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Since We've Got Some Time On Our Hands...

Daily State of the Markets
Tuesday, November 6, 2012

Good morning. Well the day is finally upon us. The day that for anyone who watches television couldn't come soon enough. The day that purportedly will make all the difference to the economy, to the future of the country, and to the stock market. Yep, it's Election Day and I trust that each and every one of you will take a few minutes out of your daily routine to go vote your conscience on who will best lead the country for the next four years.

With the stock market having gone largely sideways for the past two weeks, it is safe to say that traders have been waiting on this day. And since you can and probably have read just about any opinion you'd like to find on the election and how the outcome will affect the stock market, the bond market, the Federal Reserve, etc., I assume you don't need another crystal ball prognostication relating to how the voting is going to turn out or the election's impact on stocks, sectors, etc.

So, since we've got some time on our hands before we find out who will reside in the White House through 2016, I thought we should do something constructive this morning and take a good, hard look at stock market valuations.

Generally speaking, if you want to start an argument among money managers, just bring up the issue of valuations. For example, I know of one professional investor who believes whole heartedly that stocks are dramatically overvalued at the present time. And yet at the same time, another colleague suggests that stocks are cheap. So before I proceed, let's take a little poll by asking yourself: Are stocks overvalued, undervalued or somewhere in between?

Personally, I prefer to stay opinion agnostic on such issues. I tend to look at a host of indicators in an effort to come up with a weight-of-the-evidence view, which is what I intend on doing with the remainder of my allotted pixels in this morning's meandering market missive. So without further ado, let's get to it.

The granddaddy of all valuation indicators is the Price-to-Earnings ratio, perhaps better knows as the P/E ratio. The concept here is simple enough. In order to get the ratio, you divide the price of an index by the sum of the companies' earnings and boom - you've got your ratio. Then plot the results on a graph and see where you are now relative to history.

Unfortunately though, things are never simple in this business. While the "P" is easy enough to come up with for just about any index (we'll be looking at the S&P 500 this morning), the "E" is another story entirely as companies play all kinds of reindeer games with their earnings these days. So, in effort to get to "the truth" we look at P/E ratios several different ways. The first of which uses perhaps the purest form of "E" - GAAP (Generally Accepted Accounting Principles) Earnings. This removes all the crip-crap and levels the accounting playing field for all companies. As of the end of October, the S&P 500 GAAP P/E Ratio stands at 16.02.

So, where does this put us in relation to historical values? Cutting to the chase, the current GAAP P/E is just a smidge under the average seen over the last 87 years of 16.97. Thus, one could argue that stocks are either fairly- or modestly under-valued at the present time.

However, one thing that is important to recognize about valuation indicators is that the range of high to low tends to shift over time. For example, over the past 50 years, the average GAAP P/E has been 19.20. And over the last 25 years, that average swells to 24.7 due to the spikes in P/E ratios seen in 2003 and 2009 (remember the "E" in the P/E ratio tends to tank when a bear market occurs and/or the economy goes into recession, causing the P/E ratio to soar - this despite falling prices). Thus, the bulls will argue that P/E's are really cheap right now relative to the past 25 years and are modestly undervalued when looking back 50 years.

Another way to try and get to "the truth" about P/E valuations is to use a "Median" P/E ratio. This approach tosses out the outliers and, in theory, should give you a more realistic view. As of the end of October, the Median P/E for the S&P 500 was 17.6. While this is indeed higher than the GAAP number, it too is currently hovering around the norm for the past 50 years.

Since 1964, the median of the Median P/E has been approximately 16.5. So, given that the Median P/E in 2009 was above 22 and that it was above 32 in 2003 and over 27 in 1999, one could argue that a reading of 17.6 isn't bad. In fact, based on the median reading of the past 50 years, I'll call this a neutral or fair value reading. However (you knew that was coming, right?), up until the mid-1990's, the highest reading on record was right at 20. And then from 1964 through 1973, the highest reading was more like 18. So again, valuation assessments lie in the eyes of the beholder.

There is a bunch more data where that came from and since we'll likely have some more time on our hands tomorrow morning, I'll pick this up where we left off on Wednesday. At which time, we will review, Price-to-Book valuation, Price-to-Dividends, P/E's relative to inflation, and we'll even go global. But for now, let's call the P/E's "fairly valued." And with that question answered, let's all take a moment to step away from the computer screens and get out there and vote!

Turning to this morning... The news flow has been light in the overnight markets as all eyes are on the U.S. election. Asian markets were a bit lower overnight while European bourses and U.S. futures are modestly higher in the early going.

On the Economic front... We will get the Labor Department's JOLTS (Job Opportunities and Labor Turnover) this morning.

Thought for the day... Always give without remembering & always receive without forgetting. -Brian Tracy

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

  • Major Foreign Markets:
    • Shanghai: -0.14%
    • Hong Kong: -0.48%
    • Japan: -0.49%
    • France: -0.99%
    • Germany: -0.62%
    • Italy: -1.53%
    • Spain: -1.82%
    • London: -0.64%
  • Crude Oil Futures: -$0.02 to $84.84
  • Gold: +$5.60 to $1680.80
  • Dollar: higher against the yen, euro, and pound
  • 10-Year Bond Yield: Currently trading at 1.690%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: -4.35
    • Dow Jones Industrial Average: -32
    • NASDAQ Composite: -9.58

Positions in stocks mentioned: none

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