So is the market cheap or not?
globeandmail.com
By MATHEW INGRAM
Globe and Mail Update
After months of anguish, investors are now back where they were in late July: wondering whether the market's new lows are a sign that things have finally gotten as bad as they possibly can — and thus, whether they might finally start getting better. Strong upward moves on both Thursday and Friday sparked some hope, but were those just sucker rallies, or the start of something real?
Most market watchers seemed to feel that the bulk of Thursday and Friday's buying activity was short-covering, in which bearish investors who bet stock prices would fall have to buy shares in order to repay their debts. But some of it may also have been contrarians, betting that the bad news in the market couldn't possibly get any worse, and that therefore stocks may have hit bottom.
If bad market news is what you're looking for, there's certainly plenty to go around. For one thing, by most estimates the current "bear" market is going into its 32nd month, which is nine months longer than the downturn of 1973-74 and three months shy of the record in 1929-32. Even after the increases on Thursday and Friday, the S&P 500 is still down 45 per cent to five-year lows, the Dow is down 35 per cent to four-year lows, and the Nasdaq is off 75 per cent to five-year lows.
That's not all: September was also the worst month for the Dow since 1937, and marked the end of the worst quarter since 1987. It was also the sixth losing month in a row — the longest losing streak since 1981. The S&P 500 index, meanwhile, had its worst quarter since 1987, down by 16.4 per cent. And if the Dow and the S&P end lower this year, which they likely will, it will be their third losing year in a row — the first time the market indexes have done that since 1939-41.
So it's bad. But is it as bad as it could get, and does that mean markets will go up anytime soon? For that, you have to look not at the U.S. economy — since the markets and the economy have been out of sync for some time — but whether stocks are cheap or not. And that depends what you mean by "cheap."
The bulls, for example, agree that the S&P 500 looks expensive based on profits over the past 12 months. On that "trailing" basis, the index is trading at 30 times earnings, compared with a historical average of 15 times. However, they argue that investors look at future earnings, and based on current forecasts of about $57 a share in profits, the S&P is only selling for 15 times earnings.
Skeptics such as Merrill Lynch economist David Rosenberg, however, says it's hard to believe these forecasts when analysts have repeatedly had to revise earnings targets downward over the past couple of quarters, and may have to do the same for next year's. The forecast for 2003 also assumes that the S&P 500 will see profit growth of about 18 per cent, which some feel is too high.
The bulls say low inflation and low interest rates mean investors will buy stocks even at higher multiples. However, according to Mr. Rosenberg, "no bear market in the past five decades ended with the trailing P/E multiple higher than 16 times, and that includes a lot of low interest rate/high productivity cycles." If you use a moderate profit target and the average multiple, he says, it is not unreasonable "to see the ultimate bottom in the S&P 500 somewhere around the 700 level."
In addition, there's what you might call the "quality" of earnings. Former J.P. Morgan strategist Doug Cliggott points out that the profit for the S&P in 2001 was $38.85 a share, but this didn't include billions in writeoffs. After writeoffs, it was $25. Mr. Cliggot expects "real" earnings to be $40 next year, which translates to an S&P level of about 650 if you use a historical multiple.
And what about the "Fed model"? That's the equation that compares the yield on the 10-year U.S. Treasury bond to the S&P 500 to arrive at a fair value for the index. Dividing 100 by the yield on the Treasury note (3.8 per cent) theoretically puts fair value at 26 times earnings — and using a profit of $50 puts the index at 1,300, which means it is 35 per cent undervalued even after Friday's rise.
There are a few problems with the model, however. For one thing, it uses profit forecasts, which are unreliable (as we all know by now). It also assumes that the yield on the 10-year Treasury represents fair value — but bonds can be overvalued too. Also, Thomson Financial/First Call director Chuck Hill says that when interest rates are low, "the model blows up." For example, if the yield on the 10-year note fell to 1 per cent, that would imply an absurd S&P multiple of 100.
So is the market cheap? As you can see, that depends. And whether we've hit the bottom with a capital B is something investors will likely only discover when they look at this market in the rear-view mirror.
I've been very impressed with how well WDC has held up in this market. I for one certainly hope your bet will pay off big. I guess it's the old question of too many eggs in one basket.
RtS |
