Preview

I have been writing about the overvalued U.S. stock market for several years now:

• Thinking about historical P/E ratios, November 2006
• A testable prediction, April 2007
• Value Traps, June 2007
• The bleak outlook for the U.S. stock market, March 2008

Now that the stock market has lost 40% of its value in just 12 months, it's worth asking whether it finally represents a value worth buying.

On the whole, I'd say the stock market is a reasonable but not a compelling buy. History suggests that we will see bear market lows that are better valuations than this one, but there is no guarantee we will see such a low in this cycle. As a result, I think modest buying of the U.S. stock market makes sense with the S&P 500 currently trading below $950. Contrary to what I have been saying in the past few years, I would not discourage long-term investors from keeping their money in the market at this valuation.

Corporate earnings

First the bad news.

The big story for the stock market in 2009 will be the destruction of corporate earnings. If you believe (like I do) that a large fraction of corporate earnings in the past few years can be attributed to artificially rising home prices, then you might also be convinced that earnings could fall by as much as 50% from their peak around $82 per share in June 2007.

Consider the following updated graph of corporate earnings since 1940, which I first posted in the March Newsletter:

Click here to see the chart using a non-logarithmic scale

The chart above indicates that earnings have taken a turn for the worse, with no clear bottom in sight. As of the last data point in March 2008, S&P 500 earnings are already off 29% from the high in June 2007. After the tech bust, S&P 500 earnings fell by over 50% from September 2000 to March 2002. So we shouldn't be surprised by a decline of similar magnitude this time around, especially since this slowdown will affect a much higher fraction of the economy.

This would not be such a big problem if the S&P 500 had fully priced in the downturn, but the historical price-to-earnings ratio is still on the high side even after the latest price drop. The P/E ratio based on today's price and the last earnings release is around 16. This is far below recent levels, but also far above historical lows. The S&P 500 has crept below a P/E ratio of 10 three times in the last 100 years:

Click here to see the chart that uses a 10-year earnings moving average

The fact is that price-to-earnings ratios are still not cheap and earnings are probably going quite a bit lower. It would not surprise me if S&P 500 earnings bottomed at $45 per share next year and the stock market P/E ratio bottomed at 15. This would produce a price of $675, which is down almost 30% from current levels. Such a low is not implausible and would represent a great buying opportunity.

Projected returns

Now for the good news.

All things considered, projected returns for the S&P 500 are not all that bad. Using the same methodology that I used in my March newsletter (similar to the Hussman methodology which you can read about here), I project a likely return range for the S&P 500 over the next 7 years. The recent price discount has caused a jump in the expected return distribution. In the chart below, I project a pessimistic outcome and an optimistic outcome between which S&P 500 returns have realized for most of the last 70 years:

In 7 years, if corporate earnings end up on the weak side and the P/E ratio ends near 12, then annualized returns (including dividends) will be near 4% per year. If earnings end up on the strong side and the P/E ratio ends near 18, then annualized returns could be as high as 14% per year. These are healthy returns, even with an inflation rate currently near 5%.

Projected stock market returns look favorable relative to history when you consider that U.S. Treasury returns are much lower now compared to the past few decades. However, rising rates in the next 5-10 years would be quite negative for stocks as they become less attractive relative to risk-free rates of return.

In addition, the S&P to gold ratio which I discussed in the April newsletter is also starting to look more favorable for stocks:

The ratio is now down to 1.23 ($950 for the S&P and $775 for gold) from its high of 5.36 in September 2000. However, the momentum is clearly to the downside and the durations of past gold bull markets suggest that the trend will continue. I fully expect this ratio to reach the bottom red line at levels near 0.7-0.8. This means that gold will appreciate relative to the stock market by at least another 60% before the gold bull market is over. There is some possibility of an overshoot like there was in 1980, but I will likely be selling gold by then.

Given the inflationary environment that will likely result from continued efforts to save the financial system, I still think gold has a slight edge relative to stocks for the next few years. But I'm much closer to 50/50 than I was just a few months ago.

