With the Dow Industrial Average and S&P 500 currently near all-time highs, prudent investors should be stepping back to reassess the strength of their portfolios in the event of a major downturn. As we all know, the stock market simply can’t grow in a straight line without dips, plunges and recessions to shake out weak hands and fulfill growth cycles. In this article, I’ll discuss two major factors for investors to keep an eye on, as well as three stocks that emerged from the last recession far stronger than before.
Taking Mr. Market’s temperature
But how do we know if the stock market is overheating? Should we listen to Jim Cramer, who claims that “there’s always a bull market somewhere” despite macro conditions? Or should we follow the bleak, bearish musings of Nouriel Roubini, whose face always pops up on finance sites on days the major indices start to slide?
My advice is simple: follow neither. There are only two major factors you need to consider when evaluating the long-term strength of your portfolio: the P/E ratios of market indices, and the simple theory of “eggs and tennis balls.”
The Shiller P/E Ratio
Investors should already be familiar with the P/E (price to earnings) ratio. Generally, when a P/E ratio is low, a stock is considered undervalued, while a higher P/E indicates that investors are willing to pay a premium price in anticipation of higher earnings down the road. If a stock with a high P/E ratio misses earnings expectations, then it tends to slide more than one with a lower P/E ratio, simply due to built-up expectations.
This same metric also applies to major indices, such as the S&P 500. However, for the S&P 500, we can’t simply use a regular trailing 12-month P/E ratio as we would use for individual stocks.
If we did that, the P/E would become artificially low due to higher earnings over the past year, while depressed top and bottom line growth during a recession would cause the 12-month P/E ratio to become higher – thus rendering the metric useless.
To rectify this problem, economists generally rely on a modified P/E ratio called the Shiller P/E ratio, named after its creator, Professor Robert Shiller. Shiller’s P/E ratio calculates the P/E ratio by using earnings of the S&P 500 companies over the past decade, rather than a single year, while adjusting for inflation.
Source: www.multpl.com, author’s modifications
Looking back over historical data, we can see a pattern emerging – the Shiller P/E always rises to an unsustainable point, which Shiller calls “irrational exuberance,” and then collapses catastrophically. Therefore, as of March 12, the Shiller P/E ratio for the S&P 500 rests at 23.40 – which means that the stock market is getting slightly overvalued.
Tennis balls and eggs
Although there may still be room to grow, we need to make sure our portfolio is loaded up with tennis balls and not eggs – in other words, stocks that bounce back after hitting bottom, that don’t crack and splatter all over the floor.
So how do we distinguish the tennis balls from the eggs?
Personally, I prefer big blue chips that have global brand recognition and deep pockets, which are best equipped to bounce back after a recession.
Let’s take a look at three stocks that I think are well equipped to handle a stock market crash when it hits, which are also three of the most recognized names in America.
The Coca-Cola Company (NYSE:KO) Company
Investors sometimes call The Coca-Cola Company (NYSE:KO) the “Bank of Coca-Cola,” and for good reason. Its brand is globally known, it pays a decent dividend of 2.87%, and demand is constant despite a market full of imitators.
The Coca-Cola Company (NYSE:KO) is the best-selling soft drink in the world, and Diet Coke is ranked second. That leaves its primary rival Pepsi in a humbling third place – a situation that’s unlikely to change anytime soon. The Coca-Cola Company (NYSE:KO) is experiencing strong growth in both domestic and overseas markets, with strong demand in China and Latin America driving its international growth.
Although things got a bit scary for long-term shareholders during the nadir of the crisis in 2009, investors who didn’t panic and simply waited a year saw all their losses erased, while those who held on longer reaped some nice returns in 2011 and 2012.
The Walt Disney Company (NYSE:DIS)
The Walt Disney Company (NYSE:DIS) is the largest media and entertainment conglomerate in the world. The “House of the Mouse” generates roughly half of its revenue from its cable networks – primarily ESPN – and another third from its world renowned theme parks. The company also owns Pixar Animation Studios Inc., Marvel and Lucasfilm Ltd., making it an 800-pound gorilla when it comes to making big Hollywood blockbusters.
My reasoning behind investing in Disney is simple – although its revenue and earnings growth are cyclical, as seen in the chart below, its diverse portfolio allows it to weather downturns by allowing stronger sales from more robust segments (TV networks) to offset losses from unpredictable ones (movies). When the macro situation improves, the company can take higher risks, which can generate higher rewards.
Just like Coca-Cola, Disney bounced back from the recession and rocketed to fresh highs. Disney also pays a moderate dividend to patient investors, with a 1.32% yield.
McDonald’s Corporation (NYSE:MCD)
Fast food giant McDonald’s Corporation (NYSE:MCD) is the most recognized restaurant in the world. Although the company has been weighed down by problems in Europe, which accounts for approximately 40% of its revenue, it has survived the downturn while continuing to post positive top and bottom line growth.
McDonald’s same-store sales have been far less impressive than its industry peers, declining 1.5% in February, with a 0.5% slide in Europe.
However, my reasoning for investing in McDonald’s is simple – if the company can withstand a crisis the magnitude of the Euro crisis hitting its largest market, then think of what it can do when Europe recovers. Its 3.13% dividend yield is also higher than either The Coca-Cola Company (NYSE:KO) or Disney’s.
The Foolish Bottom Line
Investors should always be aware of one thing – the stock market is a cycle, full of peaks and troughs that often result in premature selling and buying that results in frustration and steep losses. Keeping an eye on the Shiller P/E ratio and insuring that your portfolio is loaded up with tennis balls, rather than fragile eggs, is simply the responsible thing to do to protect yourself in the event of a sudden downturn.
The article 3 Stocks to Buy in Times of ‘Irrational Exuberance’ originally appeared on Fool.com and is written by Leo Sun
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