Cheapest Valuations in Decades Will Trump Panic Selling

As financial assets remain under intense liquidation, and global equity prices plunge almost unremittingly to deeper bear market lows, many investors are asking themselves why they are invested in stocks, and other risk-bearing assets, in the first place. One of the striking aspects of this crisis, and a reflection of the indiscriminate nature of the selling, is how pretty much every equity market and commodity seems to be down 50% in US$ terms.

Over the past two months, the demand for liquidity (i.e. cash) has trumped all other considerations. No one knows when, precisely, the pressures associated with de-leveraging and panic selling will abate sufficiently to let other factors come to the fore. In my opinion, we are at or very close to that point because valuations have become so compelling as to bring out the buying that will overwhelm the panic selling. Consider the following examples:

1. The "normalized" (i.e. averaging 5 years of earnings) P/E ratio of the S&P 500 is currently 11.8x. This is the cheapest valuation we have seen since the late 1970s and early 1980s, which was one of the worst economic periods in U.S. history, and a period when T-bill yields (the "risk-free" investment alternative) ranged from 5% to 15%. Today, six to twelve month T-bills are yielding 1.5%.

2. Foreign stocks are even cheaper. The MSCI EAFE index, which tracks foreign developed markets, is currently valued at 1.08x book value and carries a dividend yield of 6%. My valuation data history for the EAFE index only goes back to 1993, but in that period of time, the previous low price-to-book multiple was 1.5x, achieved in early 2003. Even in the worst market environments in stock market history, book value has represented a valuation floor.

3. Emerging markets stocks, as measured by the MSCI EM Index, are trading at 1.05x book value. Since 1993, emerging markets stocks have only traded at book value during one quarter - the third quarter of 1998, in the midst of a rash of EM currency crises and debt defaults.

4. U.S. REIT indexes, which have plunged 40% this month, are trading at their most attractive valuations in two decades. Current yields on REIT indexes are 9%, which is over a 5% premium to the 10-year Treasury yield.

5. High yield bond indexes are currently yielding over 16%. In the past 20 years, there has been only one brief period - in the 1990 recession - when junk bond yields exceeded 16%. The average yield on high yield bonds over the past 20 years is approximately 10%.

Markets are clearly priced for a deep, extended global economic downturn. Because this risk (which may or may not turn out to be reality) has now been priced into markets, financial assets, which are trading at historically cheap levels, now offer compelling long-term value. As Jeremy Grantham of GMO aptly put it:

Topping off all the offsetting virtues of this ugly last year is the arrival of cheap assets. All too easily we forget that you compound wealth rapidly only by having cheap assets.

The primary uncertainty a patient investor faces today is not whether future returns over a multi-year period will be attractive (that is now assured barring a collapse of global capitalism), but rather how quickly the recovery in asset prices will occur.

In times like this, when asset prices are seemingly in a never-ending freefall and the media is saturated with dire and fearful messages, sound investment advice becomes a particularly precious commodity. Accordingly, I thought the paragraphs below, taken from John Hussman's weekly letter (available at hussmanfunds.com), were worthy of passing along.

Successful long-term investors set investment positions that are consistent with their tolerance for risk, they expect periodic losses, and they tend to increase their investment exposure gradually as the market declines significantly. Last week, Warren Buffett didn't say "I'm all in because I think this is the bottom." Rather, he said "If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities." That phrase implies that Buffett knows his own risk tolerance, and that he is scaling into stocks gradually as their prices decline and their expected long-term returns increase.

There's a general relationship in physics called Hooke's Law, which applies to springs: "As the extension, so the force." My impression is that the stock market behaves much the same way. When investors are very skittish, the market may behave like a very loose rubber band, generating little tension even as it moves significantly away from fair value. But as risk aversion abates, the tension becomes much more like a stiff spring, and the potential to return forcefully toward normal valuations becomes enormous, particularly when the distance from fair value is large.

The way investors do violence to their financial security is to establish an investment position outside of their actual tolerance for risk, believing they can manage that risk by panicking to sell if the market drops lower. As prices drop, poor investors set an ultimatum for the market by saying, "If this thing loses one more dime, I'm out." Invariably, the thing will lose that dime and the investor will get out near the bottom, having taken most of the losses, but abandoning any prospect for recovery and subsequent growth.

