Monday, November 3, 2008

Are we Fairly Valued or Cheap?

From this week's Barron's:

In a recent research note, you wrote: "I remain bullish and wrong." Is that still your sentiment?

Yes, it is. I was just looking at an interview I did with Barron's in December 1980, and I was called a super bull. And then we got prematurely bearish in 1998, and people started calling me a perma-bear. Right now, though, I am not a super bull, but I am a very convinced and optimistic bull.

What underscores your case?

Certainly, the intrinsic value of stocks. In terms of our valuation model, it's the most positive we have seen since 1984. We look at 28 different factors, including price-to-earnings and price-to-sales, and they are quite decidedly positive. Because we look at normalized earnings, we smooth them out over a business cycle. We have always done it that way, and we are at about 12 times earnings now.

Is that on forward earnings?

No. What we do is we take the last 4½ years of historical earnings, and then we project forward only six months. Then we divide the whole thing by 20, or the number of quarters. We have found over the years that it is almost imperative that you do that -- that is, smoothing out the business cycle to get the underlying level of earnings.

How does that 12 times P/E ratio compare to other periods?

Looking back 55 years, we are in the 15th percentile, well into the bottom quartile, and this is where markets very often have bottomed out. So on a valuation basis, this is a really cheap market. At these levels, we are really down in bull-market territory. From here, on a one-year basis -- and this goes back to 1926 -- the market has been up about 18%, on average, in the next year.

The interview is with 71 year old Steve Leuthold who has been in the investing business for over 5 decades. In other words, he's seen a thing or two. Like most serious investors/traders he has developed his own indicators so it's hard to compare his results with standard publicly available tools. However, it's important to note he sees the market as pretty inexpensive right now and that's with a system that employs 28 different factors.

While I don't use a model that proprietary the market's recent heavy sell-off has got me thinking this is a time to buy as well.


Does this particular downturn remind you of any other economic slumps in particular?

This recession is probably similar to the one that occurred around 1981. The average recession since World War II has been about 11 months. The longest was 16 months, and we've had two of those. And I think this one is going to last at least 16 months and probably longer than that, maybe 20 months.

This recession started in the fourth quarter of last year, so you are looking at a recession through the fourth quarter of 2009. But you have got to remember that the stock market is a lead economic indicator, and historically it has turned up about 60% of the way through a recession. Applying that timetable suggests that this market should be bottoming sometime this month, and that is very, very possible.

This is really interesting. I think the recession started in the first quarter of this year. Regardless of when we date it, the main thing I am interested in is 1.) how long it will last, and 2.) when to start adding stocks in relation to that prediction. I also think it will be a long recession. More importantly I think that once the recession is over there is still a decent possibility (at least 50%) that we will experience slow growth (1%-2%) for at least a year if not longer.

All that being said, his observations that stocks start rallying before the end of the recession is important. It indicates you can miss some of the the boat by waiting too long.