Stocks Look Cheap Historically, But They May Get Cheaper

With stocks at new highs, are prices too high for the value-minded investor to pay? I say no — although if you are a value-minded trader, the answer may be yes.

The way I look at stock valuations is by comparing consensus forward earnings to current long-term interest rates. That tells me whether the earnings power of stocks can compete with the interest income you can earn by holding bonds.

Today the yield of 30-year Treasury bonds is 4.83%. If you think of the S&P 500 as a bond that pays out its earnings as a “yield,” then the stock market’s yield is 6.5%.

That puts stocks ahead of bonds by 1.67%. Historically, on average, stocks’ earnings only yield 0.2% more than bonds. That means that today stocks are a very, very big value.

My valuation model has been an excellent guide to both short-term and long-term market timing. My model correctly showed stocks being horribly overvalued just before the crash of 1987, and at the top of the bubble market in 2000. It correctly had stocks as a screaming buy at the double-bottom of October 2002 and March 2003.

Over the past 22 years (the period for which I have reliable data to compute my valuation model) the S&P 500 has gained, on average, 4.9% in three-month periods when stocks started out being undervalued. But the S&P 500 gained, on average, only 1.7% in three-month periods when stocks started out being overvalued.

For 12-month periods the story is the same. The S&P 500 gained 18% on average, when stocks were undervalued — but only 9.5% when they were overvalued.

It works. So how about now?

By my valuation model stocks today are extremely undervalued in a long-term historical context. So if you are taking the long view of value, this would be a terrific time to buy stocks.

On the other hand, by my model, stocks have been deeply undervalued for the last several years. It’s been a great period to own stocks, with returns well above the long-run average and risk well below the long-run average. But right now stocks are the least undervalued they’ve been all that time.

In fact, the only time they were less undervalued was last May, just before a sharp correction set in that had the S&P 500 falling 7% in just five weeks. So if you are taking the short view of value, it might not be a bad time to stand aside and expect a pullback in stocks.

But no market-timing technique is perfect. Any model can be fooled by unique circumstances. Let’s take a close look and see if my valuation measure is at risk here of being proven wrong for the first time ever.

First, in the short term, even if my model is perfectly correct in the long term, stocks can move in whatever way they choose. Just because my model says stocks are cheap, that doesn’t mean they can’t get cheaper. Potentially a lot cheaper.

That’s what happened last May. My model said stocks were cheap. Stocks then fell by 7% in just five weeks. So, they became a lot cheaper.

That’s why, for the short term, I’m actually betting against my own model. I know that stocks are cheap, taking the long view. But in the context of the last couple of years when stocks have been persistently cheap, I see them as relatively rich.

If I’m right, then we’re due for a pullback. But what if my model is right? If stocks were to immediately return to normal valuation levels from here, according to the model, the S&P 500 would rise 30%.

I’d hate to miss that, just because I was afraid of a pullback. But that’s the difference between short-term and long-term investing. If you are a long-term investor, then just own stocks as long as they are cheap, and don’t worry about the fluctuations from month to month.

If you are a short-term investor, then you have to play the short-term angles. Get out now, and wait for stocks to get even cheaper. Then pile in, like I did last June after the last correction.

Is there anything that could make the model just downright wrong? Sadly, yes.

If earnings collapse, then the “earnings yield” of stocks won’t look so good relative to the income yield of bonds. Earnings growth is slowing just a bit here, but I certainly don’t see a collapse coming. I think the economy is quite strong — much stronger than most people seem to think — and that means that earnings should continue to motor along nicely.

Another possibility is that long-term bond yields could rise. This would make the “earnings yield” of stocks look worse by comparison. As I’ve written many, many times in this column, I do indeed expect bond yields to rise, and potentially by quite a lot. So I do see my model as vulnerable on this point.

In fact, an extreme version of that concern would have me believe that stocks aren’t really undervalued at all. They are just discounting the very high probability that interest rates will be much higher in the future. What if that’s exactly what happens?

On the face of it, it means that stocks won’t collapse as they might ordinarily under a similar rise in interest rates. After all, they’ve already priced for it. So why should they go down when it happens?

