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It has been ten weeks since the market was last subjected to a close interrogation here ("How Bad Is It?" Aug. 6), so maybe it's time to place it back on the couch. Back then, the market had just swooned after a midsummer respite, and fresh concerns about Europe turning from terra firma to terra incognita drove the Standard & Poor's 500 index down 10%, below 1200 for the first time in 2011.
It so happens that now, with stocks having fallen further in September to smooch the silly quasi-formal standard of a bear market with a 20% drop from high to low, the markets are in a similar place, only having rallied rapidly rather than having fallen away in a rush.
So, let's start with the same question posed in the midst of the early-August selloff.
Q: What just happened?
A: Well, if you comb every headline and subject yourself to the constant cable-news chatter, a ton has happened, from European bailout drama to U.S. campaign jockeying and all the rest. But in the market, not all that much has changed. Ten weeks ago the S&P closed at 1199; now it's 1224, having recouped all of September's losses and more. The CBOE Volatility index was then at 32, and encouragingly is now below 30. The credit markets had a bit of agita in the interim, but have mostly regained their footing. Indeed, it will come as a surprise even to most close market observers that large U.S. stocks are effectively flat year to date, when dividends are factored in.
In brief, what happened most recently is that the markets quit pricing in a significant likelihood of a system meltdown, encouraged by the merest hint that the European authorities are mulling over ways to recapitalize the banks (or, as one brokerage analyst hopefully couches it, "pre-capitalize" the banks).
There's more to this quicksilver 14% burst higher in the S&P 500 since the midday low a week ago Tuesday, though. While the headline writers were focused mostly on Athens and Brussels, the economic data in this country have firmed. The Chicago purchasing-managers index, auto sales, retail activity -- all of it has held in OK, especially compared with Wall Street's worst fears. The August-September market setback nicely reset economic expectations downward to make way for the recent bounce.
Right now the prevailing forecasts are looking for a U.S. GDP number above 2% for the just-ended third quarter. A month ago, the markets were bracing for something closer to zero and the increased chance that we were headed for a recession relapse.
Q: So what are the markets currently pricing in?
A: Same as in early August, the markets are tuned for slow, but still positive, economic growth, with undemanding stock valuations the result of a slavish investor focus on macroeconomic stresses.
U.S. stocks trade around 12 times published profit estimates for 2012, even after the past weeks' spurt, a modest multiple if not a dirt-cheap one given the still-looming systemic risks. Pimco's Neel Kashkari points out that the MSCI World index -- a comprehensive global equity benchmark -- sits at 12.2 times the past year's profits, versus an average of 19.5 over the past decade. Ned Davis Research reports that its measure of stock prices versus "normalized" earnings over the last decade recently dipped into "neutral" territory, where it has been only twice -- at the 2009 and 2010 market lows -- since the mid-'90s.
This helps explain why the merest hint that the world was in less of a hurry to end in a conflagration of sovereign defaults and banking seizures caused cash to flow back toward stocks.
Yet now that the S&P 500 has shuttled back to the upper end of the range that has held since midsummer, the question is how much more we can expect. It makes sense that at 1224, the S&P has become far more vulnerable to disappointing earnings and economic news than it was a few weeks ago. After the panicky shake-out took the index below 1100, the Street is quite susceptible to merely OK economic inputs.
Q: Can we expect the typical year-end rally?
A: Maybe. One of the worst bets a trader could make over the past many decades was to short the stock market in the final months of a pre-presidential-election year. This, along with the fact that investor sentiment got profoundly sour a couple of weeks ago and the market has refused some rather obvious excuses to pull back, has some tactical traders getting aggressive on the long side, believing the lows for the year to be in place. The action has been encouraging, but falls just short of an "all clear" signal.
This market has withstood a bombardment of bad news to stay about flat this year. But now, at the top of the index's recent range, it will require genuine good economic news and fresh capital, rather than the mere absence of calamity and a dearth of sellers, to propel things upward for a textbook year-end rally.
ARE STOCK DIVIDENDS BLINDING investors to valuations? That's what research by AllianceBernstein contends.
Vadim Zlotnikov, chief market strategist at the research shop, ranked the large cap universe of 650 stocks by their dividends. He compared the stocks in the top quintile with those at the bottom using both price to book and price to forward earnings. The result: The premium of high-dividend payers over low-dividend payers is the highest it has been over the past 40 years.
"The high-dividend trade is the most crowded trade in the world," Zlotnikov argues. Conversely, deep-value, cyclical stocks are the most undervalued.
As always trends continue until they don't, and that's usually longer than expected. Zlotnikov suggests rebalancing portfolios between the two groups once every three to six months. And, he notes that within the dividend-paying universe, those in the utilities, staples and telecom sector are far more expensive than those dividend payers in energy, health care and defense.
With this research in hand, Bernstein's telecom analyst, Craig Moffett, put an Outperform on Comcast (CMCSA), which pays 1.9%, and an Underperform on Verizon Communications (VZ), which boasts a 5.4% yield.
Comcast has a lower valuation than Verizon. The cable operator boasts a 10% free- cash-flow yield, based on 2013 estimates, while Verizon's FCF yield is 7.2%. Comcast trades at 12.8 times 2012 earnings estimates, while Verizon trades at 13.8 times, according to Moffet. And Comcast trades at five times Ebitda (earnings before interest, taxes, depreciation and amortization) to Verizon's 6.4.
Industry veterans attribute the valuation discrepancy to fundamental differences in the two companies. Verizon has a 55% equity stake in Verizon Wireless, which contributes 94% of its operating income. The wireless business is perceived as growing and benefitting from a dominant industry position.
Moffett argues that despite the market perception, Comcast's business has actually performed better than Verizon's. The cable company has a 25.6% return on invested capital versus Verizon's 7.3%. And Comcast's second-quarter organic revenue growth is 7.9%, compared with 4.4% for Verizon.
Moffett instead attributes Comcast's lower valuation to Verizon's juicy dividend yield. It attracts investors looking for a bond alternative. They're worried only about the sustainability of the dividend and not about the stock's valuation.
The second problem is that Comcast is lumped in with consumer discretionary stocks, while Verizon is in the telecommunication-services sector. That's a big deal, because when investors want to reduce market exposure, they often short consumer discretionary index ETFs.
If he's right, and technical factors are driving the stocks, it might take a while for the trends to reverse. When it does, Comcast investors will likely be rewarded.
-- Jacqueline Doherty
E-mail: editors@barrons.com
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