Wednesday, April 9, 2008

Has the Market Reached the Bottom?

An interesting question these days since investors have either lost money since last September, or they're waiting on the sidelines to jump back in and find some bargains for the long run. I found an interesting chart in my internet travels, and its beauty is its simplicity. Thanks to the Float for posting originally (click to enlarge):

This chart shows the value of the S&P500 index from 1980 to current
at different price to earnings ratios, or P/Es. The S&P500 is considered the market, and the price of this market index can be analyzed. A P/E ratio is a simple way of representing how much investors are paying for a dollar's worth of earnings. It's a nice ratio that allows investors to compare stocks (or markets in this case) on a relative basis, whether you are comparing the "pricey-ness" of two stocks at a point in time, or comparing how expensive a particular stock currently is relative to its past or projected future. In this case, the "price" of the market is a composite of all stocks in the market, weighted by their market cap. The S&P500's price and index value are synonymous. The "earnings" is the composite earnings of all of these companies.

As a further illustration of how you can use P/E ratios using stocks. Suppose WMT trades at a P/E of 18.0 and TGT trades at a P/E of 10.0, which is more expensive stock? (Answer is WMT; investors are paying $18 for every dollar of earnings per share that the company delivers to shareholders. If earnings are $1, then the stock is trading at $18. The bigger question is are WMT and TGT the same, and if not, is either stock mispriced relative to the other based upon the earnings each company will generate in the future...)

Back to the Chart The black line is the current P/E that the S&P500 trades at. The blue line is the P/E of the S&P500 index at "fair value" based upon historical P/Es of the index, and the red and green lines are the "overvalued" and "undervalued" P/E price series of the index, respectively.

What's distinct on the chart are the 2 peaks, no matter what color line you use. These peaks correspond to the Tech bubble of 2000, where Pets.com was worth more than GE (I'm joking of course) and the second peak represents the current market dislocation during which the housing bubble evolved and popped. This data was one piece of evidence that led many to think that the housing market was a bubble, despite "eluding" many in the media (FEd Chairman, etc.) To all who listened and got your money out, kudos. It's hard to sit on the sideline when everyone else is dancing. Staying on the sidelines while the herd made money took lots of moxie, and it probably felt like being the designated driver for your friends. My post on herd mentality and informational cascades is coming soon.

So this brings us back to the original question, is the market overvalued? Based upon this chart, the answer is "probably", and if you wanted to put some numbers to where the S&P500 support is (translation, "where will the S&P500 fall to before it turns and heads back up), then you could make the argument that the "Fair value" is where the index is around 1000. All of the talk you hear these days is that earnings season has started, and investors eagerly await to hear a company's management team speak about their outlook on the economy. Well Alcoa went first, and they downgraded their outlook after year over year profits were down 50%. UPS and FedEx both warned that sales will be lower this year. Many are even stating that we are in a recession, or have been. When companies report their earnings, these "sales and earnings" results have already happened, they are ex-post, where management's outlook on the next quarter and year are ex-ante, and more important to our question.

The point is, no one can predict the market, but corporate earnings seem to be collapsing. And they should if the consumer cannot continue to spend, and companies find it harder or more expensive to borrow money in the capital markets to invest in future growth projects that generate higher earnings in the future for shareholders.* So if the market is/was overvalued, then the denominator "E" in our P/E ratio is getting smaller, but prices must come down with it since the market isn't fairly valued. I would argue that support for the S&P500 is somewhere in between 1000 and 1200, but then again, this is a volatile market, so we could be in for a wild ride down to that support level.

*(Another aside about the market's run up during the past couple of years was also led higher by historic share repurchases by companies. Rather than deploy the cash earned back into the operations to fund new growth opportunities, these companies chose to return money to shareholders by buying back their stock.)

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