Optimism is in short supply; so are stocks cheap? Is the U.S. market now the Great Give-Away?
The answer depends on who you ask, and which yardsticks are used to measure valuation.
Investors were cheered Friday on reports that President-elect Barack Obama will name Timothy Geithner, the president of the New York Federal Reserve and a former Treasury official, as Treasury secretary. The Dow Jones Industrial Average rallied in the final hour of trading, tacking on almost 500 points to close back above 8,000 -- a gain of 6.5%.
But that upbeat finish can't gloss over a market that seems to be littered with land mines. Citigroup Inc. has been pushed to the brink after a stunning decline in the banking giant's shares, and the strapped Big Three automakers begged Congress for a bailout this week.
A fierce debate is raging between bulls and bears over whether U.S. stocks are beaten down enough to risk wading in. Even after Friday's rally, the bears are winning the argument.
Yet in these extraordinary times, it can be helpful to put emotions on the back burner and consider market history. There is no doubt that fear is propelling markets, but over the long haul, the gravity of fundamentals and valuation drives returns.
One of the most common metrics of stocks' valuation is price-to-earnings ratio, or P/E, which is a rough gauge of how much investors are willing to pay for each dollar of future earnings. Price is simply the stock's value, but a big and nagging problem of P/E is how to measure earnings. For example, investors can use forward-looking earnings estimates or trailing profits.
Based on 2009 projected operating earnings, the P/E on the Standard & Poor's 500 Index this week was around 10, according to Standard & Poor's. Valuations haven't been this cheap in decades, at least according to this measure. Meanwhile, 12-month trailing P/E was around 11, a level last seen in the late 1980s, according to Boston-based money manager Eaton Vance Corp.
'Delusional' earnings forecasts
Many market pundits think Wall Street's earnings expectations for 2009 are way too rosy as corporate America braces for what could be a nasty recession and more job losses. The financial system also looks susceptible to more tremors with credit markets still unsettled. Highlighting the fear, yields on three-month Treasury bills are virtually zero.
"Corporate earnings-per-share continue to be revised sharply lower, especially in cyclical sectors," said Sam Stovall, chief investment strategist at S&P. "While equity prices will likely precede an upturn in the fundamentals, we think the global economic and EPS outlook need to at least show tentative signs of stabilization before a lasting rally will ensue."
Nouriel Roubini, a New York University economics professor who predicted the financial crisis, in a recent commentary piece for Forbes magazine called 2009 consensus estimates for earnings "delusional" and "outright silly."
Roubini, who warned of the worst consumer recession in decades, wrote the U.S. consumer is "shopped-out, saving less and debt-burdened."
If earnings do fall sharply in an economic slowdown and profit margins are squeezed, then the market won't appear so inexpensive and stocks could sink to new depths, bears say.
Howard Silverblatt, senior index analyst at S&P, says profit estimates need to come down to reflect the economic challenges, and this is the time of year when companies and analysts typically cut forecasts. Most S&P 500 companies have already reported third-quarter earnings, and the results weren't pretty. Operating earnings fell 22% from the year-ago period, marking the fifth straight quarter of negative earnings growth, according to S&P.
Much of the damage has been centered in the financial sector, which has been pounded by the credit tsunami and write-downs on soured credit investments. The Financial Select Sector SPDR Fund, an exchange-traded fund tracking large-capitalization financial stocks, was down 67% year to date through Nov. 20, trailing the S&P 500 by 19 percentage points, according to investment researcher Morningstar Inc.
Since October 2007, the weighting of the financial sector in the Russell 1000 Index has fallen, to under 15% from more than 20%. By comparison, after the Internet bubble popped, the technology sector's representation in the index slumped to about 12% in late 2002 from 31% at its height.
Uncertainty in the financials and other sectors has led to huge and unsettling swings in stock prices.
Volatility is "off the wall," Silverblatt said. One-day shifts of 5% or more -- as happened on Friday -- have become routine. The S&P 500 has moved at least 1% up or down on more than half the trading days this year, and investors have to go back to the Great Depression to see comparable volatility, Silverblatt noted.
Wall Street's "fear" indicator, the CBOE Volatility Index (VIX), has spiked during the market turmoil. The market-sentiment benchmark measures the implied volatility of options on the S&P 500.
Highlighting investors' skittishness, the VIX jumped to a record intraday high of 89.5 on Oct. 24 and broke through 80 again this week. Prior to October, the VIX had only closed above 45 on four days, according to Russell Investment Group. Since Oct. 12, the VIX has stayed above 45 with an average reading well over 60.
