I’ve said it before and I’ll say it again (because it’s true) dropping stock prices are a good thing. Crashing stock markets are a great thing. And the reason why is unless you are retiring tomorrow, you’ll be able to pick up stocks all that much cheaper. Instead of paying $100 for a share of IBM you’re paying $40. Instead of $200 for Merck, you’re paying $125. Ergo why, especially the younger generations, should be cheering for a collapse in the stock market.
But what is interesting is trying to find out precisely when the market will bottom out. When is the “ultimate” or “ideal” time to buy. I know many people have been saying, “Hey, now’s the time, it doesn’t get any better than this” but allow me to pour a little more rain on the parade.
Based on P/E ratios furnished by Dr. Shiller at Yale, the S&P 500 as of August was still trading above its historical P/E average of 16 (the red line), trading roughly around a P/E of 20. Now this does not include the 25% drop in the S&P 500 that has occurred since August. Even adjusting for that (and assuming earnings don’t tank further), the stock markets are at best…
Accurately valued.
Sorry to tell all you people that, but right here is where the markets are in line with their historical valuations. The Dow Jones at 9,500 and the S&P 500 at around 1,000 is where things should roughly be. This is “correct.” This is “about right.”
Ergo, you should not be loading up on stocks now, because you’d be paying the historically average price of a stock which is $16 in stock price for each $1 in earnings. You’re not getting a deal, you’re paying retail. People should wait for the market to REALLY go on sale, and with a recession guaranteed, it’s almost a surety it will. You laugh at Cramer suggesting a 7,700 Dow, just like my big time former employers laughed at me when I said there was a housing bubble (and an Asian currency crisis and a Dotcom Bubble), but you might just want to (for a change) listen.
Post Script - many thanks to Dr. Glenn Reynolds at Instapundit for the link. For those visiting from Instapundit, I would be immeasurably grateful if you could mayhaps suggest to Dr. Reynolds that he take a look at my book so that I may attain my goal of beating Nancy Pelosi in book sales.
Have you noticed how eerily similar the periods 1884-1931 and 1956-2008 look? Both started off being overvalued for two decades, then plunging to record lows in 1920 and 1982, respectively. Thereafter a serious overvaluation and a huge crash followed.
ReplyDeleteLooks like the unvisible hand at practice.
Considering the magnitude of what is still to follow in the current crisis (think Credit Default Swaps), the S&P 500 and Dow Jones could fall a further 50% to a ratio of 10, which would still be higher than in earlier periods of economic crisis. The result would be a DJ index under 5000.
To anyone who considers that unrealistic: Either the rescue plans of the Fed and the Government fail to work and we will see a terrible banking crisis like 1931, or it works and we will have another decade of Great Inflation, further ballooning the debt of American consumers and the government. Just take a look at what inflation can do to stock markets (1970s).
What is your estimation of a time frame for the market to bottom out? Being vague is all right, I'm just curious.
ReplyDeleteThose lying earnings.
ReplyDeleteIts the dividends, and dividend awareness will be a key part of any turnaround in a particular stock.
Stock price appreciation will be only a part of the picture, and dividends will reassert their importance.
BriaN
It's time for an unrelated link!
ReplyDeleteclicky
(Bailout related, but worth watching even if you're as sick of hearing about the bailout as I am.)
If stock price goes down due to decreased E, then it is not good thing. P/E ratio is really about anticipation of future. Growth potential indicated by high P/E. No growth or troubled bussiness will by marked by low P/E. If future id doomed, p/e should come down.
ReplyDeleteAg, you've got it exactly opposite. Low E (earnings)-> high P/E. The crash in stock PRICES leads to a LOWER P/E.
ReplyDeletevakeraj, you understand P/E ratio way too simple. When E goes down, P will go down even more dispropotionally to have low P/E. When E goes up, P will go up even more to get high P/E. That is how market works. Market always anticipate future E with P/E ratio. I think Captain will agree with me.
ReplyDeleteOne other thing... surely all those P/E calculations are now outdated, because they are based on earnings in a boom that no longer exists.
