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I've been down for so long, it feels like up to me



June 18, 2009 – Comments (21)

The other day I caught some flack from a few people for talking about the price to earnings ratio of the S&P 500.  Mock P/E all you want, and it certainly is not a perfect statistic, but many smart investors look at the P/E multiple of major indices to judge whether stocks in general are over or under valued.  John Hussman is one such Intelligent Investor to borrow a phrase from Ben Graham.

In his weekly letter to investors, The Outlook is Not Up, But Very Widely Sideways, Hussman states that the price-to-normalized earnings multiple of the S&P 500 at the market lows during the worst markets in recent history, 1974 and 1982, was around 7.  The S&P 500 would have to fall by 60% to match the most attractive bear market valuations that we have seen over the past four decades in what is arguably a worse recession than what we experienced during either of those periods.

If you don't like looking at price to earnings, how about price to book value?  The S&P 500 is currently trading at approximately 1.9 times book value.  At the market lows during 1974 and 1982 stocks fell to around 0.8 times book. 

Hussman doesn't believe that the market is going to completely implode, just that the current rally has gotten ahead of itself and it is fairly expensive at its current level. 

At the March lows, the S&P 500 was priced to deliver long-term returns in the 10-12% range.  Certainly not bad, but only modestly above the norm on a historical basis, in an economy that faced (and still threatens to suffer) difficulties well outside the norm. While that might have been the final low, and we can't rule out further market gains, I still believe that it is a mistake to rule out eventual “revulsion.” I don't think that we need to match valuations that existed at the 1974 or 1982 lows, but at a multiple of 16 times our current estimate for normalized earnings, suffice it to say that the market is not cheap.

What we've seen in recent weeks has been a recovery of between 25-33% of the losses that the market has suffered since its 2007 peak, putting the S&P 500 up about 6% year-to-date in total return, with the Dow up about 2%. While that sort of recovery, in this event, has implied a significant gain given the extent of the prior losses, the rebound relative to the loss is not unusual (though not easily predictable either, since such rebounds can abruptly fail early or late into the bounce). I continue to believe that it is a mistake to treat the recent advance as if it has significant information content about the economy. We are observing only smaller negatives (and even those may only be a reprieve based on a temporary lull in the mortgage reset schedule).

Until now, “less bad than expected” has been enough for investors. As a friend of mine quoted last week from a song by The Doors, “I've been down for so long, it feels like up to me.” At this point, however, stocks are priced to require an economic recovery. That is a difficult bet, in my view, because as I noted last week, economic expansions are emphatically not driven by a “consumer recovery.” They are invariably driven by swings in gross domestic investment – capital spending, autos, housing, factories, and other outlays that are heavily reliant on debt financing. That's why housing starts have such a strong correlation with GDP growth.

It is a very hard sell to expect a sustained recovery in debt-financed gross investment in an economy under strong deleveraging pressure. That's particularly true since the U.S. itself has not financed a penny of the growth in U.S. gross domestic investment in more than a decade – all of the growth has been financed by foreign capital inflows via a massive current account deficit. With government spending now drawing on those foreign savings to defend bank bondholders from losses, and a continuing need to shrink the current account deficit in the years ahead, gross domestic investment is likely to continue to be squeezed. We are in the midst of – and will continue to require – perhaps the largest adjustment in U.S. personal, corporate and government balance sheets that we will see in our lifetimes. This will be a very long slog. The outlook is not up, but very widely sideways.


21 Comments – Post Your Own

#1) On June 18, 2009 at 8:20 AM, portefeuille (98.32) wrote:

I found that Hussman article yesterday and thought about posting the link as a comment to your article but since I am one of the few people you "caught some flack from" "for talking about the price to earnings ratio of the S&P 500" I refrained from doing so. Another day, another "metric". The reason why P/E for an index does not mean that much


On June 16, 2009 at 11:29 AM, bigpeach (95.59) wrote:

I'd like to smack the person who first calculated the P/E of an index and pretended it was useful. It simply doesn't work well as a valuation metric. The market may need another source of fuel to continue rising, but the P/E of the S&P 500 isn't a supporting reason.

(see comment #7 here)


carries over to the P/B. Please have a look at comments #5,6,8 here.

