January 31, 2008

Markets Risk Pricing

The market has returned 5% since it reached its lowest point in a year. So far the S&P is down 13% from its peak; hardly anything to worry about. As an investor I do not want over exuberance and I want the markets to be pessimist about events so I can find deals and discounts on businesses.

The markets is staring at a lot of negative events and it rallies 5%. That does not give me comfort. Let me recount the negatives:
  • The economy is slowing down and possibly will go into a rescission.
  • Banks have written down more than $150 Billion in assets and the meter keep running as they are faced with more uncertainties from CDO and CDS exposure.
  • Housing market is a rescission and have a huge oversupply of inventory that it is estimated to take 2 years to clear.
  • The consumer is leveraged to the tilt and just lost its ATM machine in home equity.
  • The cost of food and energy are running high further depression the baility of consumer to spend.
In face of all of this the market and banks, in particular, are rallying, which gives the impression that markets are not discounting the risk appropriately. Although I have been buying banks lately, the rally is way too soon in this group.

Even with the market down some 13% from its peak, I would not consider it cheap here. I consider some groups cheap and worth a look, but not the overall market. If you consider its PE ratio historically it is very high. Take a look at PE graph where it plots the PE ratio of the S&P, ratio is adjusted to consider the average 10 years earnings. The PE is adjusted so we abstract from the economic cycle by using
average earnings, which should cover a period of not less than five years, and preferably seven to ten years
, as Graham and Dodd used it.

The chart reveals that US equities couldn't be called cheap. In fact US equities are currently about as expensive as they have been anytime since 1929 (excluding the dotcom mania).

High valuation and rallying in face of uncertainty, gives time to pause and reconsider committing to much new money to positions. I want to buy when people are selling rather than buying.


John said...

Great post

An additional data point may be to consider PE vs. interest rate.

My point - If the interest rate is very low then lower earnings (translated into lower dividend yields) may still be desirable to investors looking for return.

Arguing against my point of view this is the Japanese situation where everything (earnings, dividends, interest) all go to zip together

Sami said...

Thanks John,

I agree with you.

Japan was slow to react and do anything to its economy once its assets bubble burst but the US seems much more proactive cutting interest rates more aggressively to avoid deflation, which is much more worse outcome than inflation by any measure.