July 14, 2008

Value Managers performance is hurting

Value investment discipline has not been paying off lately. Most value managers are hurting in a big way. Bill Miller's fund is down almost 40% in one year; he has been the superstar manager to outperform the S&P for 15 straight years. Other managers are in the same boat with average returns surpassing the decline in the S&P. Even Buffet's Berkshire is down 20% from its peak. The market fall has been very swift. And I am afraid on a valuation basis we are still got ways to go.

To value the market I use real adjusted PE ratio, basically the average S&P earnings over the last 10 years adjusted for inflation rate to get real earnings.

The market's long term real-average PE is 17 time earnings; we need another 20% decline assuming no growth in earnings to get to that level, the market's current adjusted PE level is 21. But generally speaking markets need to correct even more to balance out and the more it overshoots to the upside the more it tends to correct to the downside. If you look to the PE chart you will see that every time the market has rallied the PE tends to decline well below the long term averages.

In the 1929 bubble the S&P reached its second highest real PE ratio the market corrected in a nasty and violent way all the way to around 5 times earnings. The highest PE ratio was reached in 2000, so we are still adjusting from that peak. The process may take longer than many anticipate. The market can behave in one of the following scenarios to get to attractive valuation:
  1. Moderate growth in earnings combined with another 20-30% decline in S&P. A highly probable scenario.
  2. Above average real growth in earnings with 10-20% decline in prices, which may be not very likely in the next few quarters given all the challenges the global economy faces.
  3. Earnings will violently decline with quick price drop in the S&P. Not very likely given the decent economic activity in the rest of the world and semi-decent US economic engine.
Now nothing will move in straight line there will be some rallies and some corrections. There will also be some attractive valued companies in depressed sectors like retail and consumer discretionary stocks that will make for good buys but I do not expect them to perform any time soon but I expect them to decline less than the rest of the market as they already are trading in single digit PEs.

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