Another aspect of P/B that should be mentioned:


More importantly, the book value of the S&P 500 is overstated relative to its lows in the early 1980s, as neither technology or biotechnology R&D spending (the biotechnology industry was not born until the late 1980s) is capitalized and treated as an asset on the balance sheet.  For example, Amgen and Genentech – two of the better performing stocks on the S&P 500 over the last 18 months, have P/B ratios of 2.42 and 5.49, respectively.  Even Microsoft, a mature cash cow in the software industry, has P/B ratio of 3.94.  Assuming (conservatively) that 15% of the S&P 500 are made up of such companies that did not exist in their current forms in the early 1980s, and assuming that the book value of such companies are understated by about 50%, the S&P 500's book value for 2008 is closer to around $638 a share.  On a R&D-adjusted basis, the P/B ratio for the S&P 500 is approximately 1.07, or its lowest level since the beginning of the greatest bull market in history in late 1982.  In addition, analysts are still projecting the S&P 500's earnings to be in the range of $35 to $50 a share this year, suggesting that the S&P 500's book value will continue to grow this year.  Based on the price-to-book ratio of the S&P 500, the core earnings power of the S&P 500's components, and the range of liquidity schemes implemented by the Federal Reserve and Bank of England, there is no doubt that stocks now present the greatest buying opportunity of our generation.


(from here, see comment #8 to that old post)

But again, as bigpeach pointed out in comment #12 here


Generally however, I don't have a problem with looking at P/E as one part of a valuation analysis for a single company. The point portefeuille and I have been making on this site is that applying the same thinking to an index doesn't work. A lot of people seem to be trying to do that these days even though the math doesn't work thanks to limited liability.

Frankly I don't understand why everyone wants to try to value "the market." Short of individually valuing every company and summing, I don't know how you would even do such a thing.


(emphasis (bold face) partly his, partly mine).



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#2) On June 18, 2009 at 8:22 AM, portefeuille (98.32) wrote:

carries over to the P/B.

carries over to the P/B case.

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#3) On June 18, 2009 at 8:38 AM, alstry (< 20) wrote:

Most of the E today comes from government can't compare today's E to yesteryears a result, after factoring in government spending and accounting nonsense.....most people couldn't distinguish an E from a Z.....which in this case stands for Zombulation!!!!!!

As far as book....we will save that for a different discussion as we don't need to get past E for  the moment.

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#4) On June 18, 2009 at 8:44 AM, portefeuille (98.32) wrote:

well, I am usually the first to comment to your posts because the majority of the U.S. guys is still asleep, but this "tmfdeej -> portefeuille -> alstry -> 'Ignore.'" order has become some sort of ritual. really strange!

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#5) On June 18, 2009 at 8:56 AM, alstry (< 20) wrote:

My suggestion is CAPs readers focus on Sales and NOT earnings....sales are much more difficult to manipulate...

From Winnebego:

Revenue plunged 64 percent to $50.8 million, as motor-home shipments fell 62 percent during the quarter.

Wall Street analysts surveyed by Thomson Reuters predicted a loss of 27 cents per share, on average.

Chief Executive Robert Olson said lack of access to credit "remains the biggest hurdle" for the industry. Motor-home sales, which are closely tied to consumer confidence, have been falling for more than a year as the recession drives consumers away from showrooms.

But Winnebago said it held up better than the competition during the quarter. During the first two months of its fiscal third quarter, industrywide motor-home sales fell a steeper 77 percent, the company said.

WHEN SALES ARE DOWN over 60 or 70%.......few are making a dime while "ignoring' the problem!!!!!!!!!!!!!!!!!!!!!!!!

EVEN IF YOU KEEP WATCHING T.V. to hide from realiity:)

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#6) On June 18, 2009 at 9:10 AM, JakilaTheHun (99.91) wrote:

Sales are difficult to manipulate?  That's not very accurate.

Cash flows are difficult to manipulate.  Sales are not that difficult to manipulate.  Most manipulation of earnings probably comes from manipulation of sales revenues.

Also, basing everything around sales has some huge problems.  For one, margins are more important than sales.  In fact, that's one reason using current earnings is flawed.  Companies will start finding ways to cut expenses as sales drop.  Over time, their earnings will increase some.  They might never return to 2006-7 levels, but they are not going to stay in the current depressed state either for many companies. 

