04/28/2005
NASDAQ dropped -12.5% year to date in 2005. S&P500 index
suffered -5.7% this year. US stock market has been terrible over
past few months.
Not only general market is down, oil stocks recently had a
significant correction as well. It is easy to be nervous because
of the short term setback. However, to succeed with long term
oriented value investing, we can not be distracted by the
volatile short term market movement. It is time to step back and
look at the big picture of the current stock market and review
investment strategy to profit in this kind of tough environment.
Stocks in General and Oil Stocks
Below chart is past 1 year performance chart between Energy
Index ETF (ticker: XLE) and S&P500 index (ticker: SPY). By
looking at the chart, even a fool will know that oil market is
booming while US stock market in general is struggling.
Simply put, the current US stock market is not in bull market.
The heydays of 1980’s and 1990’s when anyone can simply put some
money in S&P500 index fund or a decent US mutual fund to earn
10% to 20% plus annual performance is long gone. I expect for
the next 8 to 10 years, the US stock market in general will be
stagnant.
If you have believed that 20 years of stock market performance
between 1980 and 2000 is stock market average performance, then
you will be shocked to know that just before that period in
1960’s and in 1970’s, US stock market went nowhere. Dow hit
995.15 in 1966 and Dow was back to 800 in 1982. If you were the
long term investor who invested in Dow index fund between 1966
and 1982, you got a negative -20% return overall for your 16
years of loyalty, how would you feel about that ?
Still remember the NASDAQ peak of 5000? In my opinion, NASDAQ is
screwed up index with full of expensive stocks even today. I
predict that we may have to wait another decade to revisit
NASDAQ 5000.
Current Stock Market Average Valuation is Not Cheap
Currently SP&500 index trades at about 17x average PE today.
Although this valuation is not terribly expensive, it is not
that cheap either.
Over past 100 years of US stock market history, market usually
bottomed at average PE of 10. That happened in 1974 or 1929 or
1980. We are not there yet, not even close over past 5 years
even though the technology stock bubble bursted in 2000. In a
major stock market bottom, we should see plenty of big cap
stable companies trading at PE of low teens. Now look at this:
Coca-Cola (KO) PE 20, Walt Disney (DIS) PE 24. Even worse, a
no-growth stock like Sun Microsystems (SUNW) is still trading at
premium PE of 19.
What is the Overall Earning Outlook of US Stock Market?
Even though the current stock market valuation is not that
cheap, if earning is good, market should do fine.
Are we going to get excellent overall earning outlook in the
next few years for the US stock market in general?
Unfortunately, my answer is no. My take is that US stock market
earning overall is decent, but not good enough to trigger a bull
market. This market is still digesting the past bubble
over-valuation coupled with poor earning outlook.
Here is one reason of my not-so-enthusiastic earning outlook:
the rising oil and commodity prices.
The Booming Commodity price
Commodity and oil market has been booming since 1999 and the
high commodity price is taking toll on overall stock market
earnings. Companies need to pay more for the things needed in
business: steel, copper, oil, natural gas etc. Historically,
when commodity market was shining, stock market did not do very
well, and vice versa. In 1960’s and 1970’s, oil and commodity
had bull market run for nearly 20 years while Dow Jone index had
horrible performance for nearly 20 years. From 1980 to 2000, the
stock market soared while oil hit as low as $15.
The Bull Oil and Commodity Cycle Could be Very Long
Jimmy Rogers is famous investor who co-founded Quantum Fund
together with George Soros. In his recent book titled “Hot
Commodities”, he is predicting that the current commodity bull
market can last until 2013 strictly due to supply and demand.
In one chapter of the book titled “Goodbye, Cheap Oil”, he
clearly lays out the reasons why oil and natural gas bull market
can last until next decade. This is as simple as supply and
demand: rising demand coupled with declining supply.
The supply of oil and natural gas was diminished partly due to
extremely low oil and gas price in 1990’s. Over past 35 years,
there was no major oil discovery in the world while the old oil
fields deplete. Oil and natural gas production level of a well
does not stay flat over the life of a well reserve. The
production level of a well actually declines gradually due to
geophysics of oil well until the reserve is fully depleted. Even
there is new oil field discovered, it will take a decade after
the discovery to actually produce oil! Increasing supply to meet
demand is a very difficult and slow process.
Coupled with declining supply, the demand of energy from China
doubled since 1990 consuming 8 percent of world’s oil in 2004.
US economy is growing with increasing oil demand year over year
while US oil production has seen sharp decline over past 50
years.
Still the oil price is not that high on historical basis. Even
with today’s oil price of $50 a barrel, the oil price is still
significantly lower than the inflation adjusted peak price of
$90 a barrel in 1970’s.
Value Investors Do Not Need a Bull Market to Make Money
As scary as the potential trouble in stock market, this kind of
tough environment is great money-making time for value investors
to pick up cheap shares.
Warren Buffet is the greatest value investor in the world. He
averaged 20% annual investment performance over past 50 years.
However, Mr. Buffet’s performance in bear market of 1960’s and
1970’s was actually 30% per year return, much higher than his
average performance.
Focus on Dirt Cheap Stocks and Booming Commodities Market
Stocks do not go straight up or go straight down. There will be
huge run up or sharp sell off in short term. While market is not
in good shape, this is and will be wonderful time for long term
oriented value investors.
Commodity price is volatile. Just like stock market, commodity
price does not go straight up or straight down. Although oil
price weakened recently, I firmly believe that oil price is not
going back to cheap oil price below $40 a barrel. As long as oil
and natural gas prices stay high, oil stocks will do fine in its
business. As painful as the recent sharp sell off in energy
stocks, energy stocks in general are still very cheap and my
investment strategy is to continue to stay long term oriented in
them.
In the short term, it is very hard to know when a stock will go
up or go down. But I do know that valuation and earning matters
and investing in cheap stocks trading significantly below market
average will be rewarding in the long run.
