Fundamental Valuation: How Low Could We Go?
An interesting recent article asks the question, "How much is this market worth?" It turns out that, over the last 30 years, the S&P 500 Index has averaged about 2.4 times the combined book values of the component stocks. At the market peak in 2000, we traded at almost 5 times book value. In 1982, we actually dipped below book value.
Periods of overvaluation and undervaluation can persist for a considerable time. We were over 3 times book value from 1997 through 2002. We were below 1.2 times book value for much of the late 1970s through 1982.
At an estimated book value of 615, we're trading around 1.5 times book value, not quite the level noted by Ned Davis as "undervalued". Should the current market and economic weakness prove as troublesome as the late 1980s -- a conclusion surely implied by those who call this the worst economic period since the Great Depression -- a move below book value would certainly be in order before we could say stocks are a screaming bargain. That could be a meaningful decline, given that book values themselves can move lower as assets held by companies (real estate, receivables, etc.) are valued downward.
Back in the Great Depression, as Jason Zwieg notes, stocks sold for less than their cash and marketable securities. Should the ratio of stock price to cash and marketable securities in the current market return to the level of 10 that we saw in the late 1970s and early 1980s, he notes, that would take us to about 600 on the S&P 500 Index -- back toward estimated book value. If we overshoot to the ratio of the market low in 1982, however, the S&P 500 Index would be closer to 400.
Interestingly, this fits with the recent analysis of market valuation based on Tobin's Q. Based upon the replacement cost for assets of the S&P 500 companies, the index should be trading around 910 -- roughly where it stands now. At historic market lows since 1920, however, indexes have tended to trade closer to somewhat above half their replacement cost.
If we look at this market from a trading vantage point, it is hard to escape the sense that we're tremendously oversold and due for a rally. In the short to intermediate term, that would not be surprising. If, however, we focus on fundamental valuations and historical norms, we're not at all at historically highly undervalued levels. There is a disconnect right now between how severe we say the economic problems are and how we think markets will move from here: most investors I talk with say the problems are quite severe and they say, with more than a little hope, that they think the worst of the market decline is behind us.
If this is indeed the worst economic crisis since the Depression, we will likely see book value in the major averages before we make a long-term bottom. That is not an extreme prediction of doom; it represents a level of valuation we've seen within the last 30 years. I don't see average investors and investment advisors thinking through or planning for this possibility -- and that could lead to sorry retirements for a number of baby boomers.
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This article has 61 comments:
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aarc
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69 Comments
Oct 18 11:17 AMif they do, a complete meltdown due to utter loss of confidence can happen
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Wefwef
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45 Comments
Oct 18 11:35 AM-
AmesTiedeman
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10 Comments
My Website
Oct 18 11:57 AMHousing took us down and housing will lead us to recovery. There is no other game in America these days but housing. We don't import houses, yet.
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AmesTiedeman
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10 Comments
My Website
Oct 18 11:58 AM-
AmesTiedeman
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10 Comments
My Website
Oct 18 11:59 AM-
jmorace
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22 Comments
Oct 18 12:02 PMAslo of note is that the credit markets are pricing in severe economic weakness. There is a mismatch between what they are saying to us, with some AAA corporates trading 600-700 basis points over treasuries.
To me that is already saying 550 - 600 is pretty certain. It takes time for a giant whale the global equity markets to get to their trough valuations during this adjustment. perhaps another year or two of downward action to do so.
just my thoughts,
jmorace
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InvictusRose
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8 Comments
Oct 18 12:12 PMSo, perhaps a little perspective on things might help. When I started out, it was considered wild speculation to buy a stock with a PE above 8 and a P/S ratio above 1. Those valuations belonged to only the very best companies available. You'd be hard pressed to find anything selling at those ratios today.
Things have certainly changed and I've made a lot of money because they have over the years. But the question at hand deals with how low the market can go, and less forthrightly, are we there yet?
Well, let's take for example, a widely-traded and particularly unspectacular stock like Yahoo (YHOO). It produces nothing proprietary that another company could not do as well or as cheaply. In fact, it offers no real "product" per se at all. It pays no dividend, and it completely dependent on advertising from companies that will almost certainly cut their budgets in any coming slump.
Yet, despite it's current price being far less than half of what it sold for in the last 52 weeks (-56.5%), it still carries a PE near 18, a forward PE over 24, a P/S of 2.5, and a book value that values the company at below its current cost at $8.4. There's more if you look, but those are the highlights. finance.yahoo.com/q/ks...
I could do this all day with most exchange traded companies, including REITS (who says the real estate market is in bad shape?), consumer computer companies that make products that people can and will live without when given the choice of food on the table, gas in the car, roof over their head, or the coolest cell phone on the market.
So, can the market go lower? Of course it can. Can it stay lower for a very long time? Certainly. It has. It did. And furthermore, it's long overdue for a long, long sleepy time.