Also, it will probably take quite some time for interest rates to rise all the way to levels that would really affect stock valuations. The long-term Treasury yield would have to rise 1.5% to fully erase the apparent undervaluation in stocks. And in the time it would take that to happen, earnings would continue to grow and would offset some of the loss of value.

The worst-case scenario: What happens if interest rates rise at the same time as earnings fall? Indeed, what happens if the rise in interest rates causes earnings to fall?

This could be exactly what happens later this year when the Fed starts raising short-term interest rates again. Long-term rates will rise, too, and if the Fed gets as aggressive as I’m afraid it might, economic growth — and earnings — could be damaged.

The bottom line is that valuation is telling lots of different stories right now. As a general matter, stocks are cheap by historic standards, so even if something goes wrong with the economy later this year, you’ll own them at good prices.

But don’t get complacent. Cheap or not, we could be in for a short-term correction. And if the Fed starts hiking rates again, all bets will be off.

The above is an “Ahead of the Curve” column first published on, where Luskin is a Contributing Editor.

Republicans: The Party of Big Government?

What should investors do about this month’s elections, in which control of Congress went to the Democratic party for the first time in a dozen years?

I suppose the first thing is to say “Thanks” to the guys who got booted from office on Tuesday. Be grateful — it’s been a nice run for investors since the Democrats lost control of Congress in 1994.

The compound annual total return for the S&P 500 over those 12 years was 11.3%, compared with an average of 10.3% over previous history. Inflation only eroded your winnings at an average annual rate of 2.6% during those 12 years, compared with 3.1% over previous history.

So “Thanks.” We investors got to make more money than usual, and what we made was safer from inflation.

But now voters have decided to give the other team a chance at bat. Seems odd, since today about 55% of voters are direct owners of stocks, either in brokerage accounts, IRAs or 401(k)s.

Perhaps this election wasn’t about the economy at all, but rather about the war in Iraq, or about corruption. Could be, but I see some patterns in the results that tell me that voters were very much thinking about economic issues.

And not in the way you might expect for an election in which Democrats seized power. Democratic politicians and pundits have made a lot of noise this year about “income inequality” and “stagnating wages” and “economic insecurity.” Their solutions are usually some form of government intervention, greater regulation, or a more extensive welfare state. But those aren’t the things that people voted for this week.

If voters wanted bigger and more intrusive government, more regulation, and more welfare, they should have voted for Republicans in a landslide. It was a Republican Congress that put the regulatory nightmare of Sarbanes-Oxley in place, that outlawed online wagering, and that created the catastrophically expensive Medicare prescription drug benefit. The Republican Congress also presided over a massive increase in overall government spending.

Voters may hate the war in Iraq. They may hate corruption. But I think they also hate the way the party that historically talks about smaller government and fiscal responsibility has gone on a regulating-and-spending binge.

According to a poll conducted by Basswood Research in 15 key battleground congressional districts, 39% of voters labeled the Republicans “The Party of Big Government” — only 28% gave that label to the Democrats. In those districts, Republican candidates got slaughtered on Tuesday.

But consider what happened in seven other districts, where the Club for Growth — a political organization dedicated to small government, lower spending, and lower taxes — financed the congressional campaigns of eight Republican newcomers dedicated to the Club’s ideals. Seven out of eight of them won on Tuesday — Iraq or no Iraq, corruption or no corruption.

A number of so-called “Blue Dog” Democrats were elected on Tuesday, too. Those are Democrats whose economic agenda is more like what the Republican one is supposed to be — smaller government, less spending, and more fiscal sanity.

Twelve states had ballot propositions that would limit state power to seize private property under “eminent domain.” Those propositions passed in 10 states, a clear message that voters want to contain the scope of government’s power to interfere in the economy.

Ballot propositions that would raise the minimum wage also passed in a number of states. There, at least, voters seemed to prefer more, not less, government interference. But that’s just a small extension of something already in place, which thankfully affects very few workers or businesses.

