Is the market cheap or expensive right now?

I'm not going to cop out and say it depends (though what methodology you use matters). I'm just going to come right out and say that it looks slightly undervalued overall.

This headline "S&P 500 Profits Cut First Time in Year by Analysts" should give some pause because I don't like it when earnings upgrades give way to downgrades while the market is struggling to make gains. That generally signals some warning signs. However, there is a fair amount of cushion regarding earnings estimates. The article states that S&P 500 earnings estimates were cut from $96 to $95 for the S&P 500. That's based on a "share" of the S&P 500 if you view the index level as a price. So then, the basic calculation is made with the S&P 500 trading at 1165 and earnings at $95 the S&P 500's PE ratio is a whopping 12.26x. Not exactly a historic high. As such, estimates could be cut a great deal and the market still would be in decent condition from a valuation perspective.

An annoying post from Mish's Global Economic Trend Analysis references the 1970s where, as market historians know, the stock market failed to advance throughout the decade. The S&P 500's PE ratio entered the decade at around 16x and left at under 7x, representing severe multiple contraction. However, if you look at long term interest rates, as we have in previous posts comparing the relative attractiveness of bonds to stocks, this makes sense. 10-year treasury rates rose from around 7% to as much as 12.75% by March of 1980 (the same month cited in that post) and then up to a high of over 15% by 1981. If you look at the comparative earnings yields and interest rates, you have stocks at 6% or so at the start of the decade with 7% on treasuries. In 1980 you have stocks at 14% (approximately) and bonds at nearly 13%. I rounded a fair amount here because I am feeling lazy, but the post I'm responding to was even lazier.

Currently, by the same comparison, stocks at a forward earnings yield of 8.15% (not the same comparison, but let's use it for now) and the ten year treasury is at 2.39%. Depending on your metric, you might use the ten year trailing PE ratio, which puts us at 21x earnings, or the one year trailing which seems to be more like 15x (depending on what is included in trailing earnings). In any case, unless interest rates start rising a great deal, which is highly unlikely, the outlook for stocks is fairly constructive at the moment.

Edit: I just remembered that we had an earlier discussion about whether or not the spread between earnings yield and interest rates is a good predictor of future returns. Generally it isn't, but the relevant comparison is whether or not it is useful for selecting between stocks and bonds which offers the best return and on that count it performs reasonably well.

Flat Footed?

Steve was kind enough to point out two opportunities in the footwear sector that opened up last week while I was in the midst of a particularly brutal week of 10 and 11 hour days. I've had the chance to take a look at them this weekend and today, and I wanted to chime in.

These are specifically Crocs (CROX) and Skechers (SKX). While Crocs has taken a more recent and dramatic hit, Skechers interests me because it is down so much over a protracted period of time and because of its PE ratio of... 7. Before continuing, here are the charts:

Under most circumstances I am usually leery of charts like Skechers'. What seems to have happened in this case is that there is a wicked case of multiple compression. Apparently, the sales forecasts for a particular shoe (I know nothing of fashion so I won't even try) the market had built into the price were a little too much and the growth rate has come into something more reasonable. To be perfectly honest, you don't need very much of a growth rate at all to justify a 7 PE.

In a market that is valuing a great many stocks at criminally cheap PEs, single digit PEs shouldn't draw so much attention, but for a clearly growing company this gives me pause. There have been fashion related stocks in the past that seem to be getting very cheap, but then they are doing so for a reason. Chicos FAS (CHS) dropped about 50% in 2006 from $40 to $20 and saw a multiple compression from 40x earnings to about 17x earnings, which was a little cheap compared to the market at the time and its growth rate still seemed alright. It's at $9 now and trading at 13.7x earnings. That being said, Skechers seems particularly attractive and could actually see earnings drop as much as 30% without becoming unattractive. It's not often you can say that about a company.

As for Crocs, I have to be honest that I never understood the trendiness of their products to begin with so when they nearly went under a year and a half ago I wasn't shocked. They've come back in nearly Ford-ian fashion, perhaps better, and I have to be honest that I don't fully understand whether or not they are back in style. Earnings have recovered notably and their forecast reduction really wasn't that bad. The stock price hit I think reflected that traders had been continuously hiking estimates and when Crocs simply brought them back down to a reasonable level the stock had to come in.

Between the two of them, a small position in Skechers makes the most sense to me, but I will confess ignorance of fashion trends and that can be more than enough to doom you in this sector.