The time for fear is when stocks are strenuously overvalued. We are now beyond the time for fear, and beyond the time for panic. Still, we are not yet to the point for aggressive investment positions. Rather, we are at the point where investors should be gradually increasing their exposure, open to the possibility that stocks could decline still lower. If they do, long-term investors should cheer, because lower prices will mean better long-term return prospects, and will be an opportunity to increase investment positions further.

Comments

[Consider_this:]

Too many "buy" articles out there. Look at what yahoo, marketwatch, seekingalpha is publishing.

Too many knife catcher. The proper contrarian play would only occur when nobody wants to talk about it, not when you have so many bottom callers writing articles like this.

Wait 3 years, perhaps we can talk then. (Japan's deflation was 18 years, so a wait of 3 years from now, DOW's high in Mar still being 14000+, is pretty aggressive! Maybe should even wait 5-8 years!)

2008 Oct 27 11:18 AM

[MarvinMBA:]

I think we should revisit the buy side of the investment equation after a few more quarters so we can get a feel of which way the global ball is going to roll...uphill or downhill.....the dislocations have been so great in financials, Real Estate and Stocks as well as Job loss and Deficiet Spending that I believe we will be in a real world survival mode like food, shelter and transportation needs that excess liquidity for non-interest producing equities
and going to be sidelined for awhile and cash/cashequivalent is going to be the place to be if you are lucky enough to have some cash...MarvinMBA

2008 Oct 27 01:53 PM

[Jackson Cash:]

I tuned out when you mentioned REIT's. Though hammered I wish to offer the following: Past performance is not an indicator of future performance.

Real Estate has another plunge to go -- commercial real estate bubble is due to pop!

2008 Oct 27 04:28 PM

[herbert hoover:]

The problem is you are using "old" thinking. The valuations aren't cheap if the "E" in P/E is unknown.

2008 Oct 27 04:50 PM

[aarc:]

Analysts are still pricing in a recession and possibly severe recession.

Wait until DOW reaches 7000 and they start pricing in a depression.

DOW 5000 is still the target for an expanded flat pattern using Elliott Wave analysis. If this target is reached, then economic analysts will start pricing in a severe depression.

Hopefully, my EW tech analysis is correct, otherwise, next support zone on century-long chart is DOW 800 to 1000 range.

Looking at the century DOW chart, the first correction happened during 1928 to 1932 where Dow plunged from 500 to 42 - a deep 90% haircut. Then a massive rally to Dow 1000 followed. Next major correction happened from 1965 to 1980 where Dow failed to break above 1000 in a shallow consolidation range 800-1000. After that, another massive rally to 12000 of year 2000. This is a classic Elliott Wave analysis.

Then another correction starts from year 2000 and still going on until now and the near future. 2007 Dow of 14000 is part of an expanding flat correction (higher high, lower low). SnP500 is the classic double top with 1553 of year 2000 as a starting point for the unfolding consolidation range. Only thing unknow at this stage is whether SnP will be able to hold 780-850 area for a higher low pattern or will it break below 2002 low of 768. Every momentum indicator projects a break below 768 including fibo price projections analysis. However, there are more cases of double top patterns producing higher lows than lower lows. That is where the rub is. Dow and SnP are not telegraphing the same outcome. But for now, the massive drop this last 2 months gives extremely high probabilities (in the upper 90%) of getting lower low below 839 in early Nov 2008 and a pullback consolidation range mid Nov to early 2009 before the floor drops again.

It is still possible that Dow can keep 7500-8000 range for a higher high, higher low scenario since 14000 is more than 138.2% price extension from 2002 low of Dow 7200 (154% in fact). Most expanded flat used 127.2% price extension as resistance (that is where investors/traders prefer to play safe and sell some holdings in anticipation of a false breakout and use the 127.2% price extension to the downside 5293 as a false breakdown buy area).

