Wednesday, June 30, 2010
Written by Bo Billeaud
If the growth rate of our economy does in fact slow going forward, the possibility of revaluing stocks (again) should not be ignored.
After enjoying an 18-year run (1982-2000) that carried stock prices (S&P 500 stock index) up by nearly 15 fold, stock market investors have now endured more than 10 years of one of the most difficult investing environments ever.
From 2000 through the end of 2002, the major stock averages fell by nearly 50 percent. A recovery in stock prices from 2003 through 2007, which made investors nearly whole, was followed by another collapse into 2008 and early 2009. The last year has seen another price recovery of sorts — although stock prices remain some 30 percent below where they stood both in the fall of 2007 and the beginning of 2000.
So what’s the problem with the market? Why did prices enjoy such a wonderful 18-year run through early 2000, only to be followed by the frustration of the last 10 years?
Quite simply, what market investors have been experiencing is the inevitable and recurring market cycles related to valuation. Markets have always moved in long-term, secular cycles of valuation — from cheap to expensive, and, ultimately, back to cheap.
How do you measure market value?
There are a number of ways to quantify the value present in the stock market. It is usually expressed as the price of a security or index relative to some particular financial metric such as earnings, sales, dividends, cash flow or book value. Each of these measures can tell a story.
If you consider just earnings alone, there is a wealth of historical information from which yardsticks of value can be formulated. In his best-selling book Irrational Exuberance, Professor Robert Schiller (Broadway Books, 2nd edition, 2005) has reintroduced and popularized Benjamin Graham’s 10-Year Price to Earnings ratio that uses a 10-year average of reported earnings for valuing the S&P 500 stock index.
In the accompanying chart, which shows that data for the S&P 500 stock index, dating back to 1925, note the oscillations of market value. There are the single-digit price-earnings ratios found at the major market bottoms of 1932, 1942 and 1982, suggesting a cheap market. And there are the higher price-earnings ratios (greater that 22) of 1929, 1937, 1965 and 2000, suggesting an expensive market.
Now here’s what’s important about this chart. Since reaching a record breaking, nosebleed altitude of 43.5 back in April 2000 (yes Virginia, stocks were really expensive then), the secular bear market of the past 10 years has — so far — pulled stock prices only down to the trough price-earnings valuation of 13.3. And while there is no law preordaining a secular bear market to ultimately slam stock prices down to a level commensurate with a single-digit P/E multiple, the fact of the matter is, that has been the market’s long-term experience.
Today’s market is priced at nearly 20 times earnings — not exactly what you would call cheap. Given the events of the last 10 years, it is often asked what it would take to re-usher in the bear, as if it might require some outside or exogenous event. Well, while there might be any number of such events that could trigger another financial downturn, the fact of the matter is this: At the current level of valuation, no outside event would necessarily be required. A simple revaluation of stock prices from the existing 20 times earnings down to the median historical valuation level of 16 times earnings would be quite enough to rock the house. If that were in fact to happen, you could expect the S&P index to fall roughly 20 percent or so, down to the mid-800 area.
Why might such a revaluation happen? In the absence of an outside catalyst, it might not at all — unless there was a change in investor expectations and/or psychology. And that might not be a stretch. Stock prices are currently discounting an awful lot of expected good economic news. At the same time, certain forward looking economic indicators are suggesting that our domestic economic growth will likely be moderating as we move into the second half of 2010. A market such as we now have, priced for happy days ahead, might have, as they say, issues with anything otherwise.
If the growth rate of our economy does in fact slow going forward, the possibility of revaluing stocks (again) should not be ignored. It is very much in your own best interest to make sure the asset allocation in your investment portfolio is such that you can withstand this adjustment, should it occur.
Forewarned is forearmed.Bo Billeaud has been president and chief investment officer of a Lafayette-based money management firm for the past 18 years. Contact him at