Three alternative viewpoints

In this section, I offer three alternative viewpoints from individuals whose investment advice I value.

Viewpoint 1: John Hussman

John Hussman manages a U.S. stock market fund worth nearly $3 billion in assets which has dramatically outperformed the S&P 500 since its inception since 2001. So he's worth paying attention to.

Consider what Hussman recently wrote about the U.S. stock market, after being overwhelmingly bearish in almost every year since 2001 (with the exception of the 2003 market low):

Stocks are now measurably undervalued

Investors will berate themselves for the panic they are now exhibiting. This, from an advisor that has adamantly argued for over a decade (with the exception of 2002-2003) that the stock market was strenuously overpriced and likely to deliver disappointing long-term returns. My impression is that investors who abandon properly diversified and carefully planned investments here, with the stock market already down by nearly half, will regret it as the emotionally panicked decision that wrecked their retirement prospects.

...Stocks are now at the same valuations that existed at the 1990 bear market low. Relative to 30-year Treasury yields, the S&P 500 is priced to deliver the highest excess return since the early 1980's. [emphasis his]

- John Hussman, Four Magic Words: "We Are Providing Capital", October 13, 2008

Viewpoint 2: Bennet Sedacca

Bennet Sedacca is a money manager who has been extremely accurate in his predictions regarding this stock market decline. He has maintained his investors' capital throughout this crisis by avoiding stock market exposure for the past few years.

His current viewpoint is still quite negative. Consider what he wrote just a few days ago:

The point here is not to depress anyone or to sound like a spoil-sport. Instead, we must face the issues at hand and deal with them in a fashion that is not a constant "Band-Aid." The only way stocks could be deemed "cheap" here is if we believe the Wall Street S&P 500 estimates of 2008 estimates of $75 per share. We actually think 2009 earnings will come in around the $55-60 range at best which would suggest an index price target (if a "normal secular bear market bottom" P/E ratio of 8 to 10 times earnings) that coincides with the price on my S&P 500 chart of 500-600. [emphasis mine]

Bounces along the way are inevitable, but for a true bottom to be put in place, some more work needs to be done to the downside.

This may be a trader's paradise, but investors beware.

- Bennet Sedacca, Traders' Paradise, But Investors Beware, Minyanville, October 13, 2008

Viewpoint 3: Warren Buffett

Warren Buffett needs no introduction. The following excerpt was taken from Buffett's must-read Op-Ed piece in today's New York Times:

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: ''I skate to where the puck is going to be, not to where it has been.''

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.

- Warren Buffett, Buy American. I am., NYTimes, October 17, 2008

Here's another quotation from a Buffett interview just a few weeks ago:

And, you know, five years from now, ten years from now, we'll look back on this period and we'll see that you could have made some extraordinary buys. That doesn't mean it won't get more extraordinary a week or a month from now. I have no idea what the stock market is going to do next month or six months from now. I do know that the American economy, over a period of time, will do very well, and people who own a piece of it will do well. But they shouldn't own it on leverage.

- Warren Buffett, CNBC Interview, September 24, 2008

Conclusion

Here's what I wrote back in January of this year:

Although I try to remain unbiased and focus on market fundamentals, I recognize that my current outlook for the U.S. economy is quite bearish. I don't anticipate a depression type of scenario, but a recession may certainly be in the cards in the near future. Either way, I expect U.S. stocks and real estate to underperform in the next few years. Unlike your stockbroker, at least you'll know that when I finally become bullish on U.S. stocks that my outlook is genuine.

I would not yet call myself bullish on stocks, but at least I am no longer bearish. It's amazing how quickly things have changed in the last 6-12 months with the S&P 500 down 36% so far in 2008. I would not advise an overwhelming allocation to stocks, but adding to long-term stock market investments is worthwhile at this time. My personal guess is that we will see the stock market creep higher through the winter and early spring before going a bit lower than current levels in 2009 when corporate earnings bottom out. But the market is no longer at the horrible valuations that it was just 12 months ago.