Market Valuations
As the market struggles to maintain current levels, companies are increasingly
challenged to deliver earnings that justify their lofty stock prices. Because of recent significant losses, prudent investors are looking for other methods to generate growth and protection of capital, but to date have felt limited in their investment choices.
Lang Asset Management
offers several products geared to the prudent investor:
- One hundred and fifty year high in current price-earning multiples.
The current earnings multiple based upon reported (GAAP) estimated S&P 500
earnings is well above its historical average. That is, investors believe that the
prospective environment is so attractive that they are willing to deem irrelevant over 150
years of investment history (periods that include booms, busts, wars, high and low
inflation and high and low interest rates). In the mid-1980's, companies began to use forward estimated operating (pro forma) earnings for reporting purposes. These earnings disregarded many ordinary expenses that all businesses experience from time to time. The historical p/e on forward operating earnings has been 11, so if operating earnings are utilized, the market is even more overvalued.
- Stock earnings yield versus bond yields (the Fed model).
This model relates the reciprocal of the p/e ratio of the S & P 500 to the 10-year Treasury bond yield. However, there are three major flaws with this model. First, the model is based upon data going back to about 1970. The problem is that the 10-year T bond rate is now lower than at any point in the model, meaning that the model does not include even a single data point that covers the current period. In fact, prior to the late 1960s, interest rates were lower for 100 years than they were from 1970 through 1997. Yet never during that time did the market sell at more than 23 times earnings. Secondly, it is difficult to assess what earnings to use (trailing or forward, broad indices or narrow, S & P or Nasdaq, operating (pro-forma) or reported (GAAP) or core. Thirdly, comparing risky stocks with non-risk bonds does not make intuitve sense.
- Significant risk even at multiples below historical average.
At the beginning of 1929, the forward p/e ratio was 16.2, and the p/e in Oct. 1929, just
before the 88% decline was 13.5! The market is now selling at about 17.5 times our smoothed trendline GAAP earnings, a P/E ratio associated with market peaks for almost 200 years prior to the last decade
- Price to sales.
Corporate earnings are quite volatile, and difficult to assess. Thus, p/e ratios are somewhat nebulous, and various iterations can be presented, depending upon the author's biases. However, corporate revenues are much more stable, and ratios based upon corporate sales reflect much less volatility. Comparing the current price to sales ratio of 1.28 to the historic average of 0.8 suggests the market is selling at a 60% premium to its long-term average. There are fundamental reasons for the market to have sold, on average, at 0.8 times sales. If one pays much above this level, it becomes very difficult to earn a reasonable rate of return on you investment.
- Dollar is vulnerable.
Mr Robert McTeer, a former member of the Federal Reserve Board, recently stated: "Theoretically, some day that process (foreigners funding our current-account deficit) will come to an end, the flows will turn against us and there will be a crisis that will result in rapidly rising interest rates and a rapidly depreciating dollar that will be very disruptive. But I don't know what to do about it". It is difficult to believe that a member of the Fed would make such a statement, and very unerving that they have no contingency plan should that situation eventuate. Continuing: "In order to correct it with income growth, we have to have artificially depressed growth pushed down below our trading partners in order to correct it... But over time, I think there is only one direction (for the dollar)."
- High equity expectations.
Polls indicate that investors anticipate stock returns in the future will average 15% per year, and that corporate earnings will increase 15% in 2010.
Surely, these investors will be disappointed.
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