Stocks Undervalued in Current Economic Environment

As a result of the 40% to 65% (depending on the index) gains we have seen off the lows, stocks have moved from (nearly) dirt cheap levels three months ago to valuations that seem appropriate to mildly undervalued given the economic environment and the yields available in fixed income markets.

The economy is clearly beginning to recover, but the strength and durability of the rebound remains to be seen. After this initial bounce from government stimulus and pent-up demand runs its course, the economy may be vulnerable to a “rolling recession” type of environment as a result of private sector balance sheet rehabilitation, which will involve a multi-year process of higher savings and debt reduction.

Emerging markets stocks, which have delivered 15% per annum returns over the past five years (versus returns of minus 1.9% per annum for the S&P 500) are the most expensive of the major equity segments-relative to their history. Of the three broadest global equity segments— U.S. stocks, foreign developed markets stocks, and emerging markets stocks, emerging markets stocks are the only asset class whose price/book multiple is close to its historic average (see charts below). This seems appropriate when one considers the relative economic positions of emerging markets versus developed markets in the context of the past fifteen years.

Broad Stock Market Index Valuation Analysis
Price/Book Value (Net Assets) Multiples 1/1/94 - 5/31/09

[click to enlarge charts]

Notes:
Blue horizontal lines represent averate price-to-book multiples over the period
Red horizontal lines represent 25th and 75th percentile price-to-book multiples over the period

Comments

[Dave Wrixon:]

All depends whether you believe the book values or not.

With the incredible degree of uncertainty in that area, I would suggest that stocks are wildly over-priced. Let face it few CEOs are queuing up to declare their companies potentially insolvent, although many undoubtedly are.

Jun 11 05:28 AM

[jeremiah74:]

"The economy is clearly beginning to recover" ...
based on the data and not on hopes, it would be more right to say:
The economy may be showing signs of recovering.

also, it might be misleading to look at averages over the last 15-20 years given the implosion of private sector credit during that time, which is now being unwound or transferred to the public sector. assuming a much more moderate increase in credit going forward the comparison to the last 15-20 years is not necessarily right

Jun 11 05:59 AM

[drewriders:]

I don't believe in the book values of the banks since all the accounting rule changes.

Jun 11 06:16 AM

[Schweizer:]

SPX GAAP PE is 63 on June 5th using ttm earnings.

GAAP Earnings for the SPX is now $27.45 for 2009 per Standard and Poors; That's a 2009 full year PE of 34.

Bear market lows have always been made at a PE under 10, so we are 3.4x too expensive.

Suck some more sheep in there Mr. Wall Street.

Jun 11 06:46 AM

[popey:]

The problem is that treasury market is imploding and we are headed for 10% interest rates across the curve. A disaster for most equities is unfolding.

Jun 11 07:21 AM

[prudentinve...:]

Your graphs begin in 1994, and current valuations appear low relative to 1995-2007. So we have to ask whether current valuations are fundamentally low, making stocks a bargain; or whether valuations during the era of the Great Bubbles were unsustainably high, and all that's happened is a natural implosion of a great bubble.

Jun 11 07:57 AM

[jgbooker:]

Yikes; I don't read things the same way at all!

Jun 11 08:12 AM

[TechnicalFu...:]

First, I think these graphs would be more valuable if they excluded financials. Second, with stocks trading at pre-melt-down levels and earnings outlooks lowered, P/E and P/S multiples have actually risen above pre-August '08 levels. Third, the relationship between developed and developing/emerging countries has changed dramatically over the past 15 years. There has been a shift in dependence, where emerging countries are wagging the tail of the 'developed' dog. Their growth is no longer a sign of our growth. We have "shown the man how to fish" and that is exactly what he's doing, with billions of people behind him slowly, but surely, being lifted out of poverty. And, some of our companies are still outsourcing during these difficult times. Fourth, the government is trying hard to produce/fabricate numbers that will support the markets. When you realize we are now Japan, you will see that the only wise move is to short this market.

