The big question: are stocks cheap or overvalued?
Well folks, I thought it might be a good time to sit down and take a look at the valuation of the S&P 500 and stocks in general.
The market has come a long way, which of course means that stocks aren't as cheap as they were. But its also fallen back a great deal in recent weeks with everything from the small and mid cap names that have led to rally to stalwarts like GS, AAPL, RIMM and more seeing corrections ranging from significant to severe.
Indeed, stocks seem cheaper now than they've been since August in alot of ways. Some names are getting hammered and sent back into the bargain bin, other names are lower despite fundamental improvements to their situation (good quarter, new financing, turned the corner, whatever). The market is having one of those panic-attack phases that it has had a couple of times since the March bottom. Earlier such phases include the day after april options day when my portfolio (in real life) fell 10% in a single day (soon to recover to new highs), a brief period in early may where a modest correction in the S&P concealed much broader profit taking in many stocks, and early July when stocks were outright cheap again and many names had seen 10, 20, 30, even 50% corrections from highs a month or two earlier. Early July had that "holy crap, bargains abound" feeling to it...
Today we don't really have that bargains abound thing going on, but a whole lot of stocks are well off their highs of the last 2-3 months... the correction in the S&P of 6-6.5% conceals much, much greater corrections in the broader markets and many individual names. So...
Are stocks cheap, or have the markets gone so far up that they are priced poorly and due for a huge correction? Do we have a stock market "bubble" or, 30% down from levels reached 10 years ago, are stocks still cheap?
First, I tacked this issue in June in these blogs, you can look at that discussion here:
Second, the valuation numbers. I used the Zacks research wizard and calculated price/sales, price/book, price/cash flow, price/ebitda, and price/earnings in a couple of ways for the S&P 500. Here are the numbers:
price/sales: 1.15, median = 1.26
price/book: 2.0, median = 2.0
price/cash flow: 7.7, median = 7.9
price/ebitda: 6.9, median = 6.4
S&P 500 dividend yield: 2%ish
Historically, as you can see here,price/book has averaged 2.4 over the last 30+ years. So we are still a bit under that (we'd hit the average at roughly S&P 1200-1250). Also as that link discusses, R&D is not accounted for as "book value" and if it was we would have to discount price/book by an additional 10-15%. So the market is cheap by price/book, although perhaps not dramatically cheap.
We are far below historical dividend yields on the S&P 500. This is in part related to dramatic dividend cuts amid the panic and chaos last year (basically all banks, insurers slashed yield, which has a huge impact on the overall reading, and many cyclics and industrials did the same), it is in part related to the new-wave companies (tech and biotech) really not paying much or anything in the way of dividends but rather hoarding huge amounts of cash for future growth. Witness aapl, goog, etc. So ... comparing price/dividend with history is perhaps not the best way to look at this, but nonetheless it remains true that dividend yields today and in the last 10-15 years have been sub-par. That in and of itself is a very relevant point, perhaps... but perhaps one for another thread.
Price/sales. We're at or slightly below historical averages here. The Bara's link from the other thread is dead now, which is regrettable.
Price/cash flow. I don't have any historical data.
Zacks research wizard offers forward p/e's of roughly 15 by two measures (12 months forward and next fiscal year foward). These are reasonable valuations neither expensive or dramatically cheap. Earnings are greatly levered to economic activity... a sudden drop can causevast losses... and all of the cost-cutting actions that have taken place should lever companies to a period of unusually high margins should economic activity continue to rebound. There are additional quirks in GAAP earnings. If an insurer, like say XL or GNW or HIG or AIG, marks down investments in a portfolio they take a GAAP loss on the mark-to-market markdown. So if bond markets crash, insurers take GAAP losses. If those same bond markets recover one day (as has happened in 2009) they DO NOT make a GAAP profit, rather just book value marks back up. This permanently and artificially lowers earnings. Some losses at these insurers were real, many were not. however, GAAP earnings will be forever lowered by this oddity.