More symbolic of the voters’ mood, in my judgment, was what happened to a ballot proposition in my home state of California that would have slapped a tax on oil companies for every barrel of oil they produce. The money would be used to finance a massive state program to develop alternative-energy sources. Wisely, this massive usurpation of private enterprises was soundly defeated by voters.

Here’s how I read it. Voters prefer the kind of economics that Republicans used to stand for — but mostly don’t anymore. Republicans who still do got elected on Tuesday. Democrats who stand for that agenda got elected, too. Ballot propositions that adhered to those principles passed; those that didn’t, flopped.

So investors should be comforted that, even after a Democratic sweep, it just could be that both the Republicans and the Democrats have moved a little closer to economic principles that are good for growth — and good for investing.

The situation isn’t without risk, though. In my judgment, the Democratic congressional leadership doesn’t share the same pro-growth agenda as an increasing proportion of the rank-and-file. We’re going to hear a lot from them about more regulation, new government powers and new spending programs. None of it will probably go anywhere — but you never know.

With a little luck and a little wisdom, this could be a great time to be an investor.

Creating Unemployment

Her’s a fantastic idea that will make everybody richer. Let’s pass a law setting a minimum price on used cars. How about, say, $15,000?

If you’ve got an old beater you want to sell, and you were worried that you’d only get a couple thousand bucks for it, then this law is for you! Now you’ll get $15,000 for it!

This law would help the least fortunate Americans most of all. Those with the lowest incomes tend to own the oldest cars in the worst condition. With this law, they’ll be assured of getting a terrific price.

There’s just one problem. There are lots of used cars that no one wants to buy for $15,000. If you want to sell one of those, under this new law chances are that you wouldn’t be able to sell it at all. The $15,000 minimum prices you right out of the market.

And the poor people whom this law was supposed to help? They’d actually get hurt two ways by it. Not only would they not be able to sell their used cars, at the same time, they wouldn’t be able to buy a used car either — since now they’d have to pay $15,000 for it, which they can’t afford (and which it probably isn’t worth, anyway).

So who would support a law this stupid? Well, actually, you might — without even realizing it.

If you support minimum-wage laws, then you’re supporting the very same logic underlying this crazy idea of a minimum price for used cars. (Thanks to Don Boudreaux1, an economist at George Mason University, for the colorful metaphor.)

If a law forces employers to pay no less than, say, $10 an hour, then employers will simply not hire anyone for jobs that are really worth less than that. And they’ll fire anyone who was doing those jobs at a lower wage, before the law was passed.

Which leaves the low-wage earner with a rather stark choice: Would he rather be employed at $9 an hour, or unemployed at $10 an hour?

Don’t kid yourself that employers will just bite the bullet and pay up for jobs that aren’t worth the legal minimum. They won’t.

Consider what happened in France, where there is a minimum wage roughly twice that mandated in the United States. Go to a grocery store or a toy store there. There are hardly any clerks to help you. No baggers to pack up your stuff when you check out. Merchants simply can’t afford to pay the too-high minimum wage for this kind of work.

So two things happen. First, you waste your own valuable time having to find what you want without help and bagging your own orders. Second, low-skilled workers who would normally be clerking and bagging — if the high minimum wage hadn’t eliminated those jobs — are simply unemployed. The minimum wage in France may be double that of the U.S., but so is the French unemployment rate.

And that high unemployment rate is persistent, too. Without low-wage entry-level jobs, unskilled French workers — especially youths and minorities — have no way to acquire the skills necessary to work their way up to higher-paying jobs.

As a result, minimum-wage laws end up not just harming certain individuals, but setting back the growth rate of the entire economy. They distort the optimal use of skills in the economy — why should I have to do my own bagging? And they keep low-skilled entry-level workers permanently out of the work force. In the long run, where is the work force going to come from?

It’s easy to think sentimentally and sympathetically of the workers who get stuck in low-skill, minimum-wage jobs for a lifetime — and imagine that a minimum-wage law would help those people. But the reality is that, in the United States, there are very, very few workers earning the minimum wage. Most minimum wage jobs are held only for a short time, by teenagers and part-time workers, for whom such jobs are merely a temporary hardship on the way to something better.

