MDCigan

Why U.S. Stocks Can Move Higher in 2007 - Part I

Jeff,

Thanks for your response. You say, "For the moment, let's just consider this idea. Either stocks were really overpriced in 2002, even after the bubble-bursting decline, or they are underpriced now."

This is an interesting point, and I think a useful way to view the question. Let's go with this. From the S&P 500 peak in 2000 to the trough in 2002, there was a decline of approximately 50%. Now, I think the gut level reaction would be of course stocks weren't overpriced in 2002. But maybe not so fast.

I'll go out on a limb here, and assume you would agree the 2000 peak level truly was an outrageous bubble valuation. Off the top of my head, I think the S&P 500 peaked at around 30-32x earnings. That was substantially higher than any other previous market peak. Off the top of my head, I think the 1929 peak was around 20x earnings and the 1972 peak was also around 20x earnings. Now let's compare the magnitude of the subsequent bear markets. The 1929-1932 bear market was an 85% decline I think while the 1973-1974 bear market was a 50% decline. So the 2000-2002 bear market was much less than the 1929-1932 drop and equal to the 1973-1974 drop despite starting from a valuation level almost 50% higher. Perhaps the 2002 trough didn't leave the S&P 500 underpriced at all, but at a valuation level that already anticipated and discounted a future profit recovery?

I completely agree with your point that future earnings are more important then trailing earnings in valuation. But the problem is we don't know future earnings, but we do know trailing earnings. And at least historically over the very long-term we know earnings for the overall market grows at around 6-7% a year when you look at the overall business cycle and not just the expansion part. If the S&P 500 can grow earnings at 10%+ for another 5 years, then absolutely it is undervalued here. But that is the million dollar question! And after the magnitude of the earnings growth over the past 5 years, there is absolutely no historical precedent for another 5 years of 10%+. At least historically earnings growth reverts. Maybe this time is different. Globalization, outsourcing labor, etc. But if the S&P 500 only grows earnings at 2-5% CAGR over the next 5 years, this market is substantially overvalued.

Geoff Gannon has written a bunch of very interesting articles posted here on valuation. Here is one link:

usmarket.seekingalpha....

Why U.S. Stocks Can Move Higher in 2007 - Part I

Interesting article, and certainly food for thought. In your summary section, you list some "bogusss" arguments without refuting them. Simply listing them doesn't make them invalid. FWIW, I think I know who you are taking a shot at with some of those (peak earnings and earnings mean reversion). Suffice it to say, I've found the arguments for those particular items compelling and supported by the historical data.

I think somewhere else you made the point that a good model has to be both descriptive and prescriptive. Otherwise, what's the point? Far too many strategists offer opinions based on notions/models that may have zero support in the historical data. One thing I think is important to note is to distinguish the ***TIME FRAME*** of the model.

You say "It is our conclusion that stocks can move much higher during 2007." It is a COMPLETELY DIFFERENT FORECAST to say what stocks may do over a 1-year time frame versus what the likely 5-10 year returns might be. If you carefully read the research which uses the concepts of peak earnings, earnings mean reversion, peak P/E ratios, you will note the conclusions refer to the probable 5-10 year returns and not what the market may or may not do in a single year.

Just use 1998-present as an example. There have been a couple of really good years, 1998,1999, 2003, 2006. Yet the cumulative return over the entire time frame for the S&P 500 has been pretty poor. One was better off in T-bills. I am somewhat skeptical of models that try to forecast 1-year returns for the market. From year to year, the market probably trades more on technicals and sentiment then anything else, and fundamental valuation asserts itself over long time frames such as 5-10 years (voting machine in the short-term and weighing machine in the long-term). 2007 may very well be a strong up-year for the S&P 500 with the cumulative 5-10 year forward return being mediocre to poor.

"Some assert that the market has gotten ahead of fundamentals, since stocks have advanced more than recent earnings growth. These analysts are focused on what we call "local efficiency." They are assuming that last year's pricing was an accurate valuation.

In fact, stocks have lagged during a multi-year period where profits grew at double-digit rates.

There is a lot of catching up to do."

This is certainly possible, but it seems to me what could just as easily argue that stocks began this multi-year profit run at more expensive valuation levels then at previous troughs in the business cycle and therefore it is no surprise stock prices have lagged profit growth. Perhaps, there is not catching up to do, but just further multiple contraction. Exactly what time frame is it that the stock market gains should exactly match profit growth?

"Our own preview of 2007 informed investors that market valuations were low when one took the current low interest rates into consideration. Those who ignore interest rates in their analysis of fundamentals are adopting a method that we find distinctly inferior."

I struggle with this one myself. I think strong theoretical arguments can be made both ways for including and ignoring interest rates. The question has to be asked though why didn't low interest rates matter in the 40s, 50s, or much of the 60s in terms of higher P/E ratios. What data from what time period are you going to include in building your model? And if you are going to ignore certain time periods, then why? And where to do you draw the line? 10 years, 20 years, 50 years, 100 years?

I look forward to any additional articles from you. I am not dogmatic, or a perma-bear, and would love to see a persuasive case supported by the data to be very bullish over the next 5-10 years and not just for a single year. But I think you are going to have to carefully examine and refute some of the arguments you list as bogusss.