Sunday, November 2, 2008

Are US Stocks Cheap or Expensive?

As with every major rebound in price during a bear market, we constantly hear from numerous media sources that we have reached bottom, and the new bull market has begun. I refer to these folks as the Pollyannish Pundits of Perpetual Prosperity. Generally, they had no idea that this was coming and still don't understand what is happening, yet our beloved mass media affords them ample airtime to mislead investors. Upon every bounce during 2008 we heard the same mantra of, "stocks are cheap."

But on this most recent, and much more violent move lower we are now starting to hear from another group of analysts who warn that the market will continue to drift lower and that investors should exercise caution. Let's call these folks the Nattering Nabobs of Neverending Negativity. They point to various economic leading indicators suggesting the economy is due to fall off a cliff and tell us "stocks are expensive."

Who do you believe? How can stocks be both cheap and expensive? Well, it depends on what metric you are using. If one was to use trailing earnings ratios, US stocks are trading at an exorbitant 25x earnings. These are based on the last quarter's earnings reports, which have been terrible to say the least.

But if I were to instead use forward projected earnings, the US stock market is trading at under 10x earnings. Where do those projected earnings come from you ask? They come from the leading analysts at top brokerage firms, banks, etc. These are supposedly the best business analysts in the country and have made a name for themselves by correctly predicting company earnings for decades. Unfortunately, these analysts have been a little unlucky in the last few quarters. They were projecting Q2 earnings to be higher by 25% and they finished lower by 25%. They had never missed by that much before. The same thing has happened for Q3. And Q4 earnings that started out as, again, 25% higher are now being slashed. But they are still expecting earnings growth of about 12%.

Keep in mind that these are year-over-year projections. When we're talking about Q4 earnings for 2008, we're comparing them to the already poor 2007 Q4 earnings. Q4 starts in October and ends in December. We'll start learning of those numbers in January. But in the meantime if estimates are cut, stock prices will fall to reflect the new earnings projections - which is what has been happening the last two quarters.

So what we have is an enormous gap between what we have already seen and what these high-paid analysts expect for the future. This is why the stock market seems to be trading with such unpredictable volatility. People have no idea who to believe. Projected earnings were a viable vehicle to value stocks for decades. Now they're essentially useless. But if we were to all of a sudden start valuing stocks based on their dismal performance this year, the market would probably fall by, uh, a lot.

I have seen estimates for 2009 S&P 500 earnings anywhere between $45 and $95. 2007 returned about $87.50. 2008 is now looking to be around $65-70. Just for fun, let's create a few possibilities.

2009 earnings:
$95x P/E ratio of 18 = S&P 1710 - This is what most analysts still expect
$75x P/E ratio of 15 = S&P 1125
$60x P/E ratio of 12 = S&P 720
$45x P/E ratio of 8 = S&P 360

Hopefully, this gives some perspective as to why stocks are so volatile lately. You can put me on the lower side of both earnings and P/E ratios, which is why I believe we will still see much lower prices in the years ahead.

But one never knows. Those Pollyannish Pundits of Perpetual Prosperity could be right. The credit crisis could blow over like a tropical storm and everything could be back to 'normal.' I'm looking at their recent track record, the current economic conditions, and the credit markets that will be effecting next year's business operations. I don't see a flying hope of them hitting their mark.

Investors should be very careful of any analyst's declaration of stocks being historically cheap or expensive. The situation is not nearly as black & white as they claim it to be.

1 comment:

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