Are Stocks Fairly Valued?

This is an update to a post on PE ratios. Last year we had for the first time the earnings of the S&P go negative, which drove the PE ratio to absurd levels, as you can see from this chart by Hans Wagner. 

 

As we got the final results in from Q4, we have an overall $51.15 per share for the trailing twelve months, putting the current PE at 23. Future projected earnings across the S&P are:

2010: $75 (BofA) and $76-79 (GS)
2011: $85 (BofA) and $90-95 (GS)
2012: $90 (BofA)

 

Hans discusses past behavior after a recession, and finds that PEs tend to drift down towards 15 as an economy normalizes. If the PE drops into a normal range of 15, as is shown in his first chart, the 2010 projections would target a year-end S&P at 1200, essentially flat for the rest of the year.  He sees the trailing EPS rising to just under $60 after Q1, putting a fair value at Sp1200 if we drift down to a 20 PE, but at a bullish 1350 if we remain around 22-23 PE.  Given the drift downward of PE from 23 to 20 and then to 15, he projects a range of 900-1250 through the end of the year. This is not far off my January predictions for a rolling market in 2010, not a break below the Mar09 lows nor a rise to new highs.

Barron's roundtable on this topic in January focused on the economy. It is well worth the read. The closest analogy discussed is Japan, which bodes poorly for the US. The biggest wildcard is whether we recover in the 4-4.5% GDP range, which should enable the Fed to completely end QE and other stimulative measures. Overall the group was gloomy, pinning their minimal optimism on a liquidity-driven market, and expecting the Fed to continue easy credit. At best their S&P range was 1250-1300 at the end of the year.

The NYT also ran a piece on fair value, and expressed the concern that interest rates are rising, putting a damper on the Fed's easy money policy. More on that topic in this post: Did ObamaCare Spook the Bond Market? The WSJ weighed in on this topic, suggesting first that a massive increase incorporate debt offerings may have pushed the swap rates with 10-yr Treasuries to negative, and second that funds were caught off guard by the negative rates, and dumped Treasuries, making last week's debt offerings unusually weak. In other words, the weakness might be a blip.

Barry Ritzholz asks rhetorically, when was the market last under-valued? He is of the camp that since the Greenspan Put after the 1987 crash, stocks have floated at much higher PE levels than in the past. We dipped briefly back into an historical level last year at the Ma09 low, then have popped back up to bubblicious levels again.

Barry may not realize he is making the opposite point of his post: that as long as the Fed's extraordinary easy credit continues, stocks will float at ahistorical PE levels, rather than drift down. Thus the bond market holds the key to stocks: if long rates drift up despite the Fed's best efforts to hold them do this is the warning signal that the excessive easing is losing its grip.

Comments

[jeff clark]

ALL ABOARD !

April Fool's Day Market Swoon

Leaving the Station Tomorrow Morning.

Jeff Clark

[Wakeupsid]

yelnick lost his mojo, now making April jokes

Yikesj

[nspolar]

Have we just witnessed a major change in trend?

Stay tuned.

I am going to wait a bit for confirmation, if it comes I will show the blog some very interesting charts, to illustrate various points we (I) have been discussing.

No sense in putting em out there until we get true confirmation ... watch the dollar, gold and oil my friends, in no particular order.

I also though the headline today was very interesting.

"Obama clears way for oil drilling off US coasts"

Drill baby drill. Drill yer hearts out.

Environmentalists ... eat your hearts out and cry yerself to sleep. Think yer going to lose this round, and I think we may be entering a period of major exploration investment in the good ole US of A. There is more oil here, lots of it, and as we already know scads of NG (there are BTU's there too).

Why might this be? One reason is all the 3rd world countries (and Chavez) are decreasing the profitability to work internationally. Big oil has its limits, in regard to how little they are willing to take. They are the best capitalists in the world. My opinion of course.

ns

[yelnick]

nspolar, be wary of the oil change. Obama may be misdirecting - he might shortly announce that the EPA CO2 regs will go forward, strangling the private economy. And the oil drilling release may get tied up for years.

[yelnick]

wakeup, that comes tomorrow! now I have to figure out what it is ....

[Mr. Panic]

I don't believe the PE ratios so I don't even bother worrying about them particularly in an economic environment like this where the economy is making a "statistical" recovery rather than a genuine one. The recent news of the Lehman Bros. accounting scandal only confirms this. I'd rather look at price to dividend ratio to judge value and this metric hasn't worked since about 1990 so I would have to agree with Barry Ritholz's take. When I started following the markets in 1994, the dividend yield for the SP was lower than at the 1929 high and that was basically the low before the big parabolic rise. SP 470, the 1994 level is basically my first target for a low one reason being that was the final year of 1990-1994 recession/ real estate depression (in CA) and I don't see why an even greater real estate wipeout won't take the markets back to those levels.

