Searching for the Bottom: Valuation
What a difference a day makes. There are varying interpretations for today's rally.
- Oversold bear market bounce — a popular view.
- News flow on mark-to-market and changes in the uptick rule — we doubt it.
- A reaction to fundamentals — Doug Kass's viewpoint, and therefore deserving respect.
The Valuation Question
In normal times stocks react to asset allocation decisions based upon relative valuations of the various asset classes. This has certainly not been a normal time. The climate of fear has generated redemptions from hedge funds and mutual funds. Even companies with solid earnings have moved lower, as everything got sold.
The reason is that no one knows what is "cheap." Even Warren Buffett, known for buying only when stocks were really cheap, is under fire for being wrong, or buying too soon, depending upon one's perspective.
In our investor portfolios we are focusing on stocks that have been unfairly crushed with the overall market and those that will rebound most strongly if the economy avoids a Great Depression scenario. There are many such choices.
For our current purposes, however, let us consider the overall market — the S&P 500. Valuation is a matter of a deceptively simple equation — the P/E ratio. One takes earnings and applies the appropriate multiple, the "correct" P/E ratio. This tells you the fair value price.
The problem lies in the various interpretations of both earnings and the multiple.
Earnings can be defined in many ways, with a myriad of decisions. Here is a sample:
- Reported or GAAP earnings, which include all of the financial write downs and various other "one-time" charges for severance pay.
- Operating earnings, attempting to exclude the one-time charges.
- Normalized earnings, where the analyst looks at a general trend over a long time period, attempting to smooth the business cycle.
- Weighted earnings, suggested by Prof. Jeremy Siegel, who believes that the reported S&P earnings over-emphasize the smaller cap stocks.
- Peak earnings, advocated by John Hussman, where one looks to past peaks in earnings and considers the trend in these peaks.
- Forward earnings, where one looks ahead instead of backward, trying to estimate the earnings power of the upcoming year.
These methods all yield different answers — but that is not all. Some analysts augment their method by calling into question past earnings. The historical financial earnings are suspect, since the companies booked false profits on derivatives now known to be over-valued. John Hussman has reduced his old peaks because he now believes the profit margins to have been excessive. If one chooses to normalize earnings, how far in the past must one analyze?
Depending upon your answers to these methodological questions, you can get a wide variety of past earnings results. We cannot even measure the past.
After deciding upon S&P earnings, one must still select an appropriate multiple. Once again, there is an array of choices:
- The historical multiple for the S&P 500. This varies with the time frame selected.
- The trough multiple, thought to reflect the valuation when markets reflected economic distress.
- A multiple reflecting interest rates and/or inflation. It should be higher when interest rates are lower.
Take your pick.
Every analyst agrees that whatever the choice of earnings and multiple, that is not necessarily the bottom. Markets overshoot in both directions, so the "fair value" could still be 50% too high.
The most bearish pundits take reported earnings and find the S&P 500 to be trading at a P/E ratio of 60 or so. There is no observable bottom for these pundits. They come up with a DJIA at 3000 and the S&P at 300, with no confidence that these values are a real bottom. No wonder investors are frightened.
If one looks at forward earnings of $60 or so, there is still the question of the correct multiple. If one applies the "trough multiple" of 10 or so, the fair value for the S&P is 600, and it could go much lower. No wonder investors are frightened.
If one disputes forward earnings, expecting further reductions in estimates, you could forecast earnings at $40 and apply the trough multiple. That is an S&P value of 400, and we all know that it could overshoot. No wonder investors are frightened.
The Doug Kass Approach
Doug Kass made a big call last week, saying that the market would bottom within three days. Tonight on Kudlow he called it a "generational bottom."
Since Doug has been so accurate in forecasting the threats to the market, he deserves special respect when he sees a bottom. His approach is to take the book value of the S&P 500, about $5.60, look at the normalized earnings over a long period (seventy years), and apply the historical ROE of 12%. This implies earnings of $67. The multiple over the same period was about 15, suggesting a fair value of 1005. He also notes past bottom multiples of 11.5 or 12, implying an S&P value of 787.
The beauty of his approach is that he avoids all of the top-down and bottoms-up arguments. He also takes plenty of historical data through many business cycles for his normalized approach.
Simply put, there is no one else in the valuation debate who is dealing with the issue on these terms.
Many investors who have been skeptical about stocks, waiting for an entry point, are frozen with fear that markets could move lower. Doug suggests that it is time to take advantage of the fear.
At "A Dash" we have advocated looking at forward earnings rather than looking backwards. This is how people evaluate individual stocks, and it will eventually show up in the market.
The "trough multiple" concept is currently used in error. Past trough multiples came when interest rates were in double digits. If the interest rate is 20%, the P/E multiple must be 5 just to get fair value. With the current low interest rates, the multiple on forward earnings should be higher. If one takes a corporate bond rate of 8% or so, you should still have a forward earnings multiple of 12.5, and that is building in plenty of risk.
Our main conclusion is the following:
Valuation methods are not helping the average investor.
That is because the pundit methods change with the winds. If one is bearish, it is easy to find a method to justify it. Or vice-versa.
Valuation should provide an anchor for the investor — a reason to buy or to sell. If Mr. Market is offering a good deal, take it. If the deal gets better, shift a little more from cash or bonds. That is what Mr. Buffett has done.
When Doug Kass and Warren Buffett are aligned, it is time to pay attention. The valuation models have been no more help in finding a bottom than the economic or political methods from our prior articles in this series.