Preview

The recent stock market rally has attracted some real attention. Any why shouldn't it? It has been an impressive run over the last two months. In the issue below, I perform the usual valuations exercises to learn more about where we go from here.

On the whole, the stock market continues to bounce around what I perceive to be a decent but not outstanding valuation for a long-term investor. Investors need not feel like they "missed" the rally if they have a mixed stock market strategy and own at least some stocks. But adding to stock positions following this rally is less compelling.

Value investing and multiple expansion

Value investing is the only successful long-term investing strategy that I know of. Unfortunately, most investors focus too much on price and not enough on value. Investing based on rising prices alone is speculation, pure and simple.

On the other hand, the biggest investment gains typically come from price appreciation and multiple expansion. Stock investors in the 1990s and real estate investors in the early 2000s made a lot of money because these assets went from undervalued to fairly valued to overvalued. Expanding price-to-earnings and price-to-rent multiples in these time periods produced exceptional investment returns. But multiple expansion always comes to an end when the underlying fundamentals are too weak to support returns that do not depend on price appreciation.

Sustainable price appreciation occurs only when fundamental value permits it. Stock prices or home prices cannot increase forever if earnings and rents are not rising accordingly. Value investing does not depend on price appreciation for investment returns but often results in price appreciation when valuation multiples expand. Warren Buffett became wealthy because the market value of his businesses increased, but the market value of his businesses increased to a large extent because they were cheap to begin with.

Stock market valuation

So is now a good time to buy stocks? The S&P 500 has increased 42% (!) from $666 to $950 in less than two months. Incredible! But you can interpret rising stock prices in one of two ways:

• (1) prices always reflect fundamental value, so earnings prospects must be improving
• (2) prices bounce around fundamental value, so valuations are getting worse

Likely some combination of both exists in reality, but I lean heavily towards number (2). That's why I am cautious about buying after such a large rally. I do not believe the 42% market gain reflects substantially improved economic conditions. The real economy does not move that fast. A better interpretation, I think, is that investor pessimism is subsiding from extreme levels.

Here's what I wrote on March 2, 2009, days before the March stock market low:

"A mixed investment outlook calls for a mixed investment strategy. We are not at a market extreme (high or low) like we were 18 months ago. Depending on your outlook for the macroeconomy, you should probably view the stock market as fairly valued (No Great Depression) or expensive (Great Depression).

But if you don't know for sure, it makes the most sense to be partially invested. The correct mix will depend on the individual. A poor strategy would be to wait for the market to go up by 50% before confirming to yourself that we are not in a depression. Buy some now, and buy more if valuations improve." [new emphasis]

So here we are, two months and 42% later. I was certainly not calling a bottom in my March Newsletter. I wish I had been more bullish for a short-term trade, but I was not exactly arguing the bear case either. That's the whole point of a mixed investment strategy - you should be pleased if prices rise because you own some stocks and you should be pleased if prices fall because you can buy more.

But buying after the price increase makes less sense. If you were willing to be X% invested at $700 on the S&P 500, why would you want to buy even more now that the price has gone up? Two months seems awfully fast for a full economic recovery. More likely the stock market is just 42% more expensive.

Robert Shiller's metric of price divided by the 10-year earnings moving average now indicates that stock prices are once again modestly expensive: at $950 the 10-year P/E is 18.3. Historically, this measure has tended to fluctuate between 10 and 20 except during extreme market conditions like the Internet Bubble:

In March, the measure dropped to 14 for the first time since 1985. The measure actually dropped below 13 for a few hours on March 9 when the S&P 500 was below $675. But at $950, the measure is back up above 18 again:

Looking back, the $666 low is very near a preliminary price target that I mentioned back in October 2008 when the S&P 500 was roughly $940: "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."

This comment notwithstanding, I did not successfully identify the March low. Even when $675 approached, it was difficult to know whether a bottom was forming or whether we would go even lower. John Hussman has repeatedly argued that these types of bounces are impossible to predict statistically because of the high likelihood of continued downward price pressure in an oversold market.

An alternative method for displaying this valuation exercise is to graph the S&P 500 price against the 10-year earnings moving average times the median price to earnings multiple (just above 15):

This graph makes evident just how overvalued was the stock market during the 1990s and 2000s. Just because the stock market is 40% lower than it was 18 months ago does not automatically make it a good value. As I have been saying, it's probably closer to a 'fair value' than a 'good value' (with the caveat that the current rally up to $950 places the S&P 500 roughly 20% above the red trend line).

