Are stocks cheap yet?

Today the stock market showed us that it is capable of going up as well as down, rising over +6%, which is obviously a nice change. Now we have to see if it can put in a few up days in a row, which it has had trouble doing for most of this year.

The impetus for today’s big jump seemed to come from Citigroup, of all places. Their CEO said that they’ve been profitable for the first 2 months of 2009, and that they expect this quarter to be their best since Q3-2007. If even Citigroup can make money in this environment, maybe the banking sector is finally on the mend after receiving $billions in bailout funds. Time will tell.

Whatever the reason for today’s move, it seems that the market “wants” to go up, as evidenced by several recent days that started with strong gains, only to be pared or turned into a loss during the final hour. In the fall, much of that final hour selling came from hedge funds; this year, it has been mostly individuals liquidating their mutual fund holdings. At some point, buyers will overwhelm sellers for more than one day, and the market will start to recover. Maybe today was the beginning of a longer trend; maybe not. We’ll know soon enough.

Regardless of what happens over the next few weeks or months, we need to feel confident that stocks really are cheap enough to buy. My last email talked about the long-term trend of stock returns and how far below trend we’ve recently fallen. As stocks gradually return to trend, they should provide above-average returns. Today, I’ll talk about stock valuations, looking at whether or not stocks today are historically cheap. I’ll do this by comparing today’s valuations with those during two major buying opportunities of the past century: 1982 and 1932.

The attached article contains the long version for those who want all the details. The Reader’s Digest version is below:

I wrote the article in part to respond to a New York Times piece entitled “Why Stocks Still Aren’t Cheap,” published on February 20, when the S&P 500 was nearly 10% higher than today. It proposed that because the 10-year average price-earnings (P/E) ratio of the S&P 500 was 14.5, below average but still well above the lows of 6 to 7 reached in 1932 and 1982, stock prices still had a ways to fall. I went on to point out the flaws in the author’s approach, and to do my own comparison of stock valuations today compared with those two prior periods.

I identified 4 shortcomings in the authors analysis: 1) 10-year periods, while they do smooth out the highs and lows of corporate earnings, are arbitrary; 2) the author didn’t account for inflation; 3) the proper or “justified” P/E ratio varies at different points in time owing to changes in interest rates, required return on stocks, payout ratios and expected earnings growth rates; and 4) accounting rules have recently changed, making comparisons with prior period earnings somewhat problematic.

To address these problems, I did the following: 1) calculated 5-, 10- and 20-year average P/E ratios at each time period (2009, 1982 and 1932) and averaged those; 2) adjusted earnings and prices for inflation; 3) calculated justified P/E ratios for each period based on interest rates and other data from the respective time period; 4) added an adjustment for recent accounting changes. I found that the last of these made little difference, so I eliminated it from the comparison.

The results indicated that stocks at 2009’s low for the S&P 500 were undervalued by about 12%, compared with a 14% undervaluation in 1932 and a 29% overvaluation in 1982. This analysis suggests that stocks today are compelling values, in line with the great buying opportunities of the past century.

I then went on to use several other valuation methods to compare stocks today with 1982 and 1932: price/sales (P/S) ratio, price/book value (P/B), price to replacement value (P/Q) and residual value. In all 4 cases, the actual measure today was below the justified measure, while in 1982 and 1932, at least one of these measures was higher than the justified value. The conclusion again was that stock valuations today compare very favorably with 1982 and 1932.

Lastly, I looked at 1974, which was a bear market bottom that did not precede a decade-plus bull market (the 1982 bear market was still to come). Valuations at that time appear to have been even lower than today, 1982 or 1932. Warren Buffett was a big buyer at that time; his superior results suggest that, if you buy stocks cheaply enough, you can make good money even if another major bear market will soon follow.

My conclusions were as follows: Putting all of these valuation measures together, we find that stocks today appear about as cheap as they did during two of the great buying opportunities of the past century, 1982 and 1932 (although perhaps not quite as cheap as in 1974). This doesn’t mean they can’t go lower still over the next few weeks or months. But their historically low valuations, based on my analysis of market history over the past 138 years, suggests that stocks should provide returns far above their historical average over the next 10 to 30 years.

I know I can’t time the bottom, but stock returns’ current distance below their trend line, plus the extremely low valuations suggested by my analysis, make me comfortable that buying stocks (or continuing to hold them) around these prices will eventually prove to be a very lucrative move.