Friday, January 9, 2009 0 comments ++[ CLICK TO COMMENT ]++

Is the market cheap based on short-term P/E?

I looked at the long-term (10 year) P/E in a post on Wednesday but how about the short-term? I don't think long-term investors should look at short-term metrics but that's not how the market behaves. The vast majority of investors in the market, including institutional investors who claim to invest for the long term, are short-term-oriented and generally look at earnings and hence valuations one year out. You can see this in observing how most sell-side Wall Street investment analysts generally only provide 1 year targets.

Well, others have done the homework so I'll refer you to a bearish post by Mike Shedlock, where he looks at earnings estimates. Here are some key excerpts, along with my thoughts:

Think the stock market is cheap? Let's do the math. The S&P closed at 910. If those earnings estimates hold, the effective PE is 21.53. The historical average PE is about 15. At a PE of 15 the S&P would drop to 634. That is a huge drop of 30% from today's closing price.

What happens if the stock market over shoots as it typically does in bear markets. Assume a PE of 12. At 12, one might expect to see the S&P at 507. That would be an even bigger decline of 44% from here.

I am of the opinion that the equity market as a whole is attractive but not cheap. The quoted words seem to be consistent with my view. The P/E has declined but it's not exceptionally cheap like the 1940's, 1974, or 1982.

A big risk, as Mike alludes to, is that the market can overshoot on the downside. In fact, it is almost a certainty that it will because of psychological reasons. Many who lost huge sums, especially baby boomers nearing retirement, will not invest in stocks for a while; those who have big losses will attempt to get out on any sizeable rally. The difficulty is predicting the size of the overshoot. It may overshoot by 10% or it may overshoot by 30%--hard to say.

Mike also questions whether earnings can rebound quickly, as they did in 2002:

Looking ahead to 2009, 2010, 2011 there is simply no driver for earnings like we saw in 2002. Enormous leverage, creative financing, and the housing bubble are all gone and are not coming back.

It will take a while before earnings start rising, hence driving the P/E ratio lower. If earnings come close to estimates and stay that way, the P/E ratio will hover around the not-exceptionally-cheap 15.

There are two reasons to be bearish on earnings.

One reason is the fact that corporate profits as a percent of GDP was very high in the last 5 years and this will revert. As Jeremy Grantham as claimed, if corporate profits don't exhibit cyclical patterns, capitalism is broken. So, either capitalism is broken (hope not!) or profits will decline (this may mean that profits stay flat while the economy grows.)

The other concern has to do with commodity businesses. Commodity businesses, particularly the energy sector, has been a huge contributor to the S&P 500 earnings in the last 5 years. It is one of the sectors that consistently increased earnings. If the commodities bubble has exploded, as I think it has, it is likely that earnings from energy, as well as the materials sector, will decline or stay flat. This has the potential to take the wind out of the S&P 500 earnings. Without earnings growth from energy, we need some other sector, such as consumer discretionary or technology picking up the slack. I suspect very few, including me, expect other sectors to post earnings growth in a weakening economy (the only exception would be financials, which will likely show earnings growth due to horrible numbers over the last two years.)

As I keep repeating, if you are a stockpicker I don't think these macro views are that important so it shouldn't prevent one from buying stocks right now. However, if you are macro-inclined, or do not pick individual stocks, caution is warranted.

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