Stocks at Fair Value: Will They Overshoot Now?

For the first time in decades, the S&P 500 is trading at fair value, according to several sources including the Financial Times of London. That is to say, the cyclically adjusted price-earnings ratio (popularized by Robert Shiller) has dropped to its long-run average. So too the Q ratio (invented by economist James Tobin), which compares market values to replacement costs. Consequently, some brave value investors, including well-known permabears Jeremy Grantham and Steve Leuthold, are now buying stocks.

But valuations have a tendency to overshoot on the downside during bear markets. As economist Andrew Smithers notes, Shiller’s cyclically adjusted price-earnings ratio bottomed out an average 50% below fair value during the six major bear markets from 1920 to 1982.

The unadjusted price-earnings ratio tells a similar story. It got down to a low of 7 in the bear markets of 1973 and 1982. Applying this valuation to strategists’ projected 2009 earnings-per-share of $70 for the S&P 500, the market would need to decline by more than a third from where it is now.

If the current recession is more of the common garden variety, valuations are not likely to overshoot as much. Over the past 14 recessions, the trough in the cyclically adjusted price-earnings ratio averaged 11, which would imply a drop of nearly a quarter from current levels.

Of course, an overshoot is not necessarily inevitable. Indeed, Shiller’s ratio remained well above fair value during the 2002 recession. As it did in 2002, perhaps the massive monetary and fiscal stimulus on its way from governments around the world may keep valuations from sliding to their lower boundary.

Comments

[mgcolin:]

This is pretty much conventional wisdom right now but I wouldn't call it overshoot, its the difference between a major recession (like the 70s and not as bad as 30s) and a garden variety recession. The equity markets are at a 'garden variety' recession valuation right now, Bond market is at a '70s type' recession valuation - equivalent to 700 S&P. So floor on the stock market is around 700, unless you believe this will be the worst economy since the 1930s.

2008 Nov 11 01:06 AM

[Steven Hansen:]

you cannot compare today with 2002 except to say the economic stimulus used in 2002 could be attributed to the equity bubble we are seeing today. the p/e ratios given as guidance are erroneous because they used rose colored glasses to make their predictions. even the company valuations used for fair value have fallen since they were originated.

the bottom line is that we remain above a realistic fair value, and the current p/e ratios have not fallen below the level of one year ago if we use realistic profit projections.

the computer model whiz kids are welcome to have a go at getting the golden fleece. i doubt historical fundamentals and markers are functioning.

2008 Nov 11 02:01 AM

[MarvinMBA:]

We have to follow the lead of China who really has it right...go for intrastructure improvement like roads, energy, transportation and medical research.

2008 Nov 11 02:02 AM

[300mph:]

Hussman is calling for 10% yearly long term returns. That hasn't happened for a good long while.

2008 Nov 11 01:56 PM

[Kunst:]

"...the cyclically adjusted price-earnings ratio...has dropped to its long-run average."

The thing about an AVERAGE is that you have to spend as much time BELOW (not just at) the average as above. Going below the average isn't overshooting; it's required in order to make that the average.

Otherwise, it would be like Lake Wobegon, where all the children are above average, or the surveys that find that 80% of drivers think their skills are above average.

2008 Nov 12 01:08 AM