In his recent mid-year market commentary, Oakmark Fund Portfolio Manager Bill Nygren says that he “continue[s] to believe that today’s long-term investors will increase their capital more by investing in stocks than by investing in other assets”, and that “the long-term return for stocks purchased today is likely to be higher than historical average returns”.
Nygren gives three main reasons for his bullishness, with the first being valuations. “The S&P 500 trades at about 900 with operating earnings in 2009 expected to be in the $60s,” he says, adding that the big question is what “normal” earnings will look like going forward. “If 2009 earnings represent a ‘normal’ base from which mid-single digit growth resumes, then expected returns from an investment today would be several percentage points above government bonds, which is consistent with historical averages,” he says, noting that “typically when a recession ends, earnings recover much more rapidly than would be implied by normal earnings growth.”
“In our view, the biggest question concerning earnings is when they will recover, not if,” Nygren says. “Starting from a ‘normal’ P/E level, we believe the market should increase from here more or less as much as earnings recover, which would lead to above-average returns.”
Another bullish sign, according to Nygren, involves cash on the sidelines. “Before the 2008 bear market, [the ratio of money market funds to S&P 500 market value] had averaged about 18% since 1980, meaning that there was typically enough cash in money market funds to buy 18% of the S&P 500,” he says. “In March 2009 it peaked at 65%, more than three times its long-term average and more than twice its prior peaks.” At the end of the second quarter, that figure had fallen to 46% — lower, but still well above the long-term average. “We conclude that there is still plenty of fire power waiting to invest in stocks,” Nygren says.
Finally, Nygren cites investor sentiment. He believes most investors think the recent market surge wasn’t accompanied by improvement in the economy, and that investors should wait for a decline to buy stocks again. “While we applaud the effort to tie stock price movements to fundamentals, we have to ask, where were these fundamentalists when the market was in freefall?” Nygren says. “We believe that panicked investors, momentum investors and short sellers all combined to drive the market far beneath the level that was justified by the economy’s cyclical decline. In our view, the March low — not today’s market — was disconnected from fundamentals.”