Introduction: Pessimism Is For Losers

I'm inspired to write this article because I am so frustrated by the plethora of all the so-called expert market prognosticators that continuously bombard the public with negative forecasts. I consider this to be both erroneous and irrational. When the markets are doing well, we are immediately inundated with articles talking about how the market has surely topped and a big drop is imminent. When markets are doing poorly, we are flooded with numerous forecasts of just how bad it's going to be. The real truth of the matter is that nobody really knows. Not the Federal Reserve, nor any of the so-called experts who are more than willing to provide us with their forecasts of doom and gloom. Pessimism is pervasive, but optimism is, in fact, more accurate and rational in my opinion.

The best investing minds that I've come across, which are also the ones with the best long-term track records, universally agree that timing markets, or forecasting the economy or interest rates, etc., are exercises in futility. The great investor Bernard Baruch put it quite succinctly when he said:

"Don't try to buy at the bottom and sell at the top. It can't be done except by liars." Bernard Baruch

Or you could look to the sage advice from Peter Lynch that he offered in Chapter 2 of Beating The Street his best-selling book, which I highly recommend to anyone with money invested. Chapter 2 is titled: The Weekend Worrier. In this chapter Peter talks about the same issues that I'm complaining about in this article. The Weekend Worrier, as Peter calls them, always have many draconian reasons why they believe it's not a good time to invest in stocks or why the economy is bad and getting worse. But Peter makes a very strong point with the first two sentences of Chapter 2:

"The key to making money in stocks is not to get scared out of them. This cannot be over emphasized."

And later in the book Peter provides us with Peter Principle number 19 where he says:

"unless you are a short seller or a poet looking for a wealthy spouse, it never pays to be pessimistic."

And finally, I would like to share two of his 25 Golden Rules of Investing (he actually gives us 26), numbers 18 and 19:

"Golden rule number 18- there is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company's fundamentals deteriorate, not because the sky is falling."

or

"Golden rule number 19-nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what's actually happening to the companies in which you've invested."

My goal with this introduction was to establish a foundation that supports optimism over pessimism. Secondarily, my objective was to point out that forecasting the economy, markets, interest rates or any other macro event is both impossible and an exercise in futility. However, it never ceases to amaze me how so many people continue to incessantly promogulate headline after headline and article after article positing their negative forecasts about the economy, the stock market, interest rates, etc. No matter how often they are proven wrong, and they usually are, they remain a persistent and shameless group.

Recently there has been a spate of articles debating whether or not stocks are cheap relative to things like interest rates or forward PE ratios. These articles really get my blood boiling because they tend to be full of forecasts about the very things which I have suggested cannot be forecast. Therefore, I find that their cases are full of opinion, but usually very light on facts. But perhaps most of all, they state their cases with an arrogance and conviction that I find too incredulous to tolerate. Therefore, my goal is to counter these articles based more on fact than opinion,and most importantly of all, on real numbers rather than statistical inferences.

Stocks Are Cheap Relative to Earnings (Past Present and Future)

Before I go on, I want to be clear, and consistent with what I've already written, by stating that I do not believe in predicting economies or stock markets in general. Instead, I believe in analyzing and investing in specific (individual) well-run companies at sensible or attractive valuations. However, if I feel compelled to talk about the markets in general, it is usually because I was incited by the types of articles I've been referring to throughout this piece. Moreover, I try to focus on the actual facts as they currently exist. Consequently, if there is any forecasting involved, it needs to be based on a short time period and upon a reasonable range of probabilities given what we do already know.

The following F.A.S.T. Graphs™ reviews the S&P 500 Index since the beginning of calendar year 1994. The orange line on this graph plots earnings-per-share at a PE ratio (earnings multiple) of 15. To be clear, as you look at this graph recognize that if the stock price (black line) is above the orange line, then the PE ratio is over 15, if the stock price is below the orange line, then the PE is less than 15, and of course if the price is touching the orange line, then the PE ratio of the S&P 500 is precisely 15. The same can be said about the historically normal price earnings ratio (blue line), however, this line is a calculated PE ratio of 19.3.

With the exception of the last earnings plot, the orange line is based on actual reported earnings (what we do already know) , and therefore, is a factual portrayal of how "Mr. Market" has been valuing the S&P 500 Index since 1994. To repeat, when the price is above the orange line the S&P 500 is overvalued, when the price is touching the orange line the S&P 500 is fairly valued, and when the price (black line) is below the orange line, as it is now, the S&P 500 is undervalued. Statistically speaking, which is a language I hate to speak in, a PE ratio of 15 is the long-term historical average PE ratio for the S&P 500. Once again, statistically speaking, a PE ratio of 20 is the historical norm over the past 20 years (note that the blue line on the graph is drawn using a calculated PE of 19.3 over the past 19 years, which is obviously very close to the 20-year average of 20).

