February 4, 2008

Tops ...bottoms...and valleys!!!

Many experts are talking about how market has bottomed because the credit crisis has stabilized and such. Well such calls are extremely dangerous to your potential returns as it leads you to make decisions for all the wrong reasons. You should tune-out anyone who foresees market directions. period.

What you should do is look at the market from a valuation perspective. And the only relevant question is: Is the market over or under valued at the present?

I have talked about this in a previous post that the market sans some groups are not undervalued by any means. A superficial look at the current market Price Earnings ratio (PE) may lead you to believe that the market is actually undervalued or cheap but you should look a bit deeper.

The nominal PE for the S&P is around 17 x TTM earnings, which is close to its long term average of 15x (average monthly PE since January 1871). Also the current ratio has declined from a recent high of 19.5 in September 2007. However the stock market is fairly expensive one Q4 earnings are factored in.

Q4 earnings have declined a whopping 19.3%; a pro forma PE is around 22 at the current market level. However this measure is also misleading.

A look at the inflation adjusted and 10 year average earnings PE tell another story. The real-adjusted PE stands at 28 x earnings well above its long term average of 17. See graph for the difference between nominal and adjusted PE over time. The adjustment is necessary to normalize the effect of economic cycle on earnings as the cyclical affect of economic expansion can distort the ratio.

The current market although declined by about 13% is nowhere close to being cheap. However it can become cheap by either:
1. A huge decline in prices o offset the decline in earnings, or
2. Side way movement while earnings go up once the economy grows, and this will happen very quickly in a growing economy.
Either way there has to b an adjustment and an alignment to long term averages. I am hoping for the real-adjusted PE to come under its long term average before I buy more. Therefore I am hoping for one of these scenarios to happen to buy more and redeploy my fixed income part of the portfolio.


John said...

Great post as usual.

In this case the only positive I can see is interest rates at 2 to 3%%.

The logic is that if interest rates are 2% then dividends from banks at 3% (proportional to the high PE) will still attract investors “looking for yield”

If interest rates go up again then poof – your scenario of a quick and brutal correction will happen.

Till then – we chop sideways

Sami said...

Thanks John

either way there has to be repricing and contraction of PE. I will take it either way, as it great environment to invest.