So from a strict valuations standpoint, excluding p/e's (to be discussed below), we're not remotely priced near "bubble" territory. That doesn't mean the market can't golower or anything like that, but average valuations would probably be seen around S&P 1200, a bit higher than here.
Now from a technical standpoint. Practicioners of TA ... don't hang me by my entrails here. This isn't an elaborate or in depth analysis, its a broad one. Its no elliott wave lets count the wave and make definitive declarations deal, its no oversold overbought deal, its the broadest most simplistic kind of TA.
Exhibit 1: the long term trend.
Stocks have had a remarkably constant trend for 200 years. In the US this is true even as we rose from an infant nation to preeminent world power. Its true in the UK even as they fell from preeminent world power to just another country, suffered through 2 world wars, and saw their currency fall from "reserve" status. And on and on.
We were below this trend in the 30's, above it in the 60s, below it in the 70s, above it in the late 90s (dramatically above it), we fell approximately to it in the 2002 bear market (below at times perhaps but only briefly), and we fell far below it in the crash last fall and early this year. We remain below it. By my guesstimations it points to roughly S&P 1200-1250. So exhibit 1 is bullish.
TA exhibit 2: where are we here? What have stocks done historically after 10 year bad periods?
We are 30+% down from where we were roughly 10 years ago on the S&P. We are 33% down from where we were 2 years ago. In the S&P 500 since 1950 we have seen a situation where stocks were down 30% in 10 years exactly once, at the 1974 bottoms. Lets face it that was a great entry point. They were down 33% in 2 years again, only in the 70s (since 1950). So looking at the S&P over the last 60 years, this technical indicator would imply that this is probably a pretty decent long term entry point.
Looking farther back, at the Dow today and since 1929... The dow isn't up in roughly 11 years. its down about 30% over 2 years. The last time that happened was the 1970s, again a very good long term entry point when viewed through thte lense of history. So exhibit 2 is bullish.
TA exhibit 3: Where are we here? part 2. We are up hugely, 50% off the lows. Lets take a look at where htat has put stocks historically.
From the 1974 bottom stocks rocketed up more than 50% from their bottoms only to sputter sideways to down for a couple of years. The recovery highs were reached 5-6 months after the big 1974 bottom... and ... from those rapid recovery highs there were no real gains for 6 years. Were the recovery highs of 1975 a good long trem entry point? Yes. Were they a good short termentry point? Terrible.
In early 2003 stocks began a quick move up so that the DJIA was up 33% by early 2004. It went much higher from there in time, but for the rest of 2004 and 2005 it sputtered largely sideways.
In 1933 stocks nearly doubled over several months from DJIA 50ish to over 100. From there they sputtered sideways for a year and a half before rocketing up to nrearly 200 by 1937.
Each of these historical precedents imply that we aren't likely to see any big upside from here after having this monster move up from the bottom. They do not imply that there won't be big upside at some future time or that we're destined to crash anew, but in general history seems to imply that the big fast money is made fairly quickly in recoveries from big crashes and once the first phase of the recovery is run out, the markets tend to consolidate for a time before resuming their march upward.
These 3 examples differ from the current situation in that stocks were cheaper in absolute terms then than they are now. They also differ (especially the 70s) in that interest rates on government bonds were far higher then than now, inflation was far higher, and so forth.
Will we go higher in 2009 or 2010 than the 1100 we saw thus far in 2009? No way to know, and I don't offer any predictions.
But based on the preponderance of the data i've dug up here, it looks like we are probably at a pretty good long term entry point still. Stocks aren't expensive, they are well down from previous highs, etc. But it may also be that the market won't move dramatically up after this monster move. Historically, monster moves off major bottoms have lasted less than a year and then spent a longer time consolidating.
Now, if that happens here again, and we don't move impressively up from here for a time, that doesn't mean that the market will crash. It may simply sputter sideways, frustrating both bears and bulls and momentum traders alike.