If stocks are cheap, why are they falling?
Markets can certainly fall much further from here and this week's sell-off was a stark reminder of that, but successful contrarian investors know that trying to take advantage of opportunities when others are fearful requires an iron stomach and a long-term mindset. Many investors have already thrown in the towel on stocks for the foreseeable future, and the flight to quality has pushed Treasury bond yields to rock-bottom levels.
Stocks look cheap relative to bonds, but investors face the dilemma of trying to catch a falling knife, said Ernest Ankrim, chief investment strategist at Russell. It might be a good time to buy stocks, but they could get even cheaper if investors simply wait.
"The momentum against stocks is so strong that we have a hard time ringing the bell to overweight stocks," Ankrim said.
"The nature of bear markets is that they can go to extremes," added Duncan Richardson, chief equity investment officer at Eaton Vance. "Valuations can quickly go from reasonable to ridiculous."
An elevated VIX, fast-moving markets and investors trading on fear makes it even more difficult to value equities. Nervous investors have dumped stocks and piled into money market funds on overwhelming evidence the economy is worsening.
"It's easy to be pessimistic with all the selling," Richardson said. "The question is at what point does the market say it's safe to get back into the water."
It seems like U.S. companies are about halfway through the earnings decline, said Richardson, adding that stocks will have a tough time rallying until there is some improvement in troubled pockets of the fixed-income markets.
Merrill Lynch's investment strategy team is advising a cautious stance even though stock valuations have come down.
"The key question is when will equity expected returns outweigh the risks imbedded in the economy," Merrill wrote in a Nov. 17 note to clients.
Even though some well-respected investors such as Warren Buffett are moving back into stocks, "history shows quite clearly that being early can carry substantial performance penalties," Merrill said. "We believe it has historically been better to actually be somewhat late."
In other words, sometimes it doesn't pay to be a hero in a bear market. Until the risk-reward picture improves, the strategists recommended conservative themes such as high-quality bonds, defensive sectors and secure dividend-paying stocks.
At the same time, investors have reason to hope. The stock market has historically rebounded before the economy gets back on its feet. There have been nine recessions since 1950. At the midpoint of these slowdowns, the U.S. stock market jumped about 29% on average over the following 12 months.
No one knows how long this recession will last, but if investors wait for absolute evidence the economy and job market are turning around, they could miss out on much of the gains when stocks turn. See related story.
A combination of low Treasury bond yields and pessimistic forecasts for long-term capital appreciation in stocks has led to renewed interest in dividends. Since 1926, dividends have accounted for about 42% of the S&P index's total return.
The dividend yield on the S&P 500 is now higher than the yield on the 10-year Treasury bond -- the first time this has occurred in almost 50 years.
Bob Doll, global chief investment officer of equities at BlackRock Inc., in a Nov. 17 report noted more than 60% of the stocks in the S&P 500 have a P/E of less than 10, a situation not seen since 1982.
"To us, this suggests that valuation levels are helping to create a floor for equity prices," Doll wrote.
Still, the broader economy faces serious headwinds in the form of weaker consumer spending, falling home prices, rising unemployment and lingering credit issues.
"The bad news is that the severity of the credit issues may push the economy into a deeper recession and could limit the strength of any recovery," Doll said. "The risks clearly remain to the downside and the economy remains vulnerable to additional financial shocks."
A little at a time
Investors truly do have to go back to the Great Depression to see something similar to the pain and fear currently gripping the markets. Aside from Black Monday in 1987, the three next largest one-day declines in the Dow were during in 1929 Crash. During that year, the Dow peaked at 381.17 and fell to 198.69, a drop of 48%.
However, worse was to come and the 1930s were the most volatile decade on record for stock prices, according to Dow Jones Indexes.
The Dow plunged about 53% in 1931 and 33% in 1937, but it surged 67% in 1933 and jumped roughly 39% in 1935. Huge one-day swings were common during the 1930s as the Great Depression caused fits of euphoria and fear, a situation that today's investor can appreciate.
In volatile markets, one way investors can reduce risk is by dollar-cost averaging into stocks, rather than buying all at once. Nevertheless, they should set aside enough cash to cover any short-term surprises in this uncertain economic climate.
Additionally, financial planners encourage workers to max out their retirement plans as much as possible to take advantage of the company matching if their employer offers it, and also the tax benefits. This "free money" is a kind of leverage that lets investors scoop up more shares on the cheap in bear markets.