Stop Calling Markets, Start Buying Individual Values

by: Paul Price

Chart patterns and absolute numbers tell investors nothing when viewed in isolation. Are Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) expensive because they trade for $629.71 and $742.75 even with forward P/Es of 11.8x and 15x respectively?

Are Pandora (NYSE:P), Zip Car (ZIP) and Groupon (NASDAQ:GRPN) bargains at $9.40, $5.29 and $7.34 even with no GAAP earnings at all?

To answer those questions you'd need to evaluate many specific items looking backwards and into the future. With the broad market it's easier due to the wide diversification of companies and industries. When predicting movement of indices macro-economic factors weigh more heavily than company specifics.

When the DJIA peaked 5 years ago in October 2007 the trailing P/E for the 30-stock index was 17.7x. That would have been a bit high by historical standards even if you suspected we were on the verge of recession.

The DJIA October 12, 2012 close of 13,326.40 looks very similar to the peak 2007 level on the chart above. Improvements in corporate profits, though, place the trailing and forward P/Es at discounts to normalized market valuations presently rather than the premium levels that were observed five years earlier.

That's a huge difference. Perhaps more importantly, equities must always compete with fixed income when fighting for market share of the total investment dollars that need to be put to work. CD, Treasury bond and corporate bond coupon rates have an inverse effect on where P/E ratios tend to settle out.

When risk-free returns are high, multiples tend to be low and vice versa. Both 10 and 20 -year rates have plummeted over the past five years. In theory, P/E multiples should now be way above what they were at the time the DJIA peaked in 2007. Instead we have exactly the opposite situation.

Consciously eliminate any personal biases. Buy shares that are now available cheaper than their own normalized valuations. Sell stocks that look over extended. Over time you'll do much better than futilely trying to outguess market action (and with less mental anguish).

Here are two lists of some stocks. The first one details companies I see as bargains. The second grouping shows good-quality stocks that appear to be priced at unsustainable valuations.

The next list is of well-run companies that now sell at historically unsustainable levels. I'd expect these stocks to underperform the market over the next few years even if the underlying businesses continue to perform well.

The only selection from the second group with a decent distribution rate is MMP. Their 4.17% rate looks good only by ZIRP standards. Magellan Midstream Partners is a Master Limited Partnership that averaged a 6.68% distribution rate from 2002 - 2011. That makes today's level 37.5% less than their prior decade's average percentage income rate.

Each of the stocks on the 'overpriced' list has been available at much better entry points on multiple occasions over the past five years. If you want to own them show some patience and you will likely get the chance to buy at much lower absolute and relative valuations.

Stop trying to predict the unpredictable. Buy stocks when they're on sale and sell when they're pricey. You will probably achieve better investment results while avoiding the frustration involved in trying to guess not only future headlines but the market's often counter-intuitive reaction to them.

Disclosure: I am long COH, CMI, DE, DOV, ESRX, MOS, ORCL, POT, SCHW, SPLS, TMO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.