Another View on Interest Rates and PE Ratios

In the interest of fairness, here is a view saying that comparing interest rates and PE ratios is a useless exercise: http://www.marketwatch.com/story/are-stocks-really-undervalued-2010-09-03?dist=beforebell

I have several issues with the way the study was conducted as it seems a painfully simply regression analysis for a firm that specializes in it. What I found in my own research was that periods of a big positive spread between earnings yield and interest rates correlated very highly with periods before a major bull market and the inverse was also true. There was one period where this relationship broke down badly which was the 1990s, but that was the only one I could find.

I will do my own regression along the lines of the way they designed it and try to figure out how they came up with what they did because my knowledge of the data does not seem to support the notion here. Now, they used real rates of return against nominal comparisons of PE ratios and interest rates, whereas I kept everything in nominal terms.

Dynamic Asset Allocation Model: August Update

I had hoped to do these on a more regular schedule, but life has not been particularly permitting on that front. In any case, the August Dynamic Asset Allocation Model suggests an 80% weighting for equities going forward. Of course, this is the same as it has been since pretty much the end of 2008 with a few small twinges back and forth here and there.

However, August did see some interesting movement in a couple of the indicators. The yield curve measure moved down as ten year rates have continued to come in. Corporate spreads also narrowed in August, suggesting looser credit conditions for corporations, which is bearish for the model due to the contrarian intention of the indicator. The overall model remains very bullish because the earnings yield metric is at levels similar to the early 1950s as well as the bottom in 1974, which is immensely bullish for stocks.

Still, this model was based on historical patterns and a deflationary environment would ruin some well established historical relationships on which investors have relied. Principally, in our discussions of PE ratios we talked about how PE ratios work because there is the implicit assumption that earnings in the future will be higher. In a deflationary environment this isn't the case. As such, keep your eyes peeled. I still think that stocks are quite cheap on a historical basis relative to alternative investments, but it isn't as unqualified as the indicators in the model would suggest. 

How do I value stocks anyway? Part 2

This will be relatively brief as a follow-up to the previous discussion and it will predominantly focus on a particular part of how price to earnings ratios (PEs) are used to value stocks. I will confess that I have not read a finance textbook in some time so the following is more what I have observed and what economic theory would dictate than any particular theory that is widely accepted.

When you look at a stock quote page on any website such as Bloomberg, Yahoo! Finance, Marketwatch, or whatever brokerage account you use, you will see an estimate of the company's PE ratio. More often than not, this is based on the earnings per share for the prior one year as reported on a GAAP basis. Often when you hear an analyst on TV talking about a stock that they like, they will either use this prior one year number or use analyst estimates of the next fiscal year. Either way, it is almost always a one year snapshot. The market in general is usually somewhere between 10 and 20 times earnings, though individual companies vary widely.

Now, you might be asking yourself "Why would I pay 10-20 times a year's worth of earnings for a company?". This, on its face, is a good question. It does seem a bit absurd. However, implicit in our acceptance of any given PE ratio is the assumption that the current year's earnings per share are a good point for estimating future years' earnings. Indeed, stocks, more or less, conform to the discounted future earnings (or the related dividends and cash flows) of a company over a number of years. Take a current year's earnings, grow them at 8% per year, appropriately discount them for inflation or a risk free rate of return (people do both), sum up, say, 10 years and you get a number that makes considerably more theoretical sense.

Now, some interesting implications of this can be found in real life examples. Take Bristol-Myers Squibb (BMY) for a moment. In 2000, it traded at about 25 times earnings, which was not absurd given its growth rate in the 1990s. This was true of nearly all pharmaceutical stocks. However, collectively, their pipelines dried up and their patents expired, leading to earnings stagnation. Despite having a reasonable PE often around 13-17 times current year earnings, the stock first plunged and then simply faltered. This was repeated across the pharmaceutical industry.

Many analysts routinely mentioned the low PE ratios of the pharmaceutical companies as being a cause to buy these stocks under the assumption that they were now underpriced. However, the only thing that makes a PE ratio of 15 or so reasonable is if that company is going to be growing earnings over the next decade by at least 7% a year. In the case of BMY, you can see in the lower panel of that chart that they have had no earnings growth for a long time. Hence, the stock has fallen well off its highs and continues to languish.

Of course, the same thing happens the other way too. Seemingly unreasonable PEs like Google's (GOOG) can be made reasonable by truly extraordinary growth rates. A company can trade at 60x earnings if it is about to grow 35% a year or more for five years straight.

