Stocks Are Cheaper, but Still Not Cheap

12/11/2008 1:40 pm EST


Howard Gold

Founder & President, GoldenEgg Investing

Even as global economies unravel before our eyes, there's been growing speculation equity markets have bottomed.

Permabears like Robert Shiller and Steve Leuthold argue that stocks have been driven down to levels that are historically cheap.

I wish I could believe them, but I don’t.

Remember, I had been wrongly bullish about stocks well into this year. Like many others I thought we might have seen a bottom in March (when Bear Stearns collapsed) and at other points.

But, as I wrote here last week, I believe that the world economy will not be a hospitable place for equities for some time. A long, deep recession, massive debt liquidation, fiscal strains on governments around the world, and a new frugality among consumers could produce subpar economic growth well into the next decade.

And by some key measures, stocks aren’t very cheap at all.

At its recent closing low of 7552, the Dow Jones Industrial Average had lost nearly half its value from last October’s closing peak above 14100. The Standard & Poor’s 500 index was down nearly 52% from its all-time closing high of 1565.15.

But even at those lows, stocks don’t reflect the bargain-basement valuations we’ve seen at the bottom of other bear markets.

A recent Wall Street Journal article laid out the born-again bulls’ case for a bottom. At its November 20th lows, Leuthold calculates, the S&P 500 changed hands at roughly ten times average corporate profits over the past five years, among the lowest such readings in half a century.

Yale professor Robert Shiller does the same comparison over ten years and comes up with a P/E multiple of 13.4x—“the lowest level in 21 years and its first dip below the average of 15 or 16 since 1991,” according to the Journal. Shiller thinks the S&P 500 is “fairly valued” at current prices below 900.

But according to S&P’s senior index analyst Howard Silverblatt, the S&P 500 now trades at above 19x reported earnings for the 12 months ended September 30th.

That’s much lower than it was in the fourth quarter of October 2002, the last bear market’s nadir, when it changed hands at nearly 32x reported earnings. That period featured substantial write-offs across corporate America, seriously depressing earnings.

But it’s also much higher than the 14x reported earnings at which the S&P 500 traded in the third quarter of 1990 (that bear market’s bottom) and the incredible seven times earnings at which the S&P changed hands in the third quarter of 1974, the end of that ferocious bear.

(S&P’s equity market strategist Alec Young points out, however, that double-digit inflation in the 1970s makes it difficult to compare those valuations with today’s.)

But since markets anticipate the future, what about next year?

Currently, Silverblatt anticipates about $42 a share in reported earnings for the S&P 500 next year. That’s about half of what those companies earned in the 12 months ended June 2007.

So, you do the math: What does ten to 15 times $42 get you? A lot lower than even the November bottom.

Meanwhile, dividend yield fell out of favor in recent years as companies found other ways to use cash. But as share prices languish, dividends have become more important to investors.

So, how do we stand there? For the last 70 years, the average yield on the S&P 500 has been 3.82%. It's currently around 3%.

Historically, markets haven’t been considered cheap until dividend yields top 4% or even 5%, as they did in 1974 and in 1981, the year before the 25-year bull market began. The yield got up to 3.87% in the third quarter of 1990, which also turned out to be a good buying point.

But as companies cut dividends, S&P is projecting a slight decline in dividend payments next year, to around $28—the first expected decrease since 2001.

So, let’s do the math again. Assuming $28 dividend payments, a 4% yield gives us 700 in the S&P, not too far from recent lows. But 5.5% brings us close to 500—a lot lower.

And remember: Yale’s Robert Shiller says that the S&P is fairly valued now. But Andrew Smithers reminds us that “previous serious market collapses did not end until they were, on average, at only half fair value.” Yikes.

Meanwhile, investors may not be as glum as they look. True, members of the American Association of Individual Investors hold 37% of their portfolios in cash, approaching previous peak levels of October 1990 and October 2002.

But in the AAII’s most recent sentiment survey, bulls and bears were about evenly divided, in the high-30% range. Back in 1990, bears topped bulls by more than 40 percentage points, and the number of bulls fell to a minuscule 13%. (The spread approached 40 in January and March of this year, but bulls never dipped below 20%.) It’s hardly doom and gloom now.

Our recent sentiment indicator revealed little capitulation, either.

So, it should be no surprise that smart traders and technicians like Sandy Jadeja, who called the top of equities markets last fall and crude oil this summer, don’t believe we’ve hit bottom.

Jadeja, chief market strategist of ODL Markets in London, says we may see a nice rally that could last into the spring and bring the Dow close to 10,000 again.

“I’m looking at that as a suckers’ rally,” he says. “Longer term, the trend is still down.”

He doesn’t see a bottom for the Dow until somewhere in the 6,000 range, maybe lower.

I’m not looking for the market to do much, either. We could be in a time like 1966 to 1982, which was punctuated by bear market rallies but took 16 years for stocks to rescale their previous highs.

I have no idea how long this one will last, but it may have begun in 2000, despite the illusory market highs we saw last year, and it may have several more years to run.

What should you do? If you’re under 50, you should still invest regularly in a well-diversified portfolio, because the market will ultimately give you good returns to fund your long-term needs.

If you’re retired or getting close, I’d stay invested in stocks but sell a little into rallies to lighten your equity holdings. And I’d be looking for bonds and more stable, dividend-paying stocks to give you income while you wait for the market to recover.

Because unfortunately, that may take a long, long time.

Howard R. Gold is executive editor of The opinions expressed here are his own and do not necessarily reflect the views of InterShow or

  By clicking submit, you agree to our privacy policy & terms of service.

Related Articles on MARKETS

Keyword Image
2 Ways to Bet on BDCs
14 hours ago

Business development companies (BDCs) lend money to private companies in the form of fixed and varia...