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  • Many individual stocks are no longer expensive.
  • The S&P 500's returns are historically tepid following periods when its forward P/E has exceeded 22x, such as in 2021.
  • Inflation and higher rates suggest investors buy value stocks.

At the invitation of Real Money Pro’s Doug Kass, Billionaire hedge fund investor Leon Cooperman recently offered up his market thoughts. The wide-ranging presentation is posted for Action Alerts PLUS members here. It’s highly entertaining and well worth watching.

The TL;DR? Cooperman thinks stocks are the best house in a bad neighborhood.

Stock pickers will win

Cooperman’s track record is impressive. His career began in 1967 at Goldman Sachs. Later, he founded the highly-successful hedge fund Omega Advisors. His many decades of experience means he’s seen a thing or two, including more than one “lost decade” of market returns. That experience informs his thinking.

While stocks aren’t necessarily bargains, Cooperman doesn’t believe they’re overly expensive. He’s about 85% net long, less than four years ago, but higher than others who are more pessimistic. His long exposure isn’t because he’s overly optimistic about the market, though. It’s because his team has found a lot of individual stocks worth owning.

In explaining his views, he compared the current environment to frothy periods in the 1970s and 2000. In the 1970s, 50 stocks were in vogue (the nifty 50). As investors piled into them, many reached sky-high P/E ratios. For example, Cooperman highlighted 12 of the best-known companies, and their P/Es ranged between 25 and 65. In 2000, P/Es were similarly high for top stocks, with Intel  (INTC) , Apple  (AAPL) , and Microsoft  (MSFT)  boasting P/Es of 54, 25, and 39.

Those sky-high valuations compare better to 2021 than today. For example, Cooperman mentions Alphabet  (GOOGL)  as a top stock with a fortress balance sheet. Its P/E is in the teens, which is hardly frothy. Overall, Cooperman believes unprofitable stocks are still too expensive, but profitable companies aren’t too pricey.

He’s less sanguine on the S&P 500. Cooperman thinks the S&P 500’s target P/E should be 17. So, on earnings of $220, the S&P 500 target is 3,740. If a recession occurs, he thinks 18 times $180 in earnings is appropriate, or 3,240. The S&P 500 is currently 3,919, so that’s not overly encouraging.

The big takeaway is Cooperman thinks stock pickers will do better than the market. He worries that similar to the post-2000 market, there will be rallies and sell-offs along the way, but S&P 500’s peak above 4,800 in 2021 could be its high for years.

The following chart, showing returns for the S&P 500 following various forward P/E levels, suggests there's good reason for tempered enthusiasm. The S&P 500's forward P/E ratio was above 22 in 2021, and 1-year, 3-year, and 5-year returns are lackluster relative to historical norms following a forward P/E above 22. 

TABLE-Street-Smarts-012023

The Smart Play

Cooperman wouldn’t be surprised if S&P 500 returns are “negligible” over the next five years, but he thinks there are individual stocks worth buying. What could change his view? An S&P 500 close above 4,400 (he rates the likelihood of that at 5%) or a surprise Federal Reserve rate hike (he believes that’s unlikely this year) could prompt him to adjust his calculus.

For now, he’s tilted toward stocks with low P/E ratios, believing those will perform best during a higher interest rate environment. When Treasury yields offer a compelling alternative to stocks, such as now, investors prefer companies that put money in their pockets sooner rather than later. For this reason, his holdings are concentrated in companies that pay dividends, repurchase stock, or do both.

Over 20% of his assets are in energy stocks, a position he built two years ago when they were essentially out of favor. He’s become a bit more concerned about those positions now that everyone is talking bullishly about them in the media. However, he still thinks energy stocks will benefit from tight supply and, historically, higher prices, given China’s reopening and the need to replenish U.S. strategic petroleum reserves released in 2022.

My take? Business cycle research from Fidelity suggests energy stocks perform best in the late stage when inflation is highest. It’s a mixed bag in the recessionary stage and trails in the early stage when bulls are back in charge.

business cycle.jfif

Producers in low-cost formations, such as the Permian shale players, can make money selling crude above the mid-$30s per barrel. So, given tougher year-over-year comparisons, I suspect we’ll see production spending grow to maintain growth rates, favoring energy service stocks. 

As a result, I’m more excited about their growth prospects than I am producers. One energy service stock to consider? Real Money technical analyst Bruce Kamich has been analyzing price action for decades. He recently suggested buying  Schlumberger  (SLB)  "closer to $56," with an $83 price target. 

Cooperman doesn’t own many technology ideas, but he does hold Alphabet, Microsoft, and Motorola Solutions  (MSI) . Currently, those stocks boast forward P/Es of 18, 21, and 23, respectively. Given higher interest rates this year, you may want to follow Cooperman's lead and stick with low P/E ideas in that sector too.

His list doesn't include many small-cap stocks, but perhaps, that’s because large funds need to traffic in large market-cap stocks for liquidity (they have to get in and out quickly without moving prices up or down). Nevertheless, small-cap stocks are cheaper than large-caps, so you might want to consider them. 

For example, the S&P 600 Small Cap forward P/E is 13, according to Yardeni. Since mid and small-cap stocks boast lower P/Es than large-cap stocks, and their returns have been better recently, you might not want to ignore them, particularly if they pay dividends or are buying back stock. Historically, small-cap has outperformed large-cap stocks when interest rates are rising or exiting a recession since 1978, according to T. Rowe Price.

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