Expanded flat with 5000 is still the highest probability since most "failed" higher high patterns resolves into lower low. The massive drop from 11500 to 8000 for 2 months is a classic iiird of 3rd wave of a C wave down with more than 90% chance of finally resolving into a 4th up and 5th down to 4750 nominal target. 5000 is a good psychological support while 2846 is an extended 127.2% C wave target (seldom happens). Since a C wave of an expanded flat is extremely fast and furious and purely dependent on panic psychology, usual targets using equal move method is only good as an approximation. Hence, best to use 4500 to 5293 as buy area. 7500 to 8000 range is a good buy area for very long term investors and for technicians familiar with the 127.2% price extension resistance failure (Dow resistance at 13000 failed to hold in early 2007 that resulted to Dow 14200 of Oct 2007) and the SnP double top pattern that usually resolve into higher low.

How to know if 7500 will hold (since the highest probability is a pullback to 9000-10000 in the next few weeks then a drop to 7500 before another sharp rally to 10000 to 10500)?

Answer is if the sharp rally produced a higher low and be able to break above 12000, then Dow will have a chance to produce a running triangle in the 7200 to 16000 range (running triangle being higher high higher low consolidation range with 2002 Dow 7200 already set in. The 154% price extension from 7200 to 14200 provides the potential failure for an expanded flat in most cases. However, most cases still resolved to an expanded flat and running triangle or running flats are more based on hope than in statistics.

A failure to break above 12000 ultimately will yield a breakdown below 7200 with 5000 psychological target.

2008 Oct 27 04:51 PM

[User 286994:]

How can you talk about valuations when nobody has any idea what earnings are going to look like in the next few quarters. The bursting of the credit bubble, and that is exactly what it is, may cause economic disruptions that we have not seen in our lifetimes. If the economic downturn is severe enough -- and the opinions are all over the place -- then earnings in the next few months could make current valuations look awfully pricey.

2008 Oct 27 07:47 PM

[icandoitdon:]

got that, everybody?

2008 Oct 27 08:49 PM

[User 265729:]

FEAR!

FEAR!

FEAR!

FEAR!

Actually... The market is highly overpriced, considering what the wold landscape to look like in the decades to come. No homes that will appreciate 60 percent/year... No tech bubble... Very little or no credit to the consumer... People living within their means and delaying gratification until they can save for something.

Dow 4,000 to 3,000 a real possibility within four months.

Unless you'd like to create the Dow or S & P bubble?

2008 Oct 27 08:57 PM

[User 265729:]

Dear user286994:

You CAN see it! Look at the shelves in your grocery store, box store, etc. What do you see? Lot's of empty spaces or empty shelves. Talk to the managers and find out why... Nothing is in the pipeline and there is zero demand for anything except the basics. When the frill things are gone, they are not reordered. Manufactures have stopped man=king a wide range of product due to demand falling off a cliff. Consumers are now maxing out their credit cards... Next shoe to drop..

Then you have a brisk sales in firearms and ammunition in the United States. People are smarter than you think... They see the store shelves that are empty... They know what's going down.

As Bush would say... This sucker is going down.

2008 Oct 27 09:03 PM

[User 265729:]

aarc:

Interesting points. But Economics 101...

Beware the model... It is there to be broken...

There are far too many extraneous variables entered into the global marketplace to enumerate here that will throw any theory or model into the local dumpster.

I think it may have been best said, by Sir Winston Churchill, referring to Gallipoli:

The terrible ifs accumulate.

2008 Oct 27 09:56 PM

[zalo:]

Valuations are extremely cheap, even for a massive correction of earnings. The problem is that as fear continues, what was not real could actually become self fulfilling. But i think that the governments have intervened timely and aggresively to stop this armaggedon of becoming true by recapitalizing and backing banks. So, without a systemic risk in hands, governments can focus on rebuilding credit, even if it is necessary to do it with their own hands. For the sake of corporations and consumers, it doesn´t matter from whom they get the credit as long as they receive them. For governments, it is also important to keep the economy up and running.
So, even though we are still headed towards a strong recession, the kind of stock price crash that we had is more representative of a complete economic meltdown, which is, by the minute, reducing its probability of occuring. Even for cyclical industries like commodities producers, i think that as there was probably a bubble some months ago, now we are seeing the opposite. Nothing has changed fundamentally regarding the extreme tightness in demand and supply.