Another implication of this concept is when a company is poised to have an explosive year due to a big one-time payment or government contract. It may have a very low PE ratio due to these artificially expanded earnings. However, it will be a rude surprise for you indeed if you buy based on that and the company's earnings return to earth a few years later 80% below that inflated level. The discounted sum of its earnings over ten years (or whatever interval you choose) will be far less than you might expect.

This actually also relates to my prior post on bad trend analysis. You have to do more homework than just extrapolating out the past five years' average growth rate over the next decade for a company. You need to do good qualitative analysis to determine whether or not that makes sense or else using a particular PE as a rationale for purchasing a stock will not be fruitful.

Q: How do I value stocks anyway? A: Umm....

One of the basic questions that is brought up time and again is: Is the stock market overvalued or undervalued? Investors are chronically asking this question and the debate between the two factions is what creates a market. Those who think their stocks have had their run will sell and those that think that those stocks can continue to run will buy and where the two meet is the price of the stock. The question for you is which side of that trade do you come down on?

I wish there was an easy answer here, but there is no easy answer. I don't subscribe to any one view of it. Efficient market theorists insist that the price of a stock is always justified because that is what the market values it at. Well.... that's nice, but kind of useless. Then, to quote Cheech Marin's character at the end of From Dusk Till Dawn, "One place's just as good as another". Put in terms of market history, buying Microstrategy (MSTR) at $3,000 a share in March of 2000 made just as much sense as buying Ford (F) at $1 in late 2008.

Dismissing this idea for a moment, how then should stocks, or the stock market at large, be valued? One idea for the overall market is by relative valuation. This is the previously mentioned earnings yield (1/PE * 100%) and compare it to long term bonds. If the earnings yield is at 5% and the 10-year Treasury Note is at 3.5%, stocks seem cheap. If the earnings yield is at 4% and the 10-year Treasury Note is at 7%, stocks are horrifically overvalued. There are some problems with this method in that it is possible that the "E", or earnings, in the PE ratio may be temporarily distorted. Also, interest rates can change in a hurry. It is not uncommon for long term rates to move 100 basis points in a six week period.

If you have taken a microeconomics class that has discussed financial markets at all, or any finance class, you have heard of the Dividend Discount Model. There are two problems with this as well. One is that many companies do not pay dividends, or do not pay particularly large dividends as a matter of policy. As a result, these companies get the shaft in this method of valuation. Also, you have to make the leap of faith that some given level of dividend growth will be sustainable. Just because a company has grown dividends at 8% each year for the past ten years does not mean that they will continue to do so. Case in point: the financials during the 2007-2008 period. If you valued those companies with the assumption that their current dividends were a good proxy of their dividends over the next five years, you would get hosed. Purely conceptually, however, this is probably the best method. It's just that it is difficult to apply to a large number of stocks.

Treasuries vs. Equities - Round 1

The reason I put "Round 1" here is that this will be an ongoing battle that changes with market conditions. As of right now, I would agree with the general sentiment expressed in this article from Seeking Alpha that long term treasuries are a poor place to be at the moment, with an important caveat.

If the Greece situation continues to spiral with little hope of a firm solution, long term treasuries are just about the best place to be. Every time Greece flares up slightly, treasuries have rallied. If there was a protracted debt crisis in Europe, capital would flee the Euro Zone and make its way to the U.S. and seek the safety of government paper.

If you have a modest long term treasury position, as I do myself, I don't see the pressing need to sell. If you have been moving vast amounts into bonds over the past few months, I question the wisdom of that decision. As long rates move up, which they will barring another major financial panic, you will lose money for the next couple of years. In short, your equity position should dramatically outweigh your bond position going forward for a while yet.

The article also addresses an important point about equity valuations which is that there are several ways to look at them. There is the absolute view that, for example, a price to earnings ratio (PE) for the S&P 500 of 20 is high. There is also the relative view which is that a PE of 20 in the context of a 3.70% ten year treasury rate is actually quite modest. Then, of course, there is the fundamental question of which measure of PE to use. Do you use the 12-month trailing earnings number? Do you use operating versus net earnings? Do you use a ten year trailing average of earnings as Robert Shiller does? Do you use the estimates for the next year?

I will address these differences next week in a larger post on how to value equities (an art I am still working on). Of course, you could just take that view that whatever the market pays for a stock is appropriate because all actors are rational and there is perfect information. It makes life easier... until you lose all of your money.