This Market Is One of Opportunity

For long-term investors, there is little doubt that the market is oversold in the near term. Our standard valuation metric, the price-to-peak earnings multiple, is down to 10.4x this week. We think this is further evidence that, although we are not necessarily at a bottom, the stock market is poised to provide better than average long-term returns. For a very clear and thorough explanation of why using normalized peak earnings is so vital to understanding market valuation, allow me to refer you to John P Hussman’s (Ph.D.) weekly comment (How Low? How Bad? How Long?).  Hussman is one of the best writers in finance today and this insight, in particular, caught our attention:

It is important to note that even in the Great Depression, it took until 1931 for the price/peak-earnings multiple on the S&P 500 to drop below 11. That did not occur after the 1929 plunge. Moreover, the peak earnings level in 1929 reflected a spike that (aside from a brief period in 1917) was unusually high in the context of normal earnings. I can’t possibly overemphasize how important it is to gauge valuations on normalized earnings, not spike peaks or spike troughs. On normalized earnings, stocks were still overvalued at the 1929 trough. It took until 1931 for stocks to look cheap even on the basis of peak earnings from 1929.

So historically speaking, this market is one of opportunity; for the last five weeks the S&P 500 has traded below 11 times peak earnings. Valuation has not been the driver of this market downturn, as fear of recession has dominated investor psychology - but valuation will not be ignored indefinitely. Instead of claiming to be able to time the market, which has always been a fool’s game, we would recommend looking at further market weakness with an opportunistic eye.

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A clear consensus has been reached regarding investor sentiment. For the fifth straight week the percentage of NYSE stocks selling above their 30 week moving average is below 10% (this week it's 4.8%). As we have mentioned in previous newsletters, since we began publishing the EIG nearly 20 years ago, never have we seen such clear evidence of a bearish slant on the market. Admittedly, this is a relatively short time frame, but compared to the recession of the early 2000s, this instance is extreme. After the dotcom bubble burst and the NASDAQ lost nearly 80% of its “value”, there were never even two weeks below the 20% level in this investor sentiment indicator. To be a good value investor is to be a contrarian and it is tough to find a more clearly laid out consensus in overall sentiment than we see right now.

Our asset allocation model advocates greater than normal exposure to equities right now. Of course, this is not a proclamation to buy stocks blindly with little regard to macroeconomic conditions; however, we believe that U.S. equities will be among the first securities to rebound when the dust settles. In our view, earnings thus far have not been worse than we expected; it has been the lowering of future guidance that has dragged down many stocks. While it is probably prudent for a company to lower its guidance in the face of uncertainty, that lowered guidance does not necessarily mean that earnings will in fact drop in line with guidance. Governments around the globe, as we have seen with China over the weekend with their stimulus plan, are recognizing the crisis facing the global economy and are being proactive in combating it with stimulus packages and looser monetary policy. In a globalized economy, with all major central banks acting in unison to combat economic malaise, we should begin to see results from these efforts in the coming quarters.

Comments

[leh:]

China's even cheaper, with some decent real companies selling their stock for below cash value of the business. YZC is one.

2008 Nov 11 09:06 AM

[wallyjm:]

sume stocks offer outstanding value, what makes you think that your dollar holdings are a safe place to be holding your wealth?

2008 Nov 11 11:53 AM

[tsinvest:]

11 P/E could rise if earnings drop over the next few months. As a result, stock prices would have to drop to give us an 11 P/E Market Opportunity again. I guess my point is P/E's move - they are not static.

2008 Nov 11 01:23 PM

[ockham:]

tsinvest,

You missed the purpose of the price-to-peak earnings, this serves the to smooth erratic earnings results. It is a little known fact that corporate earnings are actually more volatile than stock prices, historically speaking. So, since a equity is a claim to all future cash flows and not just the next quarter's cash flow we think this smoothed valuation metric is more enlightening than just a standard P/E.

For a much better explanation of why price-to-peak can be a valuable metric check out that link to John Hussman's website above.

Thanks.


On Nov 11 01:23 PM tsinvest wrote:

> 11 P/E could rise if earnings drop over the next few months. As
> a result, stock prices would have to drop to give us an 11 P/E Market
> Opportunity again. I guess my point is P/E's move - they are not
> static.

2008 Nov 11 04:05 PM

[Troz:]

Government and private debt went parabolic in the 20 years, with most of GDP growth being debt-fueled. Personally, I wouldn't be making any future predictions based on earnings within that time frame, unless you can model money growth and contraction accurately.

2008 Nov 12 12:34 AM

[Troz:]

That should read "in the last 20 years" in the above comment

2008 Nov 12 12:35 AM

[johnbee:]

why take the Great Depression as the base? Debt is now greater than then
and most people in the world had no debt and were able to live off the land.
For most people now if you can't borrow and have lost you job you can't eat. That in turn creates national protectionism by public demand that no Government can ignore.
Governments have only one way out and that's to print money and create demand which fuels higher prices (not real value) and pile up Government debt to an extent that it can't be repaid or becomes worthless through an iflationary spiral. That's Wermacht republic stuff and the way out of that was war. Obama will need find a new solution and bailing out GM will not be it.

2008 Nov 14 06:06 AM