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#7) On June 18, 2009 at 9:13 AM, JakilaTheHun (99.91) wrote:

As to the original blog, I do think P/B is a better measure for the market than P/E, but I also agree with portefeuille in that there are reasons that does not work well either. 

Basically, I agree with the premise that 'short of valuing every individual company in an index, there's no effective way to "value the market"'.  If I didn't have a job or a life and could find no better use of my time, maybe I would value the Dow 30 companies individual and compare it to the P/E and P/B of the market. 

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#8) On June 18, 2009 at 9:15 AM, portefeuille (98.32) wrote:

Cash flows are difficult to manipulate.  Sales are not that difficult to manipulate.  Most manipulation of earnings probably comes from manipulation of sales revenues.

-> Enron

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#9) On June 18, 2009 at 9:16 AM, alstry (< 20) wrote:

Jakila....maybe a better perspective would have been sales are more difficult to manipulate than earnings.....

For those who understand any given industry....most competent analysts can look at sales and cost structure and determine profitablilty with relative ease.

For example, I can walk into a restaurant, look at the menu, look at staffing, and if someone were to give me receipts and tell me the rent....within 5 minutes I could tell you if the store was profitable or not....simply because I have owned restaurants and know how to analyze them.....most experienced restauranteurs can do this with ease.

A lot of earnings these days are simply being recorded because companies are buying back their debt at a discount.  Could you imagine paying off one credit card at a discount by borrowing from another and telling your wife how much you "earned" this month as you sit in front of the T.V. and watch Pig Shows????

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#10) On June 18, 2009 at 9:21 AM, JakilaTheHun (99.91) wrote:

Btw, I'm not totally opposed to the use of P/Es.  I just think that 90%+ of investors who use them don't actually understand the logic behind the P/E ratio.

A P/E ratio is essentially a shortcut DCF analysis.  If you use about a 10% cost of capital and find a company that has no net assets, but has FCFs of $1 per share --- that would yield a valuation of around $14.  Obviously, this analysis is a "vacuum analysis" of sorts in that I'm not taking into account any external factors that would be issues in the real world, but that's the basic premise behind the DCF. 

You could do the same analysis with a 9% cost of capital and the valuation will be around $16.  An 11% COC makes it drop to about $12.35. 

Essentially, the P/E ratio works best when it's used with a company with relatively low net assets but high cash flows.  Think MSFT. 

If I have no access to a spreadsheet program or calculator, I will occasionally use Net Tangible Assets + (Earnings * 15) to try to get a ballpark valuation. 

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#11) On June 18, 2009 at 9:27 AM, alstry (< 20) wrote:




DETROIT -- They call this the Motor City, but you have to leave town to buy a Chrysler or a Jeep.

Borders Inc. was founded 40 miles away, but the only one of the chain's bookstores here closed this month. And Starbucks Corp., famous for saturating U.S. cities with its storefronts, has only four left in this city of 900,000 after closures last summer.

There was a time early in the decade when downtown Detroit was sprouting new cafes and shops, and residents began to nurture hopes of a rebound. But lately, they are finding it increasingly tough to buy groceries or get a cup of fresh-roast coffee as the 11th largest U.S. city struggles with the recession and the auto-industry crisis.

No national grocery chain operates a store here. A lack of outlets that sell fresh produce and meat has led the United Food and Commercial Workers union and a community group to think about building a grocery store of its own.

With an average home price around $6,000 and retailers exited out of town.....I guess the good news is that the pace of decline will likely slow as few remain and there is not much further to fall.......

When sales are DOWN much further can you go before you have NO sales!!!!!!


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#12) On June 18, 2009 at 9:31 AM, JakilaTheHun (99.91) wrote:


You have no clue what you are talking about.  "Earnings management" is very often a case of "Sales Revenue management".  Earnings are manipulated via this route more than any other route. 

What you likely do not understand is the accounting behind sales revenues.  AOL is a classic example of a company that was doing this.  They sent out those stupid AOL CDs to everyone in the mail.  For every person who took the free one-month trial, they decided to go ahead and book sales revenue.  Only problem being --- that some people cancelled.  AOL didn't bother to take this factor into account. 

It's much more difficult to manipulate cash flows.  Earnings and sales can be manipulated much more easily. 

Hell, the entire dot com boom was largely based on people believing that "sales" were the most important thing.  Earnings didn't matter.  Cash flows didn't matter.  People looked solely at sales.  It doesn't work. 

