Stock Market Investing: Will Dollar-Cost Averaging Over The Next 6 Months Work?

Given where the bottom-up analyst forecasts are for the S&P 500 (^GSPC) - currently at about $62.50 for 2009 - and the rate of decline of the forecasts, it seems likely that the eventual actual earnings for the S&P 500 will be about $50. This refers to operating earnings, excluding one time charges and gains.

There will be far more charges than gains, so the level of reported earnings will be well south of $50. We will most likely see a bit of an economic recovery in 2010, but it will be anemic. As with 2009, the bottom-up forecast is both far too optimistic and falling fast. It currently stands at $78.34.  Based on a much longer time frame, and the current rate of descent, I think the final number for 2010 will be somewhere around $60.

The question then becomes: What sort of multiple do you put on those earnings? The secular growth rate of corporate earnings will probably be lower going forward than it has been in the past. Consumers will have to save more. Their retirements can no longer be funded by the equity in their houses, and their 401-Ks are at best more like 201-Ks.

The same is true for the college savings accounts. This will be a long-term process, and will be a serious drag on growth and with it corporate profits. With lower growth should come a low multiple.

On the other hand, interest rates are very low, provided you happen to be a gold-plated credit like the U.S. Government (not quite as low if you are a mere mortal). Still, low interest rates are usually associated with high P/E multiples in the stock market.

On a related note, inflation is also very low, also something associated with high multiples. However, just because historically 2% inflation was associated with higher P/E multiples than 4%, which was in turn associated with better multiples than 6% inflation, does not mean that deflation of 2% is good for the market. We simply do not have a lot of experience with negative inflation to know.

All things considered, I think that we will probably get down to about a P/E ratio of 12 based on this year’s earnings. That would put the market at 600, or about 12% down from here. However, there is significant uncertainty about both the final level of earnings, and the multiple to be associated with them.

If anything, I might be on the optimistic side on earnings, and perhaps a bit too cautious on the multiple. Nobody is likely to catch the absolute low tick on the market.

I think it is time to start cautiously dipping a toe into the water, and to slowly build positions through dollar-cost averaging. If the 12 multiple holds, then that would set up a 20% return in 2010.

Don’t try to be a hero in your stock picks. In this environment, it is far better to be safe than sorry. Go for quality.

What do I mean by quality? First and foremost, look at the balance sheet. The less debt, particularly short-term debt, the better. If the company has a lot of cash on the balance sheet, that is a huge positive.

Next ask yourself, “Does this company make things people need, or just stuff people want?” If just a “want,” avoid it. Of course, what is a “need” and what is a “want” is a bit of a sliding scale. Things that people in the U.S. consider absolute “needs” might well be considered ridiculously silly “wants” to people living in the slums of Calcutta.

Still, people need food, and in this country, things like basic toiletries. They are still likely to need gasoline and heating oil and natural gas. They need electricity. They do not need to take vacations. They do not need jewelry. They do not need new clothes; stuff out of the closet will keep you nice and warm and allow for personal modesty.

The first sorts of companies you should be looking at are things like Electric Utilities (although they often have a bunch of debt, but mostly long-term). Two of those to consider would be Sempra Energy (SRE), which also has a nice natural gas pipeline operation and Allegheny Energy (AYE).

Some of the Consumer Non-Durable names, like Hershey Foods (HSY) are worth trying to build positions in. As far as gasoline is concerned, Exxon (XOM) is probably the first place to look, as it has a balance sheet like no other company in the world. It will be able to deploy its huge cash hoard and come out stronger on the other side of this.

Don’t overlook things like natural gas pipelines. Many of those are structured as limited partnerships, but don’t let that stop you (although it does stop some institutional investors). The pipeline companies are more influenced by the volume of natural gas consumed than by its price, and the volume tends to be pretty stable. These companies also have the advantage of paying big dividends. One such name to consider building a position in would be Energy Transfer Partners (ETP) which is yielding almost 10% now, and the payout is more likely to rise than fall over the next few years.

In short, don’t try to find the absolute bottom of the market, but slowly take advantage of the opportunities that are being offered in good, solid, conservative companies. The market will turn before the economy does, but that could still be a ways off. Dollar-cost averaging in over the course of the next 6 months is likely to prove to be a winning strategy for the long term.

Subscribe by RSS Subscribe by Email