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A description of the content follows : This crazy wheel we call the market never seems to stop spinning, does it? Either too hot or too cold at any given time (for real, or only perceived), wild moves have become the norm. There is an underlying root to the insanity though... valuation. Yes, when you take a few steps back and look at the...

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The Micro Cap Press - Discover the Power of Early Stage Growth
Saturday, October 9, 2010 @ 9:43 am PDT Volume IV : Issue 39
In This Edition...

This crazy wheel we call the market never seems to stop spinning, does it? Either too hot or too cold at any given time (for real, or only perceived), wild moves have become the norm. There is an underlying root to the insanity though... valuation.

Yes, when you take a few steps back and look at the market's centerline - or average - over the last several months, you will see a reasonable price based on a P/E ratio. Better still, we can use the forward-looking earnings projections to make some assumptions about what the market should be worth by this point next year. Before we get to it though, let's mention a couple of recent blog entries: 

  • First and foremost, for those of you keeping tabs on the editor's 'sandbox' portfolio, he's started to carve out a few names in an effort to pare down exposure. Click here to see which name has already been sold, and know that more sells are likely on the way. 
  • Second, though the apparent market tide has remained bullish through last week, all of the near-term signs still suggest at least a moderate pullback lies ahead. Just for the record, the bearish rationale now is the same one that spotted April's top. You can see it for yourself here
What Are Stocks Really Worth? 

It's a great question, and one that isn't being asked enough with the distractions of unemployment, mid-term elections, brewing currency wars, and now earnings season, popping up on a daily basis. It is the ultimate determinant of stock prices (eventually) though. As such, we'll make a point of answering the question today. Yet, we also want to offer some needed perspective on why a compelling valuation comparison may not be enough to push stocks much higher now.

A little background is in order first, however. 

You may recall our April 8th warning that stocks were overvalued, with a trailing operating P/E of 18.56, and a projected (2010) P/E of 17.25 (an opinion that, by the way, many scoffed at.) Sure enough, the S&P 500 topped out later that month, and ultimately gave up 20% of its value. 

You may also recall our July 1st explanation that stocks were undervalued, and ripe for a bounce. The trailing operating P/E at the time was a very palatable 15.5, with a forward-looking (and stunningly cheap) P/E of 12.2. Three months later - as of this week - the market has gained 13%. 

And where are we today in terms of valuation? Currently, the market's trailing operating P/E ratio is still a palatable 15.9. And, the trailing GAAP P/E ratio has even settled down to something nominal....17.3

On a forward-looking basis (and this includes the yet-to-be-announced Q3 numbers), the S&P 500 is currently priced at an operating P/E of 13.89 - something a little closer to normal than the prior projected P/E of 12.2. The projected GAAP P/E ratio is now figured to be 15.18, which is also something a little closer to the norm than Q2's forward-looking 14.5. 

Lesson learned: The market may hit extreme valuations on a temporary basis, but given enough time, stocks 'find' the right value. The 'time' factor can be the spoiler though, as you'll see below. 

Is That Good, or Bad? 

So is a trailing operating P/E of 15.9 and a GAAP P/E ratio of 17.3 the norm? For that matter, does a projected operating P/E 13.89 and a projected GAAP P/E ratio of 15.18 mean stocks are undervalued? 

Just for perspective, the S&P 500's average operating P/E ratio for the last 20 years has been 19.3. Even taking out the highest 20% of all those quarterly P/E ratio [the really skewed ones from the late 90's, mostly], the average is still 17.62. On a GAAP basis, the average has been 25.93 over the last two decades. However, even when its statistical outliers are removed like we did for the operating P/E figures, the average GAAP P/E reading is still 20.30. 

And if you take out the highest 40% of all the operating and GAAP P/E ratios over the last 20 years (a measure that would make most statisticians cringe, as it's well beyond the realm of 'statistically significant') you still come up with an average operating P/E of 16.5, and an average GAAP P/E of 18.5. Both are higher than the current trailing or projected readings. 

Folks, it's tough to believe, but given the numbers, stocks are quite undervalued in comparison to norms. They are NOT undervalued, however, when you factor in timing. 

Sorry to burst your bubble, but history is what it is. 

History Says These Low P/E Ratios May Get Even Lower 

Yes, while it is true that stocks are cheap right now, you should also know STOCKS ARE SUPPOSED TO BE CHEAPER THAN AVERAGE RIGHT NOW. As such, being 'undervalued' on an average P/E basis isn't necessarily a recipe for a rally. 

As we specifically pointed out back on February 25th - and this is exactly the reason we made the point then - P/E ratios fall to the lower end of their normal range coming out of recession-based bear markets. The P/E ratio didn't bottom out from the 1990 recession until 1994...four years later. The 2001/2002 recession's rebound didn't see its lowest P/E measures until 2006.... four years later.

See the point? While it's encouraging that stocks do indeed offer low P/E ratios right now, whether it's on a trailing or projected basis, that doesn't necessarily mean stocks are poised to go higher. Indeed, if history is any guide, the P/E readings are apt to sink as the 'E' continues to increase while the 'P' stays flat or even points lower

Of course, the 'P' and the 'E' could each rise and fall - respectively - by various degrees and still repeat that history of weak post-recession P/E levels, but at this point a gradually-rising 'E' seems to be the path we're mostly on. One way or another though, lower valuations are the way things are likely pointed. 

The Bottom Line 

Clear as mud? Here's the bottom line - the definition of 'undervalued' is a moving target. What might be a cheap P/E compared to long-term norms may not be cheap at this stage of the economic rebound. Indeed, we think stocks are fairly valued right around where they are right now, having adjusted our P/E expectations lower than the norm to accommodate the typical economic recovery's timeline. 

Way back on February 25th, we specifically mentioned that the S&P 500 should be worth about 1165 by year's end, given the projections at the time. Well, those earnings forecasts have been slightly adjusted since then, but haven't significantly changed. So, our outlook is still the same. 

And just as a reminder, the S&P 500 closed at 1165 on Friday. Translation?The market is roughly at its 'centerline' right now.

Oh, it will most certainly ebb and flow above and below that mark as we make our way though earnings season and proceed to the always-volatile end of the year. The axis remains at the 1165 level for now, however. 

And as always, keep in mind the difference between the long-term and the short-term. The discussion above is a long-term idea, though we still fully expect - and intend to play - the short-term ebbs and flows. 


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