Stocks Still Cheap in This New Bull Market

Over at The Big Picture, Barry Ritholtz makes this point.

On a trailing one-year basis, that puts the Price to Earnings Ratio (P/E) at over 19 as of today [Tuesday]. This does not make the market cheap.

And what about 2009? Again, the analysts are in a race to find the bottom.

[click to enlarge]

The current projections are for $42.26 for 2009. That makes the forward P/E 22. That doesn’t look like value at all, when the historical average is closer to 15.

In 2001, as-reported earnings were $24.67. Operating earnings in 2002 were $27.57. Does anyone think the current recession will be milder than the last one? Or shorter?

Is the market expensive at these levels? Does it matter?

I will get to the first question later. As for the second, a better question is why would an investor value the market off cyclically low earnings?

The market bottomed in 2002 on October 10 at 768.63. Trough earnings were $24.67. Thus, the market bottomed at 31.1x trough earnings. Earnings in the third quarter of 2002 were actually higher at $30.04, or 25.6x trailing 12 month earnings. So, in fact, the market trading at 22x depressed earnings today looks cheap compared to the last bear market!

The reasons why an investor would view the market as expensive and thus avoid stocks at these levels are twofold - earnings are going to go a lot lower and stocks will follow or earnings are going to stay permanently depressed.

First, there have been occasions when the market bottomed at 8x trough earnings. Is it prudent, however, to wait for cyclically low multiples on cyclically low earnings before buying? As I explained last month, the answer is generally no, as extreme valuations are rare. Instead, a better strategy - in my opinion - is to buy as the market approaches an extreme low valuation and sell as the market approaches an extreme high valuation. You can never catch the bottom or the top - or at least I cannot - but buying and selling as the market approaches extreme levels is generally a profitable strategy over time.

As for earnings staying permanently depressed, well, perhaps, but I would not bet on it. Margins have averaged about 6% over the past two decades.

Applying a normalized profit margin, is the market expensive?

I use 7% as a normalized profit margin. This is higher than the long-term average but in the past, lower-margin hardware companies accounted for a higher proportion of technology profits than higher-margin software companies. Today, software companies generate a higher proportion of technology profits.

Based on this measure of normalized profit margins, stocks look cheap.

On other measures, the market also looks inexpensive.

The price to sales of the market is approaching multi-decade lows ...

... while the price to book of the market is at multi-decade lows.

Even though I am very long stocks, I am skeptical that we have entered into a new bull market. However, stocks are not expensive.

NOTE - I am currently reading Anatomy of the Bear and came across this line about the 1921 bottom in stocks on page 67.

The bulls of 1921 focused on the value in shares an key technical factors which suggested that market prices would recover. There was little discussion on the immediate earnings outlook. While the market bottomed in August 1921 reported earnings had a further 37% to decline before they reached bottom in December 1921. An earnings recovery significantly lagged the recovery in the stock market. [Emphasis added.]

Comments

[Steven Hansen:]

Toro I commend you on a very logical and rational argument to support the concept the market is undervalued. My view is the opposite.

Jan 07 05:20 AM

[patio:]

Good luck- buying stocks now is like picking up dimes in front of a bulldozer.

Jan 07 08:17 AM

[Tradememe:]

Timing the market bottom makes no sense in my view. It all depends on your time horizon. If you are near retirement, you shouldn't be in the market in the first place. But if you can afford to wait 10 years or more, then this is a great buying opportunity. If you think this is going to be a down market for ever, then put all your money under the mattress!

Jan 07 08:18 AM

[Alan Brochs...:]

Toro, what is the source of your earnings projections? The S&P website has a bottom-up forecast from analysts on the S&P 500 stocks as 70.78, which is down a lot over the past month or so (not too surprisingly). These are "operating earnings", which exclude one-time charges. This number is actually growth from the projected 2008 EPS (67.59). Based upon the changes since November, analysts killed Q4 estimates, leading to projected 18% y-o-y earnings decline, but they look for modest growth in 2009. I think not...

I believe that PEs will remain extremely low due to high interest rates (corporate, that is), a belief that the projected earnings are too aggressive and extreme risk-aversion.

Jan 07 08:39 AM

[Carl Spackler:]

Hey Toro! On an adjusted basis the pricing for sub-prime loans is cheap also. You want some of those right now? How about GM stock? How about banking stocks? Old adage: when something that is being sold appears cheap, its cheap for a reason - it may be because it has no value. In the end, the market is driven by economic factors, not by valuations. Six months ago stocks were valued extremely cheap by 2006 standards, yet they fell - why, because the economic picture changes. Big question is what will signal a change is the economic winds? We are tossing $1.25 trillion at the situation, but 1/2 of that will be used to recapitalize various institutions. This will not increase spending an economic activity. The other half of the stimulus will provide some help, but $500 billion tossed out on this vast large economy is like trying to kill an elephant with a pea shooter. Its not enough to make a big enough ripple.

Jan 07 05:30 PM

[Alphameister:]

Good article, Toro. Credit markets have improved dramatically since the Oct/Nov lows, and most of the ugliness of 2009 was arguably discounted at those lows.

Jan 08 09:03 PM