October 18, 2008

Is the market under valued? yes but....

It is time to value this market and look at real adjusted Price/ Earnings ratio (PE). As discussed before I use this ratio to determine if the market is fairly value or not. The ratio adjusts for inflation by calculating real earnings and real prices by adjusting them to the CPI index, as published by the government. The ratio also adjusts for economic cycles by averaging the last 10 years of earnings. This way it adjusts for abnormal economic activities, whether it is a peak or trough. Whenever I refer to PE ratio in this post, I reference the real-adjusted PE ratio.

There are good news and bad news. The good news is the market is trading under its long term PE average. The bad news is markets always have to overshoot the average on the downside. Look at chart attached.

The long term adjusted PE ratio is 17 and we are trading at an adjusted PE of 15. Real earnings have grown by 15% from the burst of the tech bubble in April 2001, while real prices have declined by 42% in the same period. Also real dividends have increased by 47% over the same period. Off course the market was over valued at that point with an adjusted PE ratio of 34x and as a result the PE ratio have contracted by 56%.

The decline in equity prices have made valuation look attractive. The contraction in prices and PE ratios have outpaced the real increase in earning and dividends. This makes the market attractive for meaningful equity investment.

However, there were no significant bull market in history that began with a double digit adjusted PE ratio. The bull market of 1880s, 1920s, 1950s and 1980-1990s all have started with an adjusted PE in single digits. The bull market of the 1920s started with PE ratio of 5x and ended at 35. The bull market of the 1980-1990s began its run with an adjusted PE ratio of 8.7x and ended with a staggering ratio of 45x.

So until we get to an adjusted PE ratio of under 10x do not buy all at once. Pace your purchases. And because I do not want to time the market I will buy some at the present, which I did by taking advantage of these prices, and allocate funds for later time if markets decline further. At this pace of decline we will get there very quickly.

Economic headlines are always bad and factor in worst case scenarios entering a recession. There is nothing new in this recession that will make it any different from the others. It may be longer but there is no question that businesses will adjust and grow their earnings. As a result investors who buy at attractive valuation will make good returns in the long run.

7 comments:

MG (moneygardener) said...

Very interesting post.

John said...

Great post

I can not read the chart. What market is your PE ratio talking about? S&P, TSE? Other?

At 10 X what would the market index in points be?

Sami said...

Thanks.

I am talking about the S&P 500. and if the earnings stay around these levels, a PE of 10x would mean the S&P at 600 points. Another 30% to the downside.

John said...

Thank you

I have started to buy, but it may be probable that the S&P at 600 could be my future

Since there is about 55 trillion in credit default swaps still to burst anything is possible.

Sami said...

yes there are still certain risks in the economy like housing situation, but like you just did I am starting to buy as I do not want to predict these things.

Living Off Dividends & Passive Income said...

i just read somewhere that the market is still overvalued. there was some other metric but i can't remember what it was.

i need to find that post.

Sami said...

Living off dividends,

sure valuation is not a science and I would not consider it art either, art should be beautiful and pretty to look at, what is pretty in looking at bunch of charts and figures :)

my point is each have a method while they may vary but the measurement is consistent. like a broken scale that adds 10 pds if you use it all the time then scale serves its purpose in monitoring your weight fluctuation.

There is no absolute right value figure, but this how I look at things and if I keep the same measurement in the long run these small error variation would not matter.