As long is everyone is quoting old chestnuts about "buying when blood is running in the streets," remember another old chestnut: "When nearly everyone bets one way, go the other." Right now, the so-called "smart" money is telling everyone that we must be near a bottom and should be loading up on stocks. And that includes Warren Buffet. I'd call it a market bottom too, if I could invest in Preferred Shares paying a 10% dividend, along with the right to options at current prices, at some point in the future when the stock is likely to be higher. That's a sweetheart deal we'll never see. So Buffet has a motive for seeing you throw in with him. Only you won't get his deal or his return.
Good luck to all.
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fatcat
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486 Comments
Oct 18 12:19 PM-
Research123
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34 Comments
Oct 18 12:22 PM-
Muzie
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103 Comments
Oct 18 12:33 PMTo all those selling everything: ok, good, what's your plan now? I guess you all give up on retirement? Treasury bonds at 3%, not going to get you really far you know. And if the world is coming to an end, well I guess corporate bonds ain't so hot either. What's the plan? Everybody pile into gold? Well that ain't working that hot so far, and if you really want to actively participate in killing the economy, then pulling all your money ou of it to put it into a stale asset like gold certainly is the quickest way to di it. Good job there.
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adan
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303 Comments
My Website
Oct 18 01:36 PMand especially nice info re historical s&p valuations; and mentioning that the book value itself may still decline, along with the book to value ratio
all in all very nice article
thanks!
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Mac77
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15 Comments
Oct 18 02:06 PMMuizie
Patience...Don't be afraid of the truth...we could get a snapback rally or we could go lower. That is an accurate analysis of the market we are in. If you want to play this current market...play the volatility... buy the dips and sell the rips or go double long and double short and exit on price extremes. For me that's too much of a casino tactic.
Wait for price movement...money will go somewhere. Even in a year like this, many people have made money...example ...long commodities for first part of 08 and short market second half. .Right now I'm 100% in cash ...not out of fear...all Asset class's are getting crushed right now...that's just a fact. Currently cash is king...that will change at some point in the future. I will continue to monitor price movements and wait for an opening.
You could have made enough money (long commodities) for the first part of 08...sold on downward price movement, and then sat tight for the rest of the year. An investor doesn't have to be doing something all the time.
Maybe inflation will come back and commodities will start to rise again, driven by Asia recovering sooner than we do or inflation. Maybe China will be the place to be. Maybe precious metals will sky rocket.
The baby boomers will have to retire...money will have to go somewhere. Follow the money but don't overstay your welcome. Buy and Hold doesn't seem to be in vogue right now.
Good luck and hang in there.
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InvictusRose
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8 Comments
Oct 18 03:27 PMIt's easy to understand your frustration. But stating a fact is simply that, nothing more or less. The market is what it is at any given moment. The plain truth of it, is that if it weren't for the fact that people allocate money to automatic monthly deductions to 401K and similar plans with little thought to where it goes and how it's invested, this market likely would have tanked years ago. Most mutual funds are required by their charters to be almost fully invested in the asset class it specializes in, and to have a given amount invested in that group of stocks at any point in time, which causes them to buy more in low price times and less in higher priced times. Barring massive redemption requests from investors, it amounts to dollar cost averaging on a much more massive scale than we can manage individually.
The problem now, as you correctly identify, is that there are massive redemptions by investors and the asset class is falling of its own weight. The beast feeds on itself and no one knows when or at what point it will stop. You are also correct to assume that at some point the bleeding will stop and people will discover that no bank is paying them enough to even keep up with the rate of inflation. You are losing money even in the best CD's at the safest banks. So, once things settle down again, people will creep out of their little cubby holes and tell their asset manager to put them back into the market.
One thing you might remember, is that the value of stocks, despite the various ways we use to measure their value (PE, P/S, P/B, etc) are only worth what we think they are worth. They have no real intrinsic value outside the value of their plant and equipment at an auction. That was why I used Yahoo as an example of just one stock that people still believed held some value, even in the face of quite a bit of evidence to the contrary. It's worth what investors say it's worth.
It's great when you buy Apple before anyone else feels they are worth something more. But it also works against you when people panic. When they want out, there's little you can do to convince them that the company has intrinsic value. It's only worth what their fears and dreams say it's worth. It's always been that way. Has the value of GE, GM, IBM, Apple, AT&T, or any other company whose price has been cut in half or more in about a month, actually occurred because that company is no longer worth what it was only a few weeks ago? Of course not. It's only that investors have lost the belief, if perhaps only temporarily, that the future is limitless.
We live in a world that is interconnected. The housing mess brought on the banking mess, the banking mess brought on the lending crisis, the lending mess brought on the foreclosure or rescue of other messes and on and on. Then the government stepped in and really screwed the pooch.
