Is it time to buy? Part 2

Valuations

One key factor in assessing whether it's time to buy - if not THE factor - is the market's valuation. But how do we determine that?

Let's start by figuring out the market's P/E ratio. Where do we get that information from?

One source is from the S&P 500's namesake, Standard and Poor's.
www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS

From this worksheet, we can see that the S&P's 2009 earnings are forecast as:
-Operating earnings per share (bottom up): $97.32

Is that the best estimate to use? I honestly don't know - the news media make reference to Thomson Financial's IBES database, but it looks like that's a paid database. Please write to me if you know a better source!

Meanwhile, the S&P 500 closed at 850 on October 27, 2008. This implies a P/E of only 8.7 for 2009. The sounds like a screaming buy, given that the market normally trades at a P/E ratio of 15.

But, how solid is that earnings number? The asset management firm GMO has put together a timely analysis for our purposes at http://www.gmo.com/websitecontent/JGLetter_ALL_3Q08.pdf. Here the news is bleak: profit margins are still 20% above average, but typically fall to fall to 20% BELOW average during severe recessions.

That suggests a floor of $58 to the S&P 500's 2009 (or 2o10) earnings, earning the S&P 500 index a less-appealing valuation of 14.6.

Add to that the fact that P/E ratios typically drop below 10 during really bad bear markets. To be generous, let's use that 10x ratio (yes, it can go even lower, all the way down to 8 in the 1970's, but let's hope that doesn't happen again) and our trough earnings of $58. That would imply an S&P 500 index level of 580 - scary stuff. (And, not coincidentally, the bottom end of GMO's forecast range).

So what? Well, at "normalized" levels - earnings of $78 and a P/E of 15 - the market would be fairly valued at 1168. But these are not normal times, since bear markets often overshoot. I'm not going to give any financial advice here, but let's just say I'm comfortable buying with a P/E of 12 at earnings 70% of today's - with both P/E and earnings below long-term trend, I can be more confident in a solid long-term return. That, in turn, implies a price target of 817, so I'll start buying sometime soon.

And if you buy, too, good luck to us all!

Is it time to buy? Part 1

You know the saddest part about the credit crisis? The fact that it was predictable. Warren Buffet called derivatives "financial weapons of mass destruction." Many times in the past decade, more clear-eyed regulators called for greater financial regulation, only to be turned down by high officials entranced with free-markets ideology. But by 2007, some of the smartest investing minds in the world, like Warren Buffet, Bill Gross, and Jeremy Grantham, had put their money where their mouths were, holding tens of billions of cash, waiting for the crisis to unfold. I wouldn't give as much as credit to Nouriel Roubini, who really does seem like a perma-bear, clearly anyone who had listened to him over the past few years would be in much better financial shape for it.

So that said, since the data was there for all to see, how do we cut through the clutter in the future to make sure we really know what's going on? There's really only one - look at the data yourself. And that's what we're going to do.

Is this a good time to buy stocks?

This is the question one everyone's mind, after the gut-wrenching decline of last week and the equally shocking rally on Monday.

I think there is a good opportunity to buy stocks here, but it really depends on your time horizon. No one knows if the market will come back in 5 years, but if you can wait 10 years, then this may be a good time to buy.

Here are the reasons why the market could come back in 5 years:
1. The normal fundamental drivers should be strong in 5 years. We would need corporate earnings to be good, inflation to remain low, and interest remains to remain low/moderate. Corporate earnings will decline in the near term, but global growth should resume in the medium term. Inflation has been driven by rising commodity prices lately, but that has proven to be temporary, with oil falling back below $100. More importantly, wage inflation has not occurred, meaning the inflationary expectations remain stable. Finally, interest rates are likely to go up, which is bad for stocks, but they should remain moderate.
2. Price/earnings valuations are low. Earnings will have to be cut, so valuations are not as good as they first appear, but, they're still below average (currently closer to 10 than the historical average of 15, and much better than the 2001 bubble of 30). While there are some bear markets in which P/E ratios reached the single digits, this did not happen in most bear markets.
3. The typical bear market goes down less than 40% , and we've already reached that point. For some historical context, look at:
http://www.nytimes.com/2008/10/12/business/12stox.html?em
http://www.nytimes.com/interactive/2008/10/11/business/20081011_BEAR_MARKETS.html

But, there is a possibility that the market won't come back for 10 years. If you want to put more money in now, you have to be prepared for that possibility. Here's are the reasons why the market might not come back quickly:
1. There have been 10-year periods when stocks did nothing. The 1930s and 1970s are good examples of this. However, the 1930s was the Great Depression, which shouldn't happen again since government authorities are trying everything they can to fix the economy, unlike in 1929-1933. And in 1970, earnings growth was low and inflation and interest rates were high, so it was not a good time for stocks.
2. The "credit crunch" is the really unique part of what's going on. Beyond the stock market crash, the fact that banks have stopped lending to each other will eventually crash the economy if not fixed. The rapid bank failures have scared all lenders and all banking and credit-related activity has stopped, which is unprecedented - this has not happened since the Great Depression. Will the recently announced bank recapitalizations in the U.S. and Europe get banks lending again? No one honestly knows.
3. If the government can't get banks lending again, then the economy is in for an extremely bad time, for a long time - like what happened to Japan in the 1990s. This is the single biggest question about the crisis. If the government can get the bank lending going again, then there's a good possibility the economy will be back to normal in 5 years. If not, then we're looking at 10 very painful years before a full recovery.

So which it be? Stay tuned.