Ultimately, though, picking exact market lows are not necessary (or possible) for most investors. By the measures above, periods of overvaluation and undervaluation can persist for years. The best we can do (in my humble opinion) is to overweight stocks when value measures are low and underweight stocks when value measures are high.

Given that I continue to argue something like 'fair value' (or slightly overvalued after the recent rally), at least some stock exposure makes sense as a part of every investor's portfolio, but an overwhelming allocation to stocks would still be unwise even after the 2008 stock market crash.

Bear market anatomy

By far the most interesting book I have read in the past 3 months is The Anatomy of the Bear, by Russell Napier. The book provides an extraordinary data-oriented analysis of the major bear market bottoms in 1921, 1932, 1949, and 1982. One of my hobbies is to go to Barnes and Noble and skim 4-6 investment books in an afternoon. I bought Napier's book to take home for a more in-depth reading after skimming just the first 5 pages. I was not disappointed.

The main thesis of Napier's book is that the U.S. stock market tends to make generational valuation lows every 20-40 years. Importantly, Napier argues that these lows are identifiable in real time. Overall, I am convinced by his evidence, although my preferred investment style is already quite consistent with Napier's.

Here is a key excerpt from the June 2007 prologue (the original book was written in 2005):

"The key strategic conclusion from this book is that swings in equity valuation are driven primarily by changes in inflation. The global outlook for inflation is now changing and investors must be wary of investing in equities with historically high valuations. The cyclically adjusted PE of US equities has already declined from 39.5x at its peak in 2000 to 29.4x. The good news is that this adjustment has been achieved through stable nominal prices and material rises in earnings. The bad news is that one should expect the cyclically adjusted PE to decline to less than 12x before this bear market is complete. The rise in inflation which will instigate such a decline is now more clearly evident."

- Russell Napier, Anatomy of the Bear, CLSA Books, July 2007 Prologue p. xvi

Mr. Napier clearly avoided the 2007-2008 market crash, although he was expecting valuations to improve on the basis of earnings inflation rather than price declines. So was I. But now that a large price decline has already occurred, it's time to re-evaluate.

Among his list of ingredients for a major bear market low are:

• (1) Cyclically adjusted PE ratio (like the 10-year MA measure above) below 12
This measure dipped below 14 for just a few days in March but is still outside the 4.7 (1932) - 11.7 (1949) range seen at other bear market lows.


• (2) Q-ratio (replacement value of assets) below 0.3
The current Q-ratio is almost twice the 0.3 typically seen at major bear market lows (reference: Trading Volume Separates Bull Markets from Bear Rallies by Bill Hester).


• (3) Material disturbance in the price level (inflation or severe deflation)
Napier discussed in detail the rotation towards inflation in 1921, 1949, and 1982 and severe deflation in 1932. Importantly, all of these turning points represent a major shift from the previous time period.


• (4) Good economic news being ignored by the market
Napier presents substantial evidence against the common perception that "there is no good news at the bottom" and instead writes that "Bear market bottoms are characterized by an increasing supply of good economic news being ignored by the market." (p. 296) That hardly describes the "green shoots" sentiment of today's stock market coverage.


• (5) Final declines occur with low volume and rise on high volume
For (5), Bill Hester of Hussman funds discusses:

"To some extent, all stock market bottoms carve out a ‘V' bottom. Prices move lower, and then change direction. But look at the clump of blue data points in the upper left portion of the graph. These aren't the capitulations that most investors have in their minds when they think of a classic bear-market V-bottom. The bulk of bear markets have ended by falling less than 10 percent in the final month – and were followed by similarly modest moves off of the bottom. There are exceptions which include 1987 and 1998. But those corrections were sharp and condensed. Even so, they were both followed by tepid rebounds in the initial upswing...

Contracting volume is not enough evidence to qualify this is a bear-market rally with certainty. There are other measures that are showing more strength – such as various indicators of market breadth. But new bull markets, whether at their inception or soon after, have a history of recruiting noticeable improvements in volume. So far this rally lacks that important quality. Over the next few weeks stock market volume will be a metric to watch closely."