The issue of minimum-wage laws is hot right now, because there’s an election coming up. There’s been lots of agitation in the U.S. Congress to raise the federal minimum wage, and several states will have their own minimum-wage laws on the ballot this November.

While individual members of both political parties have their own views on the minimum wage, traditionally it’s been a Democratic issue, probably because, historically, the Democratic party has drawn support from labor unions. According to the New York Times, the Democrats are trying to get minimum-wage laws on as many state ballots as possible this November, in order to attract voters to the polls. It’s the same strategy the Republicans used in the last election, with state ballot initiatives to ban same-sex marriage.

So most of what you’ll hear about the minimum wage over the next couple months is going to be pure politics — from both sides. Try to listen skeptically.

For me, I know from my own career experience that, sometimes, it can be a very good thing to work for nothing. And nothing is as about as far below the minimum wage as you can get.

When I first started as a trader 25 years ago, my only income was my trading profits. I did well from the start, but I started small. So for quite a while my expenses ate up all my profits — and there was nothing left over for me at all.

But those early years were years of learning. Living in poverty was my “tuition” — a price I had to pay when I was young to develop the skills that started me on what turned into a high-income career in trading and investment management.

I hate to think where I’d be today if there had been a law that made it illegal for me to start my own trading operation 25 years ago, just because I couldn’t pay myself a minimum wage at first.

Fortunately, the magnitude of minimum wages being mandated by most of the initiatives on ballots this November is modest. Nobody’s talking about taking us up to levels like the ones in France.

But as an investor, stay on high alert. In politics, the road to hell is paved with good intentions — and the longest journey down that road begins with a single bad law. Remember, the S&P 500 lost 25% of its value in early 2002 while Congress was creating the well-intentioned economic disaster known as Sarbanes-Oxley.

The above is an “Ahead of the Curve” column published July 14, 2006 on, where Luskin is a Contributing Editor.

Hands Off My Net

The S&P 500 has more than doubled over the last 10 years — a decade in which the Internet came out of nowhere, and established itself as the technology platform of the new global economy. The Internet has been the greatest engine of economic growth the world has ever seen.

Now, for the first time, the continued expansion of the Internet is at risk. We’re about to kill the goose that lays the golden global eggs.

How? By regulating it.

Ever since the Department of Defense turned over the Internet for public use, it’s been a free-for-all. The result has been innovation on unprecedented scale and at unprecedented speed. But now there’s a move among a coterie of powerful business interests, lobbyists and politicians to change all that — to shut down the free-for-all, and turn the Internet into a government-controlled mediocrity.

The stakes here are more than just your continued ability to enjoy simple innovations on the Internet, like being able to read this column online, and to instantly give me your feedback via email.

Do you shop at Wal-Mart Stores? Do you like the low prices? You can thank the Internet for that, even if you only shop in Wal-Mart’s physical stores, not on their e-commerce site.

The Internet is the secret of Wal-Mart’s success because it has enabled the dizzyingly complex web of global communications and coordination that has made it possible to bring together the ideas, the materials, the factories, the labor and the logistics that put inexpensive goods on the shelves of Wal-Mart stores in towns all over America.

Who can imagine what miracles the next 10 years of the Internet will bring? But now it’s all being put at risk.

The crisis has been triggered by the prospect of telephone and cable operators investing tens of billions of dollars to build the Internet of the future. With the technology they’re talking about investing in, the Internet will be able to bring high-definition images and sounds into your home, on demand. Not just movies and TV shows whenever you want them, but also “virtual meetings” with dazzlingly real telepresence that will replace the common phone call — and may end up replacing in-person meetings, too.

And who knows what other amazing innovations will come from that kind of capability? That’s why they’re called “innovations.” If I could tell you what they’ll be, they wouldn’t be innovations, now would they?

But whatever might possibly come from this new technology in the future, nothing will actually happen if the telephone and cable operators won’t put billions of dollars at risk here and now to get it done. And companies like Verizon or Comcast aren’t going to do that unless they think they can make a well-earned profit from it.