ReplyDeleteNow that everything is tanking, earnings will drop for many companies... so current P/E ratios may be a mirage. They may be far too optimistic.
Has anybody done a study of the relation of the book value of a company to it's stock price and P/E?
ReplyDeleteAccording to this article in the Wall Street Journal, the P/E ratio was 10.7 at the market's close on Thursday.
ReplyDeleteBut, isn't the P/E ratio based on actual earnings, i.e., earnings up to now?
If earnings fall in the future, the price would also fall to maintain a ratio near the historical average -- absent the kind of irrational speculation that drove up share prices in the past few years and back in the 1990s.
The speculation led to high P/E ratios primarily because of the expectation that share prices would keep going up, not that future earnings would justify such a high ratio.
My feeling is that once the market hits bottom it will stay there for a while. The economy is not looking good and I can’t imagine the general public rushing into stocks after the investing lesson we have all just learned. So my question is how long will the market stay on the floor? I think six to twelve months.
ReplyDeleteTrying to "time" the market is dangerous for the average investor, even when you think the market is down. "Laddering" a bit at a time and "balancing" a portfolio with cash and bonds is really a must except for those very seasoned in this discipline.
ReplyDeleteI agree though now is a buy time especially for younger people.
I don't see how you can accurately value most of the bank and financial stocks until you have some idea of what their assets are worth. And I don't think we'll have any idea of what their mortgages are really worth until 2010 at the earliest. That's when the option-ARM resets peak; it's the next category of mortgages with lead-pipe certainty of mass defaults.
ReplyDeleteFirst, congratulations on the Instalanche!
ReplyDeleteSecond, the P/E ratio is the wrong metric by which to judge whether the stock market is properly valued. Here's why: the main driver of stock prices is the stable component of their earnings, which is perhaps best reflected by their dividends per share. The relationship between stock prices and full earnings per share is much weaker.
Historically, investors bid up stock prices slightly faster than the growth rate of dividends. That has two big results: first, it causes dividend yields to tend to decrease over time (D/P - since P generally increases faster than D, dividend yields generally decrease.)
The second effect is less direct. As dividends per share generally increase at a slower rate than stock prices, so do the topline earnings from which dividends are drawn. That has caused price/earnings ratios to generally trend upward over time (P/E - since P generally increases faster than E, the price earnings ratio tends to increase.)
That's a long way of saying that we should expect P/E ratios today to be higher than in the past, and that values around the very long-term average will actually be undervalued. From that aspect, your analysis looks pretty sound!
Richard Russell of the Dow Theory Letters thinks it's the dividends that matter. Right now the yield on the Dow is 3.6%. At bear market bottoms, it typically yields 5-6%. That would imply a Dow of 6520-5400. Now, with interest rates at historic lows - 3 month T-Bills yield a miniscule 0.2%, which doesn't even account for inflation - yields might only grow to 4-4.5%, which would imply a Dow of about 8100-7500. So the bottom might not be too far off.
ReplyDelete"Crashing stock markets are a great thing."
ReplyDeleteThis can only be said by someone who doesn't own stock that's "crashed."
The historical average P/E ratio is not a good guide to investment today for two reasons. Number one, if you look at Shiller's chart, you will notice that actual P/E's have remained above or below the historical average for very long periods of time (from (roughly) 1906-1927 it was below; since (roughly) 1992 it has been above; ditto in 1881-1906). So if you had an investment horizon of 20 years back in 1906 and you bought on the notion that stocks were cheap, you would never have seen the P/E rise to 16; and conversely, if in 1992 you were waiting for stocks to become "cheap" in the sense of a P/E below the historical average, you would still be waiting today.
ReplyDeleteSecond, the historical average obviously moves with the times. It rises when P/E ratios stay high for a sustained period of time (like recently), and it falls when they stay low for a long time (like in 1906-1927). So if P/E's were to stay above the current historical average for a few more years, then the average itself would move up, and then today's prices would look like a (missed) buying opportunity in hindsight.