However, even though these ratios are statistically (mathematically) portrayed, a closer scrutiny of the graph can show how statistics can be misleading. Instead of relying on a mere numerical statistical calculation, the reviewer can clearly see how the market has actually valued the S&P 500 since 1994. More importantly, by carefully studying the graph we can see a vivid and clear picture of when the S&P 500 was overvalued, fairly valued or undervalued. Therefore, based on actual 2011 earnings and Standard & Poor's Corp.'s own forecast for 2012 earnings, we see a clear depiction of the S&P 500's current valuation. Since the price is below the orange line, it is clear that current PE ratio of 13.9 on the S&P 500 indicates modest undervaluation at this time. I believe this is fact not fantasy, certainly the historical part is.

With this next graph, I plot the yield of the 10-year Treasury note (the burgundy shaded area) with the actual S&P 500 PE ratios since 1994 (dark blue line). There are two very interesting phenomenon that this graphic reveals, one I would consider normal, and the other aberrant. The normal phenomenon runs from approximately 1994 to 2002. Here we find an expected correlation between interest rates and stock values. As interest rates are falling (the yellow arrow) we see a logical increase in the PE ratio of the S&P 500 (blue line). This is logical, because as interest rates on Treasury Notes move lower, they simultaneously become less competitive with stock returns, and therefore, stock valuations increase as demand for stocks logically increases.

However, from 2002 to current time we see a conflicting relationship between interest rates and stock prices. In this case, as interest rates continued to decline, stock valuations (PE's) followed suit and declined as well. In theory, this should not happen. Because with interest rates so low, as a practical matter bonds become less competitive to stocks, but even worse, today bonds don't even offer any real return. This is especially true when you compare blue-chip dividend yields available from stalwarts such as PepsiCo (PEP), Proctor & Gamble (PG), and Johnson & Johnson (JNJ), etc., to interest rates. For the first time since I can remember, these companies are offering higher dividend yields than not only the 10-year Treasury but the 30-year as well.

Therefore, interest rates are clearly very low, which is another way of saying bond prices are excessively high. Conversely, dividend yields are significantly higher than normal, which is a straightforward and simple indicator that blue-chip dividend paying stocks at least, are currently inexpensive. Typically, bonds are attractive because and when they provide a significantly higher yield, but no growth, as compared to a stock. Therefore, when you can buy stocks with higher yields than bonds, it should be clear to anyone with any common sense that stocks are cheap and bonds are expensive.

Many authors of financial articles, and other pundits are very fond of reporting all types of statistical, what I like to call innuendo, that doesn't hold up under real world scrutiny. So maybe it's not true that statistics don't lie, and thus maybe both statistics and statisticians are darn liars. Perhaps unintentionally, but when examined against the truth, their hypotheses are more often than not proven false. Nevertheless, thre is a large cadre of people that are willing to bet their portfolios, and consequently their financial futures on what these authors present and promote.

The following graphic shows the actual historical record of 10-year Treasury Bond yields since 1890. Therefore, I let the reader decide for themselves whether or not interest rates are currently at aberrantly low levels or not.

Specifically, Some Stocks are Cheap and Some Are Very Expensive

As I've stated more than once for this article, I believe in dealing with specifics rather than generalities. Therefore, I offer two specific examples of well-known companies where one is cheap, while the other is expensive. The following are two examples of individual companies that are being priced by the exact same stock market. I ask that the reader please recognize that I am not writing about either of these specific examples. Instead, I am simply using them to illustrate that general statements about stocks can be very misleading.

Oracle Corp. (ORCL)

The orange line on the following historical earnings and price correlated graph of Oracle Corp. (ORCL) shows that this consistent and fast growing technology company is clearly trading below its intrinsic value (the orange line). Even though this company has grown earnings almost 3 times faster than the S&P 500, it can currently be purchased at a PE ratio of 12.2 which is less than you can buy the average company for. In other words, whether or not the stock market in general is cheap, I for one will certainly argue that Oracle definitely is.

Brown - Forman (BF.B)

In contrast to Oracle Corp., we discover that Brown-Forman with a significantly lower earnings growth rate is currently trading at one of its highest valuations ever. When you consider that this company trades at a PE ratio of 23.3 versus the S&P 500 at a PE ratio of 13.7 or against Oracle with a PE ratio of only 12.1, we can see a wide variation in stock valuations of individual stocks as compared to the S&P 500 index.

The major point that I am attempting to make with the above portion of this article is that I believe focusing on generalities like the S&P 500's valuation is less relevant ( and even misleading) than looking at individual companies instead. In other words, unless you are investing in the index, I believe it always makes more sense to focus on what you actually own and their relative valuations.

Optimism The More Rational Perspective

Based on extensive research that I have conducted, and research that I am continuing to carry out, I believe the case for optimism regarding the future of the economies of our country, and even the world, is more persuasive than a negative view. Nevertheless, there continues to be a pervasive and prolific amount of negative press and articles suggesting that our economy is going to hell in a hand basket. And even worse, is the arrogant and even sanctimonious conviction where many writers present their opinion as fact. In other words, I can tolerate someone expressing their opinion, but I cannot tolerate expressing something you cannot possibly know as fact.

For example, I will paraphrase a comment that I recently read that illustrates my point. An author wrote an article expressing his view that economic growth in the future will be below trend and he followed this statement with the following words in parenthesis (which it almost certainly will be) followed by words to the effect that earnings growth will almost certainly be below trend. An underlying theme of this article is that neither he, nor I, nor anyone else can say with certainty what our future economic growth will be. The best that we can expect to do is to assess the facts and assign the most reasonable range of probabilities we can logically estimate. When I do this, I see a preponderance of evidence suggesting that our future sits on the threshold of the greatest growth ever witnessed in the history of humanity.

Most importantly, I base my optimistic view on looking to the future. By doing this, the evidence becomes very clear, technological advancements are improving our lives and economic opportunities at a mind-numbing and accelerating rate. However, far too many of us remain traumatized, and therefore, negative. Although the vast majority of us have a mountain of positive aspects in our lives and economic well-being to focus on, and perhaps only a thimble full of negative aspects, we tend to obsess with the negative while ignoring the positive. This may be the greatest risk of all that we face.

In the current New York Times best-selling book, Abundance the Future is Better Than You Think the authors Peter H. Diamandis and Steven Kotler put it in these words as they close Chapter 2 of their book:

"but first it's helpful to understand a little more about the roots of this cynicism, and why it's this reaction--- the inability of people to see the positive trends through the sea of bad news--- that may be the biggest stumbling block on the road toward abundance."

In other words, the above authors, like me, believe that perhaps the biggest risk we face is our attitude about the future. However, even our attitudes cannot stop the unbelievable potential in front of us. Unfortunately, most economic theory is based on what many call the scarcity principle. Under this theory, people constantly worry about dividing our economic pie into enough slices for everyone. However, what we are ignoring is that for the first time in history we will very soon no longer need to figure out how to divide our current pie, but instead we are learning how to bake an almost infinite number of more pies. Once we accomplish this, then abundance for all is certainly within our grasp.

Summary and Conclusion

I fully acknowledge that there are numerous economic challenges and problems facing us. And furthermore, I acknowledge that some of these problems are significant enough to frighten or even overwhelm us. However, I also believe that we should never underestimate the indomitable human spirit and its enthusiasm, willingness and capability of solving even our most serious problems.

In the book Abundance referenced above, the authors discuss current and future advancements that portend to solve most of the challenges facing the world. These would include energy, education, healthcare, water scarcity and much more. The solutions they are writing about are available today or will be available within the next decade or two. In other words, most of what they are talking about already is available or will be in the very near future.

As I come to the end of this article I would like to share two of my all-time favorite quotes, one by American anthropologist Margaret Mead and the other from the 1997 Apple Computer advertising campaign Think Different, that were also included in the book Abundance:

"Never doubt that a small group of thoughtful, committed citizens can change the world. Indeed, it is the only thing that ever has."Margaret Mead

And from Apple's Think Different advertising campaign:

"Think Different-here's to the crazy ones, the misfits, the rebels, the troublemakers, the round pegs in square holes... the ones who see things differently--- they're not fond of rules... you can quote them, disagree with them, glorify or vilify them, but the only thing you can't do is ignore them because they change things... they push the human race forward, and while some may see them as the crazy ones, we see genius, because the ones who are crazy enough to think that they can change the world are the ones who do."

With my final remarks on my belief in the validity of optimism, I would like to reference another book that I believe is a must read written by Matt Ridley appropriately titled The Rational Optimist as follows:

"it will be hard to snuff out the flame of innovation, because it is such an evolutionary, bottom-up phenomenon in such a networked world. So long as human exchange and specialization are allowed to thrive somewhere, then culture evolves whether leaders help it or hinder it, and the result is that prosperity spreads, technology progresses, poverty declines, disease retreats, fecundity falls, happiness increases, violence atrophies, freedom grows, knowledge flourishes, the environment improves, and wilderness expands."

The bottom line point of this article is that the only way that it could be argued that stocks are not historically cheap today is to believe the pessimists who say that our future economy and corporate earnings are going to be weak. However, if you take an optimistic approach, as I do, then the only rational conclusion that can be made is that stocks are cheap today.

Disclosure: Long PEP, PG, JNJ and ORCL at the time of writing.