2008 Oct 28 01:30 AM

[john s. gordon:]

what you describe will happen eventually but by then all our 401k's will be erased. remember emperor george w. and his private social security accounts which would gain 20% annually? people were not dumb enough to climb on board that one.
> jack

2008 Oct 28 08:18 AM

[marketbear:]

History is littered with prognosticators like yourself constantly calling a bottom. Just read the headlines from 1929 and 1930 and you'll find famous investors calling a bottom and declaring that stocks are cheap relative to their technical analysis. John Maynard Keynes himself declared we were free from economic crisis prior to the great depression. Someone that hasnt lived through the bursting of an asset bubble like the one we just experienced has no appreciation for the path that lies ahead.

What you dont seem to understand is that its impossible to price an asset, whose value is only derived from its ability to appreciate, that will have negative earnings growth for the foreseeable future. The price action of that asset will move between extremes from 'unload at all costs' to 'technically oversold' condition until we've reached a bottom. The price action of those securities are always determined by the most optimistic of prognosticators that are willing to bet that earnings will be better than the consensus expectations. The bottom will only be reached when the most optimistic earnings expectations for that asset is consistently lower than the actual earnings for a few consecutive quarters.

The difference between this recession and other recessions is that we had a wave of baby boomers and increasing consumer base that lifted us out of those previous recessions and asset bubbles and allowed earnings to recover and appreciate. This time thats not the case. We just experienced an asset bubble that impacted the broadest consumer base that will have a profound impact on earnings going forward. All at a time when we have a natural contraction of the consumer base due to the aging of the baby boomers.

We're going from a financial crisis to an economic crisis. The financial crisis was just round one of this crisis and was the veritable dust bowl of the 21st century. The economic crisis and the contraction in earnings is just starting now. The contraction in spending and the impact of unemployment will just begin to hit the earnings of large corporations in 3-6 months.

During the Great Depression we had a 25% drop in GDP. GDP is made up of 70% consumer spending. So, the question that I have is, should we expect a similar drop in spending while households and demographic trends contract the overall consumer base. Logic dictates that in order for stocks to be priced at a premium to earnings then the stock has to provide some relative guarantee of substantial earnings growth. If thats not the case then the stock will trade at a discount to earnings (relative to historic ratios).

So in order for us to be able to maintain the trajectory of GDP the contracting demographics need to compensate for;
1 - The aging of the baby boomer and the loss of that consumer on the amount of overall available disposable income.
2 - The equity extraction that took place during the last 10 years that was on the order of 5 times that of normal periods which basically increased the disposable income of most americans on top of the largest base of consumers.
3 - The negative savings rate due to the availability of cheap money and the period of frugality we're about to enter
4 - Stricter lending rules

I dont see how the market will go up anytime soon. The drop in the DOW during the Great Depression took 3 years. That period included large drops followed by strong bear market rallies. Those rallies were always the result of optimistic prognosticators like youself declaring that stocks were technically cheap and provided a great value relative to 'historic' ratios.

Good Luck. But I think theres a flaw in your logic and you're missing the bigger macroeconomic picture. There certainly will be rallies ahead but the overall trend of the market for the foreseeable future will be down. We're in a period of wealth destruction, each drop will bring more money into the market causing it to rally, which will invariably followed by a strong drop causing more destruction of wealth. Its the law of nature.

2008 Oct 28 08:32 AM

[cynic69:]

Dear JD
Do you realize how naive it sounds to state that "the PE ratio of the S&P 500 is 11". If you are talking about the past my reaction is that history is no harbinger of the future. If you are talking about future PE ratios you are dreaming a polyana dream. When I read articles like this it raises my suspicion that the author is already in the market and is hoping that he can trick the rest of us into piling in after him. I think that the consumer is in debt up to his hips and the price of oil is going to skyrocket again. I think that future PE ratios are more like 30 or 40. I have been banking a ton of money by buying puts everytime the market rallies. Anyway, best of luck to all you bulls.

2008 Oct 28 11:31 PM