Market Valuation Signals from the 'Smart Money'

Americans are an impatient lot. 2008 was a wretched year for most of us, as virtually every asset class was brutalized in a synchronous, global recession. Furthermore, this has not been your “garden variety” recession but rather one induced by severe imbalances in the world’s financial system that will take years to work through. Now, as we blessedly enter a new year, many people are pining for some good economic news. For stock investors, this would entail the end of what has been an almost decade-long bear market.

The forecasts for the coming year for the U.S. stock market are as varied as one can imagine. Bearish analysts point out that corporate earnings estimates are still too high for U.S. equities and, after entering more realistic earnings numbers for the broader indices, the market’s price-to-earnings multiple is far from cheap. In his weekly newsletter for this week, John Mauldin points out the valuation problem confronting U.S. equities. S&P 500 earnings estimates for 2009 are currently $42.26, which is down from $92 in March of 2007! That gives us a market multiple in the low twenties—above the historic average of 15 and not the kind of territory one expects to see at the end of a secular bear market.

Other analysts point out that the market is a forward-looking, discounting mechanism and that using trough earnings (those at the very nadir of a recession) when computing valuation measures is not a good idea. Many analysts would prefer to use normalized earnings which factor in all phases of the business cycle. John Hussman prefers to use peak earnings, which uses the overall market’s prior peak earnings number as the divisor. The theory behind using peak earnings is that the broader market’s earnings power always returns to previous levels after recessions abate and this number is a more reliable measure of market valuation than using a divisor which may be heavily skewed in one direction or the other. By Hussman’s measure, the market is currently pretty inexpensive.

Other factors must be considered as well. One is the overall state of valuation of competing asset classes. Looking back at the end of the last major secular bear market in 1982, riskless investments such as short-term CDs, savings accounts, etc. were yielding close to 20%. Comparable investments today offer yields which are heading for zero! Real estate has certainly lost its allure and is still over-valued in many parts of the country compared to equities.

Foreign equities—also beaten down badly in the ongoing bear market—probably have diminished allure at present as investors flock to safer havens. Commodities offer a less appealing alternative as well, given the dismal performance so many of them turned in last year. While radio and cable television ads touting gold are ubiquitous, gold’s price is far from cheap. Investors in the late seventies and early eighties learned the downside of buying precious metals at the wrong time and investors would do well to study that period and the ensuing twenty plus years before putting too much money into gold.

There are other bullish signs out there as well. According to John Mauldin, famous bear Bill Fleckenstein is closing down his short-only fund and sending the money back to investors. According to Mauldin, Fleckenstein said that: “Right now, my list of stocks that I want to be long is longer than the list I want to short.” When the “smart money” starts giving you signals about market valuation, it is wise to pay heed. This comes on top of a number of other market sages who seem to be indicating at least a passing interest in the long side of U.S. equities right now. As long as overall sentiment is decidedly morose and “smart money” types are beginning to see value, that is a positive for stocks.

Make no mistake about it, 2009 will be a tough year for Main Street as corporate earnings drop, unemployment increases and businesses retrench. However, markets tend to look ahead to the next phase of the economy rather than dwell on the present. We are already in the thirteenth month of this recession—which is a pretty long time as recessions go. Even if the economy faces another year of retrenchment, the market will start to discount in a recovery six months or so prior to one being visible. That gets us to the mid-year point.

Clearly, there are a number of events that could cause a renewed panic sell-off in U.S. stocks. Further bad headlines like the Madoff affair, a major war somewhere in the world (Israel’s action versus Hamas in Gaza does not appear to be rattling the markets just yet), an oil embargo, etc. could cause short-term jitters that could take out the lows established in the various indices in late 2008. However, absent some large shock, expect the markets to be pretty range-bound for several months before beginning a rally near the end of the year that begins to price in a better economic environment in 2010.

Comments

[investor88:]

range bound for now, action starts end of year. fair enough roadmap, subject to revision along the way.

Jan 06 08:46 AM

[frosty:]

The rationale to use 'peak earnings/current price' could justify virtually any investment because the price of virtually everything has gone down dramatically, unless you were fortunate enough to have bought treasuries a year or more ago. The theory that earnings will return to previous levels might be believable on a macro level but the danger is that some investors may try to apply it to individual stocks. For example, AIG, GM, and countless others are unlikely to return to prior earnings levels anytime within a reasonable investment timeframe. The fact that the price of foreign equities, commodities, real estate, even precious metals (down significantly from their peaks) have fallen would make all of those asset classes also attractive by this measure. Stock bigots (of which I am one) will always use the mathematical tools that 'prove' their case however the fact is that they don't. It may well be that this ratio is quite attractive right now (although I don't see how it favors domestic equities over other asset classes) but that doesn't mean that it won't get significantly MORE attractive in the future.

Jan 06 08:56 AM

[prudentinve...:]

In the recent past, guesses by astute amateurs appear to have been as good as, or better than, the average pundit's. The average pundit has stocks to sell (after he or she bought them), or advice to sell as to which stock we should all buy, so this tends to slant the advice. The latter is not true of bearish hedge funds, but they are a minority, and have their own agenda to sell. This means that independent investors have to rely on their own judgment.

If you look objectively, you will see unsound economic fundamentals that have resulted from decades of market distortion by the fed, with no end in sight. Not only are we failing to remedy the past distortions, but even implementing new and more egregious ones with bailouts, ZIRP, QE, and so on.

Thus, it is hard for this independent investor to believe that the economy and hence the market are going to advance significantly this year. While I am not predicting doom and collapse, I cannot see how we can have the strong rebound that many pundits are now predicting as eminent.

Jan 06 09:39 AM

[Larry House:]

Sorry, but this adds nothing meaningful, no new insight into the situation at hand.

Jan 06 10:23 AM

[Maxe Paul:]

I think your analysis is sound. I have a theory on the "6 month forward" the stockmarket uses as a discount or forward looking mechanism, i call it the "6 month mania". If you look at two year charts of the s&p you will see you had around 6 months to get out near the top even though the canary in the mine was long dead.

The market then rallies off the bottom of the intial bear 6 months early, falls back to a further bottom, then when again fundamentals are sound will start to rally. The 6 month rule is a psychological myth in theory. It was 6 months too late on the bear, and will be 6 months too early on the bull IMO. History shows us this is a recurring factor.

Jan 06 10:27 AM

[debtacid:]

This sounds like just another sales pitch to calm any remaining clients these guys have. It reminds me of the zombie chant in The Mummy. Imo-Tep, Imo-Tep, Imo-Tep...

Jan 06 10:59 AM

[cyclingscholar:]

Hussman's idea makes sense. I have that long term chart of the SP500/EPS/PE ratios that alot of other people do as well.

Perhaps the best thing to do is to assume NO PE expansion from current levels for a while, and thus stock prices will grow only as fast as nominal earnings?

Jan 06 11:05 AM