Friday, October 10, 2008
How cheap are stocks?
By some measures, stocks are as cheap as they have been since 1985. But that does not mean that prices will not fall further:
How cheap are stocks?
By one important measure, they’re cheaper than they have been since 1985. They’re 20 percent less expensive than they have been, on average, over the past 100 years. And yet they still may have a ways to fall.
The standard measure of the cost of stocks is the price-earnings ratio: the current price of stocks divided by some measure of annual earnings. Wall Street often likes to use the past year’s earnings or the forecasted earnings over the next year. But I find the first of these measures to be too volatile and the second to be too — shall we say — optimistic. So I prefer a p-e ratio based on the average corporate earnings over the past 5 or 10 years. It’s fair to assume that Warren Buffett also has some sympathy for this measure.
Just before 1 p.m. today, the Standard & Poor’s 500-stock index was at about 870. That meant the five-year p-e ratio was just below 12. (The corporate earnings data isn’t all available yet, so this is an estimate.) It was last that low in late 1985. Over the past 100 years, the average p-e has been about 15.5.
If you use a 10-year p-e instead, stocks look somewhat more expensive — the ratio is 14, the lowest since 1988 but only a little lower than the 100-year average.
There are two things to keep in mind, in the event that you consider these ratios to be a sign that now is the time to buy. First, the p-e ratio typically falls well below its long-run average during a bust. It fell to about 6 in both the 1930s and early 1980s.
Second, remember that there are two components to the p-e ratio: the ‘p’ and the ‘e.’ Based on the kind of recession we may now be entering, it’s entirely reasonable to think that corporate earnings will fall, maybe significantly. That would mean that stocks would also have to fall just to keep the p-e ratio in its current place.
I suspect that if you have money you can park for five years you would earn a good return if even today you bought strong companies with transparent and none-too-leveraged balance sheets. I still think that stocks are headed lower, though, below 7000 by the end of the winter (see our DJIA prediction post). My guess is that even when the nail-biting stops we will still suffer in an excrutiating bear market until a few months before the real economy turns up, and that could be a while.
3 Comments:
By 
, at
Fri Oct 10, 03:04:00 PM:
If the market is primarily a predictive mechanism, one wonders if the rout we're seeing is a straightforward reaction to the higher taxes and tariff's likely President Obama threatens to unleash. McCain's campaign released a statement the other day whose sentiments should find universal agreement in these difficult times. Stripped of the political rhetoric, one would hope that Obama himself would understand how important it is that he come out publicly and support it. Fat chance.
By 
Who Struck John, at
Fri Oct 10, 08:42:00 PM:
Keep in mind, this is the front half of the mortgage crisis. The first peak of mortgage resets ends this winter. There is a second, equally high and broad peak in 2010-2011.
Which is why I made the prediction that I did.
By PD Quig, at
Sat Oct 11, 09:52:00 AM:
Estimates of 2009 S&P 500 earnings are as low as $45-$50. At a PE of 14, an index value of 630-700 is indicated. Of course, such back of the envelope projections are problematic: there's nothing to say that the earnings or ratio couldn't end up even lower...or higher. What seems clear, however, is that the bias has to be downward, for technical, fundamental and psychological reasons.