The mortgage appointment I made only a week ago has seen the mortgage rate rise about 7/8's of a point. Why? Because the government nationalized Fannie Mae and Freddie Mac and now the market is selling their bonds at fire sale prices because no one believes in them anymore. Bond prices go in the opposite direction of bond yields and so, the interest rate has risen like a rocket in response to the Law of Unintended Consequences. The government tried to help save the mess it started in the first place, and only made things worse.
If you think this is the end of the mess, then I would have to disagree. We haven't even heard much from the rest of the world yet. There's more and worse to come and it is simply a case of, "Sometimes you eat the bear, and sometimes he eats you." The poster who advised you that sometimes the best thing to do is to do nothing, is completely on target. This market tanking, for anyone paying attention, was pretty easy to see coming. If you listened, you could hear the desperation in their voices, every time a talking head or congressperson told you the system was completely solvent. You know what? When something is really working well, there's never any need to reassure people that it's working well. When you see Nancy Pelosi, Harry Reid, George Bush, Barney Frank, Ben Bernake, et al, posing for pictures together with the caption saying essentially, "Hi! We're from the government and we're here to help!" Hold onto your wallet.
The good news? This too shall pass.
Best of luck.
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mkreisel
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306 Comments
Oct 18 03:40 PM-
User 199423
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5 Comments
Oct 18 03:46 PMThe historical valuation data on earnings gives a similar prognosis for market valuations.
The way I see it, we are in a secular bear market for valuations, within which we can have oversold bounces and cyclical rallies. But the trend for valuations is probably lower.
Historically secular bear markets have lasted 12-15 years and have correlated with secular bull markets in commodities.
In the 70s, the market bottomed in late 1974; valuations did not bottom until summer of 1982. In the 30s, the market bottomed in '32; but valuations didn't bottom until '42. In between, the S&P rallied almost four-fold between 1932 and 1937 without coming anywhere close to the 1929 high. It sold off sharply from 37 to 42, but bottomed at a level almost twice the '32 low, even as valuations undercut.
If recent government initiatives are successful in stemming panic and preventing a deflationary spiral, then the indices can rally pretty sharply from these valuations. But once we anniversary the massive unwinding of financial company leverage, and once the consumer starts to comp positive, the hangover of a massive government debt burden will ultimately be inflationary...hence, another selloff and lower lows on valuations if not absolute stock prices.
Buy and Hold investors are likely to face a continuing valuation headwind for years to come.
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Moses
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49 Comments
Oct 18 04:17 PM-
Egg
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53 Comments
Oct 18 04:22 PMA very key point this article misses is that is the market trades sideways from here and the companies continue to muddle along (making a profit, but little growth) then book values will continue to rise in the coming years.
So....
Using 73-74 and 1982 as metrics....you have 8 years from now (2016)that book values will creep higher (assuming companies stay profitable) and with flat stock prices, then you might have a market with the S & P at around current prices AND also below book value.
Taking that 615 # now as book value the author states and granting an increase of 5% a year in book value (10-12 P/e + dividend would do that) then the 615 becomes over 900 in 2016.
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DrBenway
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9 Comments
Oct 18 04:32 PMBook value is an accounting term with a vague economic meaning. S&P 500 component mix is very different now from what it was 25 years ago, with many more software and services companies that are normally valued at many times their book value, also do not forget the effect of Fair Value and mark to market accounting rules that depress book values.
Comparing historical book values is not the right way to compare the fair valuation of the companies. You also ignore much lower treasury yields today than they were in the 70s and 80s.
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Owen
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138 Comments
Oct 18 05:22 PMHistorical comparisons should be done with an understanding of the changes in the playing field. Remember, 300 years ago a plot of land in Manhattan was only worth as much as the crops you could grow on it. Even with the housing crisis, I don't think real estate prices will ever fall to those levels.
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Albertasunwapta
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4 Comments
Oct 18 05:26 PMArnold Van Den Berg who has an amazing investment record on par with Buffett discussed the market's replacement value in OID a few years back. It's a worthwhile read.
Growth in book value is probably a better indicator at corporate and aggregate levels.
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TraderGreg
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28 Comments
Oct 18 05:35 PMThe K-wave will bottom in 2015 as well.
The Mortgage reset mess will bottom around 2013
The P/E may bottom around 5-7 around 2015
The E part of P/E is about to cliff dive with the economy. The earnings will go down another 50% (my educated guess)
This would imply another 75% SP500 hair cut, from where we are NOW - down to 250 level.
Based on this, I would say the SP500 will bottom out in the 300-600 range.
This is going to be a long war, with a lot of blood running the streets. We just entered the second half of the Bear.
We are not Warren Buffets - I wish I had his money and smarts.
Do you want to loose money - listen to Jim Cramer.