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#13) On June 18, 2009 at 9:39 AM, alstry (< 20) wrote:

I actually do....we are just living in different is easier to manage revenues in tech companies or manufacturing companies by pushing  sales back and  forth.....much harder in consumer direct like  grocery stores, restaurants and hotels.

I never raised the issue of cash flow because DCF analysis is a step beyond looking at a P/E ratio isn't it.  I have lititaged in court over DCF issues in corporate valuation....but this was a discussion at looking at a simple number in the paper....

Once you get to actually have to look under the hood and do some work.......and there have been cases where each side spent upwards of hundreds of thousands of dollars debating the issue.

In this situation we were keeping it pretty light.....and if I knew a companies sales were down 77%.....not much else matters....does it?????

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#14) On June 18, 2009 at 9:51 AM, portefeuille (98.32) wrote:

and if I knew a companies sales were down 77%.....not much else matters....does it?????

unless they switched to delivering (much) higher margin products/services.

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#15) On June 18, 2009 at 9:52 AM, JakilaTheHun (99.91) wrote:

Expenses.  Price of the stock.  Assets.  Liabilities.  DCF Valuations. 

If sales drop 50% and expenses drop 50%, how much do earnings drop?  It depends on expenses. 

I would "look under the hood" before doing a DCF.  I look at sales, expenses, allowances, margins, earnings, assets, liabilities, cash flows, and depreciation & amortization --- amongst other things. 


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#16) On June 18, 2009 at 10:24 AM, alstry (< 20) wrote:


You just can't drop expenses 50%......there are a significant number of costs that are fixed and can't be adjusted with a decline in sales....different industries different fixed costs...but every industry has significant fixed such as the millions necessary to remain public, rent, equipment and assets, interest for debt, key employees....etc...



give me a single public company that could sustain a sustained 77% drop in revenues  and run their  business profitably without destroying the infastructure of the company into something practically unrecognizable compared to prior to the restrcucturing.


Just wondering from the nature of both your responses...have either of you ever owned and run your own business?

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#17) On June 18, 2009 at 10:36 AM, portefeuille (98.32) wrote:

Just wondering from the nature of both your responses...have either of you ever owned and run your own business?

No, I am a proud theoretician! My point was just on the logic. It was not meant to be all that relevant. If you look at AAPL there is a lot of speculation on how they recognise revenue (-> iphone) and what would happen to sales, margins, earnings, cash flow if they would make changes to the price of their products (macbooks, ipods, introduction of a mac netbook, etc.) or the "distribution deals" for the iphone. So it is at least somewhat relevant, I hope.

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#18) On June 18, 2009 at 11:05 AM, JakilaTheHun (99.91) wrote:


I'm an Accountant. 

You are taking an analysis of one (hypothetical) company and extrapolating it to the entire economy.  Different companies have different cost structures.  Some companies have very high fixed costs.  Some companies have almost no fixed costs.  There are "avoidable fixed costs" and "unavoidable fixed costs."  The avoidable ones can often be eliminated in time. 

Many companies have hard assets that have value to them.  If a company has $10 per share of net tangible assets and low debt, do you value them at $1 because of their low sales? 

My basic point is that there are tons of factors one needs to analyze to do a realistic valuation.  Trying to analyze the entire market by declining sales is not very effective.  Sales are only meaningful when put into context. 

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#19) On June 18, 2009 at 11:08 AM, alstry (< 20) wrote:


Now I understand our fundemental difference....

In the legal order for something to be applied logically, it must be relevant before even being considered.

Under the rules of evidence, relevance is a threshold for consideration.


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#20) On June 18, 2009 at 11:11 AM, alstry (< 20) wrote:


Wasn't that my point as well....especially in DCF analysis???


See #12.

Once you get to actually have to look under the hood and do some work.......and there have been cases where each side spent upwards of hundreds of thousands of dollars debating the issue.

It looks like we are tracking...;)

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#21) On June 22, 2009 at 10:27 PM, AdirondackFund (< 20) wrote:

In any decline that I have ever seen, PE's go right out the window because they are rear view mirror perspectives.  Especially in a decline of this magnitude that we have experienced and the extent to which we have gone willy nilly  into hock to 'arrest' the decline.  Speaking of arrest....any chance some of our leaders might be hauled in for Consumer Fraud? 

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