One way they can earn a profit is by charging different Internet users different fees depending on the kind of service they get. For example, if all you want to do is get stock quotes, you’d be charged a low rate for using the network. But if you want to watch “The Da Vinci Code” in breathtaking high-def video and bone-rattling surround sound at exactly 12:42 a.m., you may have to pay a higher rate.

And why not? You use a lot more network resources with high-bandwidth applications like video-on-demand. And not just because there’s inherently more data to be transmitted over a longer period than for a couple of stock quotes. It’s also because, for a high-def movie, you want perfect quality and no interruptions, so your network traffic may have to be put into a special “fast lane” of the information superhighway.

The same thing happens right now. You pay more for DSL service than you do for dial-up service. And your network controls other elements of your usage, too. For example, your DSL service probably gives you a fast downlink speed and a slower uplink speed, because you probably receive more information from the Internet than you contribute.

Yet a group of today’s biggest providers of online content have banded together with consumer groups, lobbyists, and political-influence organizations to strip the telcos and cable operators of the ability to control how their own networks will be managed and priced. They want the network operators to spend billions to create a regulated public utility that they can’t control and may not profit from.

The interests pushing for this regulation have given it the Orwellian name “net neutrality.” They say that if the telcos and cable operators control their own next-generation networks, they’ll “discriminate” against certain users of the network. They say that the network operators need to make their next-generation network available to everyone on the same basis and at the same price, no matter how the network is to be used.

But “discriminate” is just the lobbyists’ word for “compete.” If you are Microsoft , eBay or Google — three of the dominant web-content companies pushing for this regulation — you’re afraid of competition from Verizon and Comcast. With ultra-powerful next-generation networks, the network operators may go from passive providers of “data pipes” to active providers of online content and services.

And just what would be wrong with that?

Nothing, if you ask me. I like competition. I like the idea of being able to get something from Verizon that Microsoft wants me only to get from Microsoft.

And I like the idea of a next-generation Internet, and all the innovation it will trigger. But I know that if the “net neutrality” regulations are enacted, that next-generation Internet will probably never exist.

That’s why, with all the big content companies lined up on the side of regulation, the hardware companies are lined up against it. For example, Cisco Systems — which hopes its routers will be a big part of any next-generation Internet build-out — is publicly opposed to “net neutrality.”

Maybe the fight over “net neutrality” is one of the reasons why stocks have fallen over the last month, with the NASDAQ leading the way down. The growth of the Internet is the best hope for continued growth of the global economy. Regulate away the growing Internet, and you regulate away the growing global economy.

It’s just that simple.

The above is an “Ahead of the Curve” column published June 9, 2006 on, where Luskin is a Contributing Editor.

Maryland Wallops Wal-Mart

If you own stock in Wal-Mart Stores, be afraid — be very afraid. Yes, it wasn’t all that long ago that I was recommending buying shares of the giant retailer. But things have changed.

Right after I recommended Wal-Mart last October it rallied by as much as 15%. But now it’s given most of that back, even as the Dow Jones Industrial Average — of which Wal-Mart is a part — has climbed to within shooting distance of all-time highs. And it’s not because the Christmas selling season turned out to be good rather than great. It’s because of politics.

On Thursday, the Maryland legislature decided to play Robin Hood with shareholders’ money. After they targeted Wal-Mart for a massive new tax, the stock’s market value dropped by $1.5 billion in a span of 90 minutes. But our wannabe Robin Hoods blew it. That money robbed from the rich isn’t going to the poor.

Here’s what happened Thursday. The Maryland General Assembly voted to tax Wal-Mart by the amount which the company’s expenditures on employee health care falls below 8% of payroll costs. That’s about twice as much as Wal-Mart now spends on health benefits for its 15,000 Maryland workers, so the tax is going to be hefty, indeed.

Similar taxes are now being contemplated by the legislatures of 30 other states. This could get very, very ugly for Wal-Mart.