- Trading Volume Separates Bull Markets from Bear Rallies, by Bill Hester, April 2009

I also found Bill Hester's March article especially useful for interpreting today's stock market valuation. Needless to say, rally volume so far has been less than extraordinary:

Source: OptionsXpress

No single measure is perfectly predictive, of course, but the collection of evidence tends to be against a major bear market low. Valuation metrics are not as low as previously seen major generational bottoms. And other measures like volume and sentiment do not quite fit the pattern. At best, March 2009 represents a low similar to March 2003.

I was making this case to a graduate student colleague of mine who argued that "investors will never let stocks get to those low valuations again." Perhaps, but investors were probably saying the same thing in 1931 or 1975 after big market declines had already occurred. And then stock prices went even lower.

As for the timing, Napier offers this advice (in 2005):

"As we have seen from these high levels there has been, with the exception of 1929-1932, a slow shift back to low valuations. One should expect the adjustment to take from 9 to 14 years. Our current market peaked five years ago [in 2000].

From the June 2005 level, the cyclically adjusted PE would have to decline 40% to reach its long-term average. Assuming it declined to the low levels seen at the bottom of the great bear market bottoms, one would expect a decline in the range of 60% to 84%. Just how large a decline this will be in prices will depend upon how earnings perform over the period.

[My comment: Those levels for the S&P 500 relative to the $1202/share level in June 2005 are: 40% decline = $721/share, 60% decline = $480/share, 84% decline = $192/share (!)]

This bear market will likely come to an end sometime after 2009, though probably nearer to 2014. Sometime around then you could perhaps reread this book and see if it can help you recognise the bear market bottom. In the meantime, if you have to go down to the woods, keep your wits about you."

- Russell Napier, Anatomy of the Bear, CLSA Books, 2005, p. 297

To sum up, the type of bear market low that Napier envisions would be unlikely to produce a 42% bounce off of the bottom. Most likely, market sentiment would be more negative and improvement more gradual following a major bottom.

If this market down cycle directly produces a bear market low in 2009 or 2010, I would expect the decline from the October 2007 high to be more like 70-75%. This means going below $500/share on the S&P 500. It's possible, but my guess is that we don't quite go that low in this cycle especially given the government stimulus and inflation policy bias. But that doesn't mean valuations can't improve if earnings grow faster than prices.

Regardless of whether March 2009 represents an intermediate low, I do not think it represents a generational low like the years listed above. When will we reach such a low? My best guess is that we are a few years off. I view the current "bear market" that began in 2000 as a consolidation period, much like the 1929-1942 and 1966-1980 bear markets (see my March 2008 newsletter for a more in-depth discussion). All things considered, I like Russell's estimate of 2014. But I will of course be following and re-evaluating the evidence as it comes.

Housing

One brief comment on housing as I am currently wrestling with a personal decision to rent or buy a home in California. As I reviewed in August 2008, the buy versus rent decision depends on a multitude of factors, most important of which are: (1) price to rent ratio and (2) expected price appreciation. We are likely close to break-even levels in many markets although prices will likely continue a slow decline in most areas for some time (see February 2009). In the end, I suspect that my wife and I will continue to rent for another year or two and then reconsider.

On this point, given all of the pressure from the real estate industry (and now our government) to buy now (NOW!) before mortgage rates rise, the following observation is especially important:

"Once again I am hearing that same cocktail talk, “this is the absolute bottom! Rates are at all time lows.” Keep in mind that if you buy a $600,000 home with a 4.75% mortgage and rates shoot up to 8% which is not high via historical standards, your pool of buyers just massively shrunk. There is only one place to go with rates and it isn’t lower. Most successful real estate investors realize that price is everything. They rather have a 15 percent mortgage and a solid price, than a high priced home with a 3 percent mortgage. Why? You have more options at the higher rate/lower price. If rates ever drop, you can refinance. You can always sell. Or, you can pay down quicker since you are assured a 15 percent rate of return which many people now realize would be heaven. At a low rate/high price you have no wiggle room. If rates go up, that is it. Your pool of buyers declines. And paying down the note doesn’t do much since your rate is 4.75% which isn’t a great return." [emphasis mine]

- California Confidential, Doctor Housing Bubble, April 15, 2009

From an investment perspective, I think we are still too early to start scaling into most real estate markets. Whereas other factors including stability and lifestyle may influence your decision to own your primary residence, I expect rates of return in real estate to be low for a while longer. Give it time. I will be waiting.

Conclusion

Overall, I maintain my view that the stock market continues to bounce around a reasonable but not compelling valuation, above $850 on the S&P 500 being a bit expensