For the last six years investors have enjoyed the third strongest bull market in history.
However, now experts such as Yale Professor Robert Schiller are warning that the market has become historically overvalued, with a cyclically adjusted P/E ratio, or CAPE, -- which measures the inflation adjusted 10 year average P/E ratio -- of 24.27, 52% higher than its median value of 15.93 since 1870.
If we examine the last eight bear markets we see something that is either potentially alarming, or wonderful, depending on your perspective.
|Period||CAPE at Market Peak||Stock Market Decline|
If we remove the great depression crash of 1929-1932 (its an outlier) then we get a historical average peak CAPE of 25.6 and an average bear market decline of 35.7%. As my Motley Fool colleague Morgan Housel pointed out last year, the S&P 500 usually suffers a 10% correction once per year, and a 20% bear market every few years. Given that its been 28 months since the market's last correction, it seems we are overdue.
Are we headed for a crash?
I should point out that historical data, while an interesting tool for putting market movements in perspective, is not a predictor of the future. Just because our recent CAPE peak is similar to those that preceded previous bear markets doesn't mean the market won't rebound as it did in late 2012.
That being said, today there are larger risks to the market's continued bull market, including slowing economic growth in Europe, China, and Japan that has led the IMF to cut its 2014 global economic growth forecast by 11%. In addition, the strengthening U.S. job market has given the Federal Reserve the confidence to finally end its quantitative easing program in October.
Over the past six years the Fed has pumped $4.5 trillion into the economy, which has kept borrowing rates at historic lows, and allowed companies to borrow cheaply. Some of that cheap debt was used to buy back shares and help drive the stock market rally.
Though the Fed isn't expected to raise rates until mid-2015, the end of monetary stimulus, in accordance with potential slowing of the global economy, does increase the risks of correction, or even a bear market.
While that thought may frighten many investors, I am excited at the thought of a market crash, because that's the best time to purchase great companies at rock bottom prices that allow you to beat the market over the long-term.
Be greedy when others are fearful
"You want to be greedy when others are fearful. You want to be fearful when others are greedy." -Warren Buffet, interview with Charlie Rose October 1, 2008
There are three reasons why I am looking forward to the next market crash, whenever that may occur. First, no market can always go up forever, and a market crash allows the markets to reset, thus setting the stage for the next market rally.
Second and third, as an investor in individual companies I know that a market crash, along with the panic that goes with it, results in irrational pessimism that allows you to buy quality high-yielding dividend growth companies like Seadrill (NYSE:SDRL), Linn Energy (NASDAQ:LINE), LinnCo (NASDAQ:LNCO), and Vanguard Natural Resources (NASDAQ:VNR), at fantastic prices and yields that generate market crushing long-term returns along with amazing income.
|Company/MLP||Current Yield||Peak Yield in 2009||Dividend Change 2008-2009||Dividend Growth Rate since 2009||Yield on shares bought in 2009|
|Vanguard Natural Resources||11%||38.80%||6.90%||24.80%||51.70%|
As this table shows, at the peak of the 2008-2009 panic these three companies were being priced for massive dividend/distribution cuts that never materialized. Long-term investors who had the stomach for massive volatility and confidence in the eventual recovery of the global economy and energy prices were rewarded with strong dividend/distribution growth that created a yield on invested capital that is simply mind blowing.
The financial panic of 2008-2009 isn't your typical bear market and investors shouldn't misunderstand me. I'm not predicting a crash over the next few months or quarters. Nor am I predicting that when a crash comes it will be anywhere as large as the 51% decline we saw during the great recession or that these companies will be yielding anywhere close to the above figures. My purpose in showing you this table is to illustrate how market crashes can make great companies with great present yields even better -- thus resulting in fantastic income potential and greatly improving the odds of market beating returns over the long-term.
Why these three companies should be on your radar
There are three main reasons I think that investors should have Seadrill, Vanguard Natural Resources, and Linn Energy on their watchlists should the market crash.
The first two reasons are undervaluation and yield. As the above chart shows, these three energy companies/MLPs have already crashed relative to the market, resulting in highly undervalued shares/units and some truly enormous yields -- which I believe to be sustainable and likely to grow in the long-term.
Third and most importantly, the recent decline in energy prices, a result of the combination of concerns over a slowing global economy and increased oil and gas production from U.S. shale formations, is likely to be a short-medium term trend.
Growing energy demand is a long-term megatrend
This is because the macrotrend of increasing population and growth in the developing economies such as Brazil, China, and India is likely to greatly increase energy prices. For example, according to the U.S. Department of Energy, by 2050 the world's population will reach 9.4 billion, per capital income will double, and energy use will increase by 100%.
Similarly, a report from Morgan Stanley and Rystaad Energy claims that by 2035 the world's demand for oil will increase 15%-26%, from 87 million barrels/day to 100 million-110 million barrels/day. They expect this to result in oil prices of $125 per barrel-$150 per barrel.
That long-term growth in oil demand and prices is a major growth catalyst for Seadrill, the world's second largest operator of offshore oil drilling rigs. This is because, between 2012 and 2030 ultra deep-water oil production is expected to grow 19% annually compared to just 1% annually for onshore production.
Despite the recent weakness in the offshore oil drilling industry, I strongly believe that Seadrill's strong access to alternative financing and young, state of the art fleet, means that the dividend is safe. This notion is shared by Seadrill's management, who believes the dividend's safety may last until 2016, even if market conditions don't improve.
Meanwhile the price of natural gas, important to both Linn Energy and Vanguard Natural Resources (who produce oil and natural gas), is expected to benefit from the coming boom in liquefied natural gas, or LNG, exports, and increased demand from U.S. power plants switching from coal to natural gas. In fact, analyst firm Wood Mackenzie projects that demand for natural gas will increase 36.2% in the U.S. over the next decade.
The U.S. Energy Information Administration expects the price of natural gas to rise from its current $3.89/thousand cubic feet to $7.65/thousand cubic feet by 2040 due to these long-term demand growing trends.
Whether the market's recent weakness is a sign of a coming bear market no one can predict with any confidence. However, I strongly believe that most long-term investors should welcome a market crash with open arms and view it as an opportunity to buy quality companies such as Seadrill, Vanguard Natural Resources, and Linn Energy at bargain basement prices. Don't fear a market crash, but rather embrace it. View it as a chance to lock in superb yields that not only generate income, but also greatly increase the chances for long-term market crushing capital gains and total returns.
Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Seadrill. The Motley Fool owns shares of Seadrill. 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.