Monday, 15 August 2011

We Have Probably Entered a Bear Market

Most stock markets have exhibited signs of entering a bear market, like in 2008 Jan. Most long term supports have been smashed at high volumes. The rebound appears to be short coverings and may not clear April's highs. Valuations according to PE ratios are at 14x, but according to PE10, taking the cyclically adjusted PE ratio over 10 years of earnings, S&P500 earnings are at the highest quintile. The prognosis is not good.

IMF chief has warned of western governments running out of policy options. Monetary policies are already as loose as can be. Fiscal policies have been curtailed by austerity measures. For the emerging economies, governments are walking a tight rope between inflation and stimulation. If they attempt to boost their flagging export dependent economies, inflation will flare and there will be unrest on the streets.





Is the Stock Market Cheap?
By Doug Short
August 1, 2011


 
Here is a new update of a popular market valuation method using the most recent Standard & Poor's "as reported" earnings and earnings estimates and the index monthly averages of daily closes for July 2011, which is 1325.18. The ratios in parentheses use the monthly close of 1292.28 (which this month gives the same ratios to the first decimal). For the latest earnings, see the table below created from Standard & Poor's latest earnings spreadsheet.
● TTM P/E ratio = 15.6 (15.6)
● P/E10 ratio = 22.7 (22.7)

The Valuation Thesis

A standard way to investigate market valuation is to study the historic Price-to-Earnings (P/E) ratio using reported earnings for the trailing twelve months (TTM). Proponents of this approach ignore forward estimates because they are often based on wishful thinking, erroneous assumptions, and analyst bias.
TTM P/E Ratio
The "price" part of the P/E calculation is available in real time on TV and the Internet. The "earnings" part, however, is more difficult to find. The authoritative source is the Standard & Poor's website, where the latest numbers are posted on the earnings page. (See the footnote below for instructions on accessing the file).
The table here shows the TTM earnings based on "as reported" earnings and a combination of "as reported" earnings and Standard & Poor's estimates for "as reported" earnings for the next few quarters. The values for the months between are linear interpolations from the quarterly numbers.
The average P/E ratio since the 1870's has been about 15. But the disconnect between price and TTM earnings during much of 2009 was so extreme that the P/E ratio was in triple digits — as high as the 120s — in the Spring of 2009. In 1999, a few months before the top of the Tech Bubble, the conventional P/E ratio hit 34. It peaked close to 47 two years after the market topped out.
As these examples illustrate, in times of critical importance, the conventional P/E ratio often lags the index to the point of being useless as a value indicator. "Why the lag?" you may wonder. "How can the P/E be at a record high after the price has fallen so far?" The explanation is simple. Earnings fell faster than price. In fact, the negative earnings of 2008 Q4 (-$23.25) is something that has never happened before in the history of the S&P 500.
Let's look at a chart to illustrate the unsuitability of the TTM P/E as a consistent indicator of market valuation.
The P/E10 Ratio
Legendary economist and value investor Benjamin Graham noticed the same bizarre P/E behavior during the Roaring Twenties and subsequent market crash. Graham collaborated with David Dodd to devise a more accurate way to calculate the market's value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by a multi-year average of earnings and suggested 5, 7 or 10-years. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the concept to a wider audience of investors and has selected 10 years as the earnings denominator. As the accompanying chart illustrates, this ratio closely tracks the real (inflation-adjusted) price of the S&P Composite. The historic average is 16.4. Shiller refers to this ratio as the Cyclically Adjusted Price Earnings Ratio, abbreviated as CAPE, or the more precise P/E10, which is my preferred abbreviation.

The Current P/E10
After dropping to 13.3 in March 2009, the P/E10 has rebounded to the vacinity of 22. The chart below gives us a historical context for these numbers. The ratio in this chart is doubly smoothed (10-year average of earnings and monthly averages of daily closing prices). Thus the fluctuations during the month aren't especially relevant (e.g., the difference between the monthly average and monthly close P/E10).
Of course, the historic P/E10 has never flat-lined on the average. On the contrary, over the long haul it swings dramatically between the over- and under-valued ranges. If we look at the major peaks and troughs in the P/E10, we see that the high during the Tech Bubble was the all-time high of 44 in December 1999. The 1929 high of 32 comes in at a distant second. The secular bottoms in 1921, 1932, 1942 and 1982 saw P/E10 ratios in the single digits.

Where does the current valuation put us?

For a more precise view of how today's P/E10 relates to the past, our chart includes horizontal bands to divide the monthly valuations into quintiles — five groups, each with 20% of the total. Ratios in the top 20% suggest a highly overvalued market, the bottom 20% a highly undervalued market. What can we learn from this analysis? The Financial Crisis of 2008 triggered an accelerated decline toward value territory, with the ratio dropping to the upper second quintile in March 2009. The price rebound since the 2009 low pushed the ratio back into the top quintile. By this historic measure, the market is expensive, with the ratio approximately 38% above its average (arithmetic mean) of 16.4.
We can also use a percentile analysis to put today's market valuation in the historical context. As the chart below illustrates, latest P/E10 ratio is approximately at the 87th percentile. If we leave out the Tech Bubble, the current P/E10 would be at 87.5%.
A more cautionary observation is that every time the P/E10 has fallen from the top to the second quintile, it has ultimately declined to the first quintile and bottomed in single digits. Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 540. Of course, a happier alternative would be for corporate earnings to make a strong and prolonged surge. When might we see the P/E10 bottom? These secular declines have ranged in length from over 19 years to as few as three. The current decline is now in its eleventh year.
Or was March 2009 the beginning of a secular bull market? Perhaps, but the history of market valuations suggests a cautious perspective.

Note: Follow these steps to access the Standard & Poor's earnings spreadsheet:
  1. Click the S&P 500 link in the second column of the Standard & Poor's home page.
  2. Click the plus symbol to the left of the "Download Index Data" title.
  3. Click the Index Earnings link to download the Excel file. Once you've downloaded the spreadsheet, see the data in column D.

Note: For readers unfamiliar with the S&P Composite index, see this article for some background information.





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