You’re probably wondering how a state could single out just one company for such a tax. Indeed, Article I, Section 9 of the US Constitution forbids “bills of attainder” — laws aimed at single individuals. But Maryland has a trick to get around that. The tax is on any firm that has more than 10,000 employees. It’s just sheer coincidence, you see, that Wal-Mart is the only company in Maryland with more employees that doesn’t already spend 8% on employee health care.

The idea is to force Wal-Mart to spend more on health benefits. But until and unless it does, the tax dollars will go to the government of Maryland, not Wal-Mart’s workers. And even if Wal-Mart ends up doubling its health expenditures, chances are that will just end up causing Wal-Mart to pay lower wages in the future than it would have otherwise.

Think about it. A company pays its employees a compensation package that consists of cash plus benefits, and in total is an amount that’s fair for the work that’s being done. If a law comes along that forces the company to pay out more for benefits, that doesn’t change the total value of the package if wages subsequently go down.

Wait, haven’t I contradicted myself? If total compensation isn’t going to change, then how is Wal-Mart going to get hurt by this new tax? How would the company be hurt even if 30 more states adopted it?

The answer to that is simple — and sad. Wal-Mart would be hurt because its employees would be hurt. Right now 1.3 million Americans have chosen voluntarily to work for Wal-Mart because, overall, they like the package of wages and benefits that they get. If laws are passed that force Wal-Mart to offer benefits instead of cash, it will be harder for Wal-Mart to attract and retain workers.

For example, consider the fact that Wal-Mart employs a disproportionate number of older Americans — people in retirement from their lifetime work, looking to pick up a little extra money or just something to do. Those people are already on Medicare, so why should they give up a penny of wages for Wal-Mart health benefits that they don’t even need?

If Wal-Mart finds it more difficult to attract and retain workers, then it could always simply pay more. But that’s easier said than done. Wal-Mart is a low-margin player in a ruthlessly competitive field. As things stand now, the company only earns profits of about $6,000 per employee (which means, by the way, that employees make much more money on Wal-Mart than Wal-Mart makes on Wal-Mart). If wage costs go up even a little bit, margins that are razor thin already start to vanish altogether.

If that happens, then Wal-Mart stops growing. Instead of adding more than 100,000 new jobs every year as it currently does, it will someday add none. Those lucky enough to get a job at Wal-Mart will make a few extra bucks. But the company that now does more than just about any other to provide entry-level jobs for young, unskilled Americans getting started in their working lives will become a closed door.

The other reason why Maryland’s tax is so dangerous for Wal-Mart is that it’s not really about health benefits at all; rather, it’s about unions. Wal-Mart has successfully resisted unionization, and it’s been able to do so by keeping its nonunion employees so happy that they don’t feel the need for collective bargaining. So the unions are doing everything they can to make things hot for Wal-Mart, including lobbying state legislators to punish the company with new taxes under the guise of improving employee health care.

The ultimate downside for Wal-Mart isn’t just a new tax — it’s the potential unionization of its workers. Set aside whatever noble principles you may have about the virtues of unions. The reality is that Wal-Mart has become the colossus that it is because of its genius for streamlining and efficiency, computerizing and modernizing every single element of the “value chain” that comprises today’s retailing. The inflexibility of union labor is, simply, anathema to Wal-Mart’s whole business model, and would in the end destroy it.

So here we are, seriously talking about threats that could destroy America’s largest employer, and decimate billions of dollars of shareholder wealth. And the ultimate irony is that theses risks are all being set in motion under the banner of improving health benefits that are already excellent.

Yes, it’s true: Wal-Mart already pays about as much, per worker, for health benefits as the average retail company. And more than 80% of Wal-Mart’s employees are eligible for those benefits, compared to about 60% for the average retailer.

Do you really think American innovation has improved since federal and state governments went after Microsoft on antitrust grounds? If you ask me, the technology economy was a heck of a lot more vibrant back in 1999 when Microsoft was still, supposedly, a monopoly. Its stock price sure was.

This is no different. The retail economy won’t be any better when government is done destroying Wal-Mart. Shareholders better watch out!

The above is an “Ahead of the Curve” column published January 13, 2006 on, where Luskin is a Contributing Editor.