As for Obama's energy policy, I wouldn't put too much faith in it. He isn't opening up Alaska for drilling is he? The Bakken area in Montana and the Dakotas has a greater amount of oil than Saudi Arabia and I am pretty sure they want to prevent anymore drilling there which is what XOM's purchase of XTO was designed to do.

I think the VC firms are behind Obama(similar to the Clinton years) and they have been incubating many alternative energy firms that they would like to float during an energy bubble. But I don't think an energy bubble starts until 2011 at the earliest after the stock market wipeout.

[JT]

Mr. Panic,

I've got to hand it to you . . . you sound an awful lot like a DINOSAUR given your inability to change and adjust your methodology that you apply to evaluating the equity markets.

You'd rather stubbornly look at a valuation metric such as price to dividend ratio, even though (admittedly) it hasn't shown any predictive value since '94.

You also casually dismiss earnings because of an example that you present in regards to Banks and particularly Lehman Brothers, yet you conveniently ignore the earnings power generated by the energy sector, basic materials, defense, and technology.

You sound like the typical "perma-bear" that ONLY wants to see what they want to see.

Good luck with that!

[Mr. Panic]

Price dividend doesn't have any predictive value especially in a bubble but it is very good at indicating extreme overvaluation.
Classify me as a "perma-bear" all you want. I could care less. I am realist. I understand that it is abnormal for markets to levitate at these historical valuations especially in a tenuous economy. You must have seen the consumerpriceindexs??? link over at Danerics that shows the economy turning down in January. Maybe I should be like most and be "living in the moment" totally oblivious to historical reality.
By the way, Carl Futia must be a "permabear" too. I saw an article of his from January 2009 in which he was calling for a 3-5year bear market based on a George Lindsay model(his 20 year cycle model with 1987-1990 being the last comparable) with the first and third down legs interrupted by a "weak bull market rally" (his words) that would top in 2010. (he was thinking Nov 2008 was the first low) And a drop to a new low in 2012.
Anyway, any veteran knows earnings are great at the top. And then they begin to get discounted. Sort of like RIMM in afterhours today.

[JT]

Like I said before, you are not a TRADER.

You, like the "Daneric's" of the world are simply looking for data that agrees with your BIAS, rather than trading what you see in the market.

Simply put, you wouldn't last more than a week on a trading desk with the kind of biased methodology that you apply to the markets.

Moreover, it's pretty easy for you to make all sorts of "perma-bear" comments given that you have no "skin" in the game. I would suggest that your comments would be entirely different if you actually traded for a living.

Good Luck to You.

[Dave B.]

"Anyway, any veteran knows earnings are great at the top. And then they begin to get discounted. Sort of like RIMM in afterhours today." - Mr. Panic

You have no idea what you are talking about.

RIMM's Q4 earnings were not great. They "missed" on quarterly profit, revenue, and shipments. In fact, Goldman Sachs is so concerned about them losing marketshare in North America that they downgraded RIMM to a "SELL" today.

[DG]

Mr. Panic,

These guys claim to be TRADERS, yet, if you read their posts, they read as realistically as a letter to the Penthouse Forum. They never have losing trades and, indeed, their trades never even take any "heat". They'd have us believe that they enter each trade and it immediately becomes profitable and they exit at the exact right price to maximize profits.

I mean, how realistic is any of that?

"Dear Planet Yelnick,

I always thought the posts on your website about winning trades were fake, but listen to what happened to me the other day. I entered CLF at the exact bottom and rode that baby hard all the way to the highs of the day. That stock was like putty in my hands. She wanted to give it up to a trading stud like me, that's for sure. Well, after a while of giving that stock the business, I looked at Daneric's board and saw that a bunch of PERMA-BEAR NON-TRADERS had stopped posting and that Carl Futia, who, like me, actually trades for a living, had just exited his 2 point ES scalp trade, so I knew that was my cue to exit my longs. Man, what an experience. I just had to share it with you, TRADER TO TRADER.

All the best,
MichaelJTMarketmanDaveB"

What an f-ing joke.

[Mr. Panic]

Wags doesn't trade. Before he got booted from all the EW blogs, he basically responded to every "perma-bear post". He still monitors all of them. I don't how many traders have the time to do that.
Anyway, I don't claim to be a trader. I am setting up for the big move like Jesse Livermore would. I'll let all the so-called traders trade the squiggles. And it's BS if one is claiming to trade intra-day moves considering most of the days moves are made on opening gapups.
He must be getting desperate if he's finally responding to me.

[DG]

I am setting up for the big move like Jesse Livermore would.

Livermore is The Man.

[JT]

"Anyway, I don't claim to be a trader. I am setting up for the big move like Jesse Livermore would."

That's funny.
Good luck with that.