Barfing.com: Please I beg you...don't sell!
The Big Picture - Market View
05-Mar-03 21:31 ET
If Warren Buffett says so, it must be true. On Monday, it was reported that legendary investor Buffett wrote in his letter to shareholders of his company Berkshire Hathaway, that the market is likely to go down further. He even said that many of the shares held by his company are not yet undervalued. Briefing.com recognizes some clarity of thought in these statements, although we don't necessarily agree in full.
Valuation Measures
The "true" value of a stock is a function of future earnings. Of course, no one knows what future earnings will be, so the value of a stock is a function of varying expectations. A valuation based on rapid earnings growth will be completely different that one based on sluggish earnings growth. So, it is entirely possible for two rational people to come to different conclusions as to whether a stock is overvalued or undervalued. That is what makes markets.
The same applies to the overall stock market. Whether the market is truly overvalued or undervalued is a function of uncertain projections.
Yet, there are traditional metrics from which to start that provide more stable analysis. On this basis, there is a strong case that the market is undervalued.
The price/earnings (P/E) multiple suggests the market right now is slightly undervalued. Using operating earnings, the P/E on the S&P 500 is about 18. A rule of thumb is that the P/E should be 20 less the rate of inflation. Right now, inflation is close enough to 2% to say that measure places the current valuation at about the "right" level.
Another starting point is to compare the earnings yield on stocks to the yield on bonds. The earnings yield is the inverse of the P/E and is about 5.5%. The 10-year bond yield has (amazingly) plunged to 3.63%. This puts the yield on stocks at very high historical levels relative to bonds. This is important not just because bonds are a less attractive alternative investment due to their low yield, but low interest rates also raise the value of future earnings of stocks compared to when rates are high. On this basis, the stock market is clearly undervalued.
Stocks are Undervalued, but...
It is Briefing.com's belief that stocks are indeed slightly undervalued. That is in part because we also project decent GDP and earnings growth for the remainder of this year. However, there are reasons why that does not necessarily mean that stocks are clearly a buy.
First, there are legitimate concerns about the "quality of earnings." The valuations above are based on operating earnings, which exclude one-time charges. Those charges have been large in recent years, and there is cause for concern that companies are playing too many accounting games to make earnings look better than they are in reality. One such accounting issue that is of increasing concern to Briefing.com is whether companies are booking enough current costs to cover future pension liabilities. By assuming too high a rate of return on investments in pension funds, companies are booking too low a current charge, and thus overstating current earnings. This will be the topic of a Stock Brief in the days ahead.
Second, Mr. Buffett makes a valid point when he says that "the hangover may be proportional to the binge." This is another way of saying that stocks can stay undervalued for a period of time. After all, stocks were overvalued for an extended period during the bubble years. It is possible that the pain now felt by investors keeps them out of the market even while stocks are undervalued. Just because stocks are undervalued doesn't mean they will soon go up.
Patience
There are times when patience is important to wise investing. The stock market may struggle for another year, even longer. However, that doesn't drive Briefing.com to the conclusion that long-term investors should stay out of this market.
For anyone with a large portfolio, it is worthwhile to maintain positions in high quality, high yielding stocks. A portfolio of low volatility stocks yielding 2.5% or more is easy to put together. That is a good starting point for a diversified portfolio.
Traders may look at this market and decide to stay out, or to take short positions. But long-term investors still need a diversified portfolio, and stocks should be a significant part of that at this time. It may make sense to reduce the percentage of your portfolio in stocks and to add to cash positions. But it is worthwhile to stay with stocks. The market is undervalued, and will eventually come back. Not a whole lot, but enough so that you won't want to miss the move when it does happen.
Mr. Buffett's comments were widely perceived as bearish. But don't forget, he didn't say he was selling everything. He still has a large portfolio of companies that he is holding. That presumably includes Coke (KO), which hit a seven-year low on Wednesday. Just because Coke and the overall market is down, doesn't mean he is selling. He is staying invested in the stocks he likes. And you should too.
Comments may be emailed to the author, Dick Green, at dgreen@briefing.com |
