Sunday, August 18, 2013

Are stocks reasonably priced or not?

A couple "bad" weeks for stocks and calls for the near-term end of the bull market are coming out of the woodwork in droves. As I've stressed in the last few audio commentaries, in my view we're overdue for a healthy pullback in stock prices---or, more specifically---that a pullback would be healthy at this juncture. While I make my position---that no one can time the market (least of all me)---abundantly clear, I forever look at the valuations of the stocks of companies that occupy the various sectors of the global economy and consider how the market looks (sector by sector) historically speaking, and make allocation recommendations accordingly. Now if I told you that from a simple price-to-earnings (p/e) standpoint, stocks (using the Dow Jones Industrial Average because that's what everyone's familiar with)---at 14ish times next year's projected earnings---are in no way historically expensive (particularly when inflation and interest rates are low*), would you view that as an excuse to load up, or, at a minimum, not profit-take if your strategy called for it? I sincerely hope not.

(*Note: During periods of low inflation (we can debate some other time whether inflation is as low as the reported data suggest), real returns are higher and thus investors tend to accept higher p/e ratios (that is, they're willing to pay up for stocks). Conversely, when inflation is higher, and real returns are lower, investors require higher gross returns and thus lower p/e ratios (cheaper stocks). Looking at it simply in the context of interest rates: low interest rates make fixed-income investments less competitive, thus supporting higher p/e multiples for stocks. Of course, as we've witnessed of late, the interest rate environment can change in a hurry.)

You see, stocks can appear reasonably valued (or not) by any number of metrics, all of which involve at least two main components. In the case of the p/e ratio, we have the price of a stock and the per share earnings of the company. I suggested that 14 is okay, 24, however, may not be---historically speaking. And of course it's a long way from 14 to 24. At 14 I could be bullish. At 24, 20 even, I might be bearish. So let's say that according to some historical chart pattern, the typical topping-out number---keeping it simple (not accounting for interest rates or earnings estimates), and purely hypothetical---is 20. In that case we'd still have monster upside, right? I mean going from a p/e of 14 all the way to 20 would take the Dow above 21,000. Well, yeah, but that assumes we'd get to 20 by way of rising share prices. We could also go from 14 to 20 via a 30% decline in earnings. In which case---to get back to a reasonably-priced level, say a 15 p/e---the Dow would need to drop to the mid 11,000s, or 25%. Uh oh!

So then---with the next year or so in view---are stocks presently cheap, reasonably priced, or expensive? I, alas, can't say. All I can say is that stocks are priced precisely where the world's shareholders determined they should be as of 4pm Eastern time last Friday. The question going forward is can companies, in the aggregate, continue to grow their earnings? As of 4pm Eastern time last Friday---as the Dow remained above 15,000---the world thought yes. The mere fact, however, that bear markets happen means that earnings don't always meet the world's expectations. And anyone who believes he can line up all the variables that would impact the world economy, and tell us what to expect, profoundly (and dangerously) overestimates his own talent---as I illustrated in Beware the King(s)

Now, if you're at all beginning to spin out over recent volatility and what the doomsayers are promising going forward, please read Stress Less...

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