isn't thrilling but I think it is currently by far the best option.

    Also, our nominal return should be the earnings yield plus inflation, which makes stocks look even better. For a long time, earnings yield and treasury yields were very similar, as the market discounted equities inflation hedge and treasuries safety almost equally. That has changed drastically over the past decade to the point where we are now. I know that inflation is not a major concern right now, but I think over the long term it should be, especially given the recent huge expansion in the money supply.

    Thanks, David

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