September 30, 2010
Are stock prices still cheap? It all depends on how you look at it of course and what your time horizon is for the stock’s price history.
Part of what makes the markets function properly is the multitude of belief systems, strategies, analysis and risk tolerance that we all use.
For the most part, just about every one of us has a slightly different opinion on an investment. Even if two or more of us are bullish, chances are we would pay different prices for that same stock. Hopefully, if the position became profitable, it is also likely that different investors would choose different stock price spots to sell at.
Of course for every buyer there has to be a seller, but as bullish sentiment increases, buyers may be willing to pay more as sellers move their prices up. On the flip side, if bearish sentiment is in control sellers bring the downward pressure and buyers drop their stock prices accordingly. You can trade these “variations” and short–term stock price movements as I do often, but if you are an investor, you need a different measurement for the price of a stock.
More importantly, if I want find where the market is headed longer term, I’m not so concerned with the small transactions that are taking place every second. I want to know where the BIG trends are going to come from…
Will the buyers begin to dominate and push the sellers away or will the bears take control?
Stepping Back to See the Relative Value of the Stock Market
Sometimes it’s good to take a step back and look at the big macro picture to get an idea of relative value. To find out if the stock market is relatively over or underpriced, you need to examine a couple points:
1. Economy – Even though it’s not all crimson and clover out there, the economy is SLOWLY improving according to many data sets.
Second – quarter U.S. GDP grew 1.7% (better than the previous 1.6% estimate). That is not to say that this country doesn’t have struggles ahead, but it seems that we are slowly on the way to recovery.
I do find it a bit amusing that the NBER issued a statement that the recession ended June 2009, then went on to say, “Any future downturn of the economy would be a new recession and not a continuation of the recession that began in December 2007.” You have to just adore economists… I’m just hoping the unemployment rate drops, so more Americans can start experiencing the “end of the recession.”
Regardless, the stock market has moved higher (leading as it usually does) out of the recession, looking forward in time.
2. Valuation – There are many ways to gauge the “value” of the stock market. Sara outlined some great tactics here. The most simple and common method is to examine the market’s total P/E (price/earnings) ratio.
I like to look at the S&P 500 (SPX), because it gives a much broader and diverse picture of 500 of the U.S.’s top companies compared to only 30 in the Dow Jones. Also note that many Nasdaq and Dow stocks are also contained in the S&P 500.
There are two views we need to take on P/E ratio:
- First is the trailing or actual P/E ratio, looking back over the past year. Currently that number is about 15x.
This means that if you combine all the stock prices and all of the earnings of the index, it is trading at 15 times its past year’s earnings. The good news is that this is a low number; the mean or average P/E over the past 100 years is about 16.40X.
- Second, we need to look at the forward or projected P/E ratio. This comes from analysts who use models to predict what a company will earn. Earnings season kicks off in about two weeks; this is where we will find out how companies have fared in the last quarter. The forward P/E is 13.75x, which basically means that analysts are expecting companies to continue to grow modestly. If they do so, then the actual P/E would go even lower… making stocks even more attractive at these levels.
3. Sentiment – Sentiment is a tough one to gauge. According to the AAII (American Association of Individual Investors), the weekly sentiment numbers show about 43% bullish, 26% neutral and 31% bearish.
As those numbers are a short–term, somewhat anecdotal measurement, I don’t put too much credence in them, especially with consumer confidence dropping in September. But they do give you an idea of what is on the minds of investors.
Overall sentiment is mixed, but you also must realize that in order to get the best deals, you sometimes have to go against the grain.
I also am fairly confident that the upcoming earnings season won’t be a dud and that most companies will meet or beat their expectations. Of course there will be exceptions.
Furthermore, look at how the market has reacted to data. Bad reports get a muted sell–off and moderately good news gets rewarded with a huge rally.
Don’t forget that sentiment can change fairly quickly.
4. Technicals – Looking at the longer–term picture, the SPX is above its 200–month moving average as well as its 200–day moving average, which I prefer to use when monitoring my longer–term trades. The 200–day SMA is about 1,115, which to me is a good support point. The big, nasty head and shoulders that everyone was talking about never came to fruition, which was a huge sigh of relief from a technical aspect.
The Bottom Line
In the short term, market volatility may return with earnings season and a minor retracement may occur, but looking out over a three–year period, valuations are still cheap and if the economy continues to at least make minor steps toward recovery (with the help of the Fed), American companies should continue to grow at least at a modest rate, moving the S&P higher. For the long–term investor, the broad market is still a buy.
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