Why I'm Not 100% Convinced That We've Entered A Bear Market

by: KCInvestor

Historically speaking, U.S stocks are cheap on a P/E and P/B basis. Global stocks are not, by any means. China and India are the worst on a valuation basis, trading at nearly two times 10-year historical P/E and P/B ratios. The U.S, meanwhile, is trading at a discount to its 10-year historical P/E and P/B ratios. The chart below is an interesting slide from the Morgan Stanley report I spoke about previously. The only markets that are trading at a discount to their 10-year historical P/B ratios are the U.S, the S&P 500 index, the MSCI Europe Index, and Japan. It looks a little better on a P/E basis, where all North America and Developed Non-U.S markets are still at a discount to 10-year historical P/E ratios. All emerging markets are still at a premium.

I guess one reason for this may be because the U.S had its run during the dot com era when prices were inflated, which would have bumped that 10-year historical ratio up. Nevertheless, we've still been in about a 4-year bull market, regaining almost all of the losses from the 2000-2003 era. Going out further, we've really been in about a 20-year bull market. Or, maybe all of the historical P/E and P/B ratios are inflated a bit, and have been for some time? If that is the case, then bear market here we come. I don't know...I just don't see how it can go up in a straight line forever -- look at an 80-year chart and you'll see that it doesn't; between 1965 and 1985 it was pretty flat --- with an 80-year time horizon, sure, you'll be fine. But over the next decade, it certainly is not as clear. I truly could see a major correction coming in the next 3 years -- I'm not talking the apocalypse, but something major --- and I imagine it will be a slow, painful death as opposed to a panic sell-off -- or maybe just a flat market...better than a crash, but who wants to earn 0% for three years?

What does this mean? Well, I would speculate (as Morgan Stanley does, so it's not really an original idea), that we will see a pullback, possibly a significant one, in the emerging markets in 2008. China and India would be the most susceptible to profit taking. People have been speculating about the China bubble bursting for a while, so it's not really any big revelation, but this is some of the best actual data that I've personally seen that supports this thesis.

On that same note, it's no news that U.S stocks are cheap; I've heard it in the media quite often. So this is my main concern -- low historical valuations in the U.S may provide some support to the equity markets, which would offset some or most of the negative effects of a recession (to what degree is unknown, but it sure seems like there will at least be a mild recession in 2008). Or, maybe it shouldn't be called a recession as growth and inflation seem to be just fine in general (at least for now)...how about a continued and severe correction in the housing/credit markets? This is my main concern about becoming a full-fledged bear at this point --- U.S valuations may keep them from falling too much further and may, in the end, offer a great opportunity for buying. When it's this close and extremely tough to call or place any major bet, I still think that the best strategy is to just stay long and pick your opportunities wisely (on strength) as to when to add some short exposure. I think that now is still a good time to keep some shorts in the portfolio, despite the Santa Claus rally. Technically, we're up against resistance and still not too far off all-time highs.

The below chart is hard to read, so I've computed the various ratios below that normalize all of this data. Data is current as of November 30th, 2007 and courtesy of Morgan Stanley. The ratios are calculated as current P/E or P/B values divided by 10-year average P/E and P/B ratio.

(To oversimplify it, a value of 1 would mean the market is trading near its 10-year historical value, less than one under its 10 year value...you get the point)

P/E, P/B

  • US: 0.71, 0.81
  • S&P: 0.66, 0.92
  • China: 1.72, 2.42
  • India: 1.71, 1.78
  • Brazil: 1.42, 2.06
  • Russia: 1.19, 1.60
  • MSCI EM Index: 1.06, 1.55

Russia looks the best on a valuation basis out of all of the BRIC countries, and Korea and Mexico aren't in too bad of shape either.

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