Large Cap Commentary – December 2011
The term “it’s different this time” is one of the more dangerous beliefs in investing. However, as we close out 2011 and look to what could unfold in 2012, the term may indeed be suitable. If you recall, our November commentary showed the U.S. economy decoupling from the rest of the world, showing economic growth. It is probably fair to counter that statement with the argument that emerging markets are really simply having slowing growth, it seems for Europe there is no such hope. Thus, recent economic data coming out of Europe points to a recession, yet in the face of a weaker Europe, recent U.S. data has strengthened. Could we be seeing real decoupling? Given the current conditions within the United States, it is hard to argue otherwise. In addition, when we look at valuation, it is difficult to not be enthused by domestic large cap stocks. The chart below is one we have referred to several times, the “Rule of 20.”
The Rule of 20 states the 12 month forward price-to-earnings ratio of the market (PE) should approximate twenty minus the yield of the 10 year Treasury bond. Today, the 10 year yield is below 2%. Simple math generates a resulting PE of approximately 18x. In reality, the forward PE of the market (represented by the S&P 500® Index) is closer to 12x. This six point spread is quite wide, as readily seen in the chart above. In fact, in the recent past, the only time the spread between the Rule of 20 and the actual PE of the market was wider was during the Internet bubble, a period when common wisdom claimed that valuations did not matter. As a result the stock market was overvalued relative to other asset classes at the time.
It is irrefutable that today’s interest rates are exceptionally low and are being further depressed by actions of the Federal Reserve. Nevertheless, even if one were to use a more normal 4% yield for the 10 year Treasury bond, which is twice its current yield, the Rule of 20 would generate a market PE of 16x, not today’s 12x.
What does all this mean for us as investors? We have a U.S. economy that is strengthening, even while valuations of its largest companies are depressed. At the same time, the earnings of those companies, in aggregate, are at record levels. So, maybe it is different this time, maybe we are entering the “new normal” of muted growth. On the other hand, viewing the evidence of both business and economic strength occurring within the U.S., we at Argent believe we are being paid to take the risk as we invest and enter 2012.
As always, we appreciate your interest in Argent Capital Management and hope you will mention our name to others.
Senior Portfolio Manager
Views expressed herein represent the opinion of the portfolio manager as of the date above and are subject to change. Rule of 20 graphic provided by Hays Advisory (as of 01/03/12).