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Owen
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138 Comments
Oct 18 05:45 PMOn Oct 18 05:35 PM TraderGreg wrote:
> The K-wave will bottom in 2015 as well.
> The Mortgage reset mess will bottom around 2013
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E Nuff Sed
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146 Comments
Oct 18 05:47 PMS&P 500 Div yield in the early 80's was ~6% and long bonds yielded ~14%. Now S&P Div yields at present is ~ 3% and long bonds yield ~ 4%. The market is arguably cheaper now by this measure than the 80's.
Also P/E ratio's are approaching (at 11.1) - implying a earning yeild of 9%. Even if earnings fall by 10% - this is 100%+ risk premium over a long bond.
The market is clearly irrational now and cannot separate fear from bear.
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bearfund
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546 Comments
Oct 18 05:49 PMWhat if it's not the market that's cheap but Treasuries that are expensive?
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Albertasunwapta
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4 Comments
Oct 18 05:51 PM-
prudentinvestor
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143 Comments
Oct 18 06:07 PMThe market may appear to have hit bottom, but only relative to the extraordinarily high valuations achieved since the mid-90's due to the fact that mutual funds have to buy stocks as people plow money in. People have had to keep plowing money in because their employers stopped offering fixed-benefit plans, and they could not get a return that matched inflation from bonds or CD's, so it all went into mutual funds, and so on to stocks. In a way, the 401K laws and the artificially low interest rates made mutual funds issued by private companies a de-facto replacement for sound money issued by the government.
The result has been stock market overvaluation by any rational measure, as anyone can see by just looking at a long-term chart of the Dow or S&P 500. Simply extrapolating those charts on a log curve along their historic 60-year trendline would put us at about 6000 for Dow and about 800 for the S&P. I can't tell whether we shall get that low, undershoot, or go straight up from here; but I can say that I will not be surprised by whatever happens as we are entering a totally new phase in our economy.
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User 118015
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308 Comments
Oct 18 06:24 PM-
E Nuff Sed
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146 Comments
Oct 18 06:42 PM-
Mechawreck
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2 Comments
Oct 18 07:53 PM-
InvictusRose
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8 Comments
Oct 18 07:54 PMIt has always been said of gold, that its price never changes. Ever. What changes is the currency and emotion surrounding the commodity. A theoretical ounce of gold would buy an equivalent amount of goods a thousand years ago as it buys today if there were equivalents--A good donkey then, an iPod now. Gold is a reflection of the world around it, not the other way around. If you can accept that premise, you will see that there is no "real" price of gold relative to any artificially created commodity such as treasuries or dollars or euros or anything else created by man to take the place of something with real intrinsic value, such as gold or silver. That's partly why gold rises as tensions and uncertainty rise. Treasuries merely reflect people's belief at that moment in time, and in the government that issues them. Otherwise they are as worthless as any other piece of paper with ink printing on them.
There is, however, a simple and overlooked solution to this "credit crisis." That is to make the interest on all savings tax-free. Doing so would encourage saving by raising the effective yield each bank pays. By law, banks can lend out $10 for every dollar they take in in savings. They can do this over and over again each time that same dollar is borrowed and then deposited again. That's one major reason why some mortgage lenders have found themselves leveraged 30:1. This simple and very basic solution would encourage savings, flood the banks with money to lend, thereby lowering interest rates and freeing up the credit crunch that the government created by encouraging debt and discouraging savings. With banks flush with cash and looking for places to invest it, they could again invest in homes, small and large business, business creation, community improvement, infrastructure, etc. And it can do it without confiscating wealth or redistributing it.
America today has about the lowest savings rate of any industrialized nation. No one tells you what you must do with your money, but our government does have a huge say via laws, rules and regulations, in how or what monetary behavior it encourages or discourages. A Roth IRA is a one prime example of what people do with their money when they are not taxed on their retirement savings. Unfortunately, it also encourages investments in mutual funds run by people who can rarely beat even the S&P averages.
Conversely, allowing you to sell your house tax free every two years constitutes the other end of the spectrum. That particular tax code encourages people to bet and speculate on real estate, selling often in the hope that their home price will appreciate in the next two or three years for them to sell and pocket the profit. Encouraging debt is how the mortgage mess happened. The government took an asset that older people used to almost never count as a financial tool (it was just their home--cheaper than renting, interest being tax deductible, and a sort of forced savings). But it was never really what they thought of as an "investment."... When they changed the law, they changed the outlook and the rules of the game (much to the country's long-term detriment, in my view).
Anyway, that's my point of view. It too, is worth the bandwidth it's written on.
Thanks for your kind words, prudentinvestor. Best of luck to all.
It's my opinion that the reason the government has never taken this most obvious step, considering that they are constantly complaining about how little Americans save, is because it would remove money from asset classes favored by those that benefit from other asset classes--those in power and those with lots of wealth.