Jun 11 08:25 AM

[David Roskoph:]

Shhhhhh,

The flock has convinced themselves that down is the only alternative.

Jun 11 10:19 AM

[Mad Hedge F...:]

But what if the economic environment changes? I chatted with Jeff Rubin last night, former chief economist with CIBC World Markets, who reaffirmed my own hyper-bull case for crude in bucketfuls. He was in San Francisco, admiring our civic planning and mass transit system, as part of a tour to promote his new book “Why Your World is About to Get a Whole Lot Smaller: Oil and the End of Globalization.” We are in the bottom of the ninth inning of the hydrocarbon age. The next super spike will take us to over $100/barrel within 12 months of the beginning of an economic recovery, and much higher after that. The problem is that we are losing 4 million barrels/day through depletion just when demand is increasing. The only offset will be dirty, foul, huge carbon footprint, $100/barrel Canadian tar sands, which will double, to account for 40% of our imports. The biggest increase in consumption is in OPEC itself, where consumption has ballooned to 13 million barrel/day and oil is being wasted on a prodigious scale, compared to only 7 million b/d in China. Gas there costs only 25 cents/gal, utilities in Saudi Arabia pay only three cents/gallon for bunker fuel, and Dubai is blowing 3,000 b/d equivalent running an indoor ski resort. Oil over $100/barrel will bring globalization to a screeching halt. Economies will go local because it will cost too much to transport goods, as we have in the past. No more California avocados in Toronto. More importantly, no more Chinese steel in the US, or any other heavy exports, which will lead to a resurgence in domestic manufacturing and the jobs that come with it. Last year $90 of the $600 cost of Chinese steel went to shipping costs. $10/gal gasoline will take 50 million of our 240 million cars off the road. Even if we replace them with electric cars, we don’t have the power grid to juice them. Chinese exports will collapse, but so will their Treasury purchases, meaning no more bailouts for us. Oops. Subprime neighborhoods will get plowed back into farmland so we can eat. I think Jeff is dead on about oil prices. But as necessity is the mother of invention, some of his predictions about their impact on international trade are a bit extreme for me.

Jun 11 10:45 AM

[TradingHelp...:]

Mad Hedge Fund Trader, are there 10 of you or something? I am amazed at your depth of knowledge and contacts. You are right, most of the time too. Anyway, onto business. Steinhilber, the writer, is correct I feel. Stocks, denominated in dollars, are going to get a secular boost over the next 5 years.... but not because we are entering a period of economic Nirvana, although GDP will recover, but because inflation is coming strong in 2010 and beyond and in pure monetary terms that will push the price of stocks up. In real purchasing power terms, things will also improve. Inflationary pressures have been deliberately manufactured by the Fed and US Gov to erode the real value of the debt burden. Gold, oil and equities will enjoy that inflation. The consumer less so. And did you know here in the UK we enjoyed positive GDP in April MoM? The bears will be sitting a bit lower in their seats shortly, hiding behind their trading screens.

Jun 11 11:48 AM

[Larry House:]

You don't prove your premise. Only looking back in a few months will reveal if equities were undervalued at this time. It is very hard to believe they are considering the problems at hand.

Jun 11 12:08 PM

[CLH:]

Stocks look cheap after a year of total panic which has given us great buys.

Jun 11 03:31 PM

[Graham and ...:]

Dear Prudent Investor:

You hit the nail on the head.

Stocks are "undervalued" by post Persian Gulf War standards (that was the defining political-economic event).

But they are expensive by pre Persian Gulf War metrics. those are the ones I use.


On Jun 11 07:57 AM prudentinvestor wrote:

> Your graphs begin in 1994, and current valuations appear low relative
> to 1995-2007. So we have to ask whether current valuations are fundamentally
> low, making stocks a bargain; or whether valuations during the era
> of the Great Bubbles were unsustainably high, and all that's happened
> is a natural implosion of a great bubble.

Jun 12 02:55 PM