Currently stocks on the New York Stock Exchange are selling collectively at a price-to-earnings ratio of 16.0. Or if you invert that ratio, you have a rate of return on stocks of 6.25 percent. By recent historical standards, this return in quite high. Given rates of return on “risk free” U.S. Treasuries of 3.1 percent (3 month T-bill), the premium paid to stockholders appears to be strong indeed.
So why are investors giving the stock market the cold shoulder? In my judgment, three factors are preventing stocks from rising to a more attractive price-earnings ratio. First, investors are clearly incorporating into their decision making significant Fed interest rate hikes in the months ahead. The funds rate is now 3.25 percent, up by 2.0 percent from June of 2004. Second, oil prices above $60 per barrel have spooked investors. Finally, the ever-present threat of terrorism inside and outside the U.S. has pushed investors away from equities and into what is viewed as “safer” options.
I think investors are missing a tremendous opportunity. I expect the Fed to halt rate hikes after their August 9th meeting. Outside of energy prices, there is scant evidence of significant inflationary pressures. Furthermore, slowing global economic growth will force oil prices to retreat below $50 per barrel by mid-September of 2005 just as it reduces inflationary pressures. Finally, the latest terrorists’ attacks in London demonstrate the impotence of the assaults on equity markets.
My advice---buy solid stocks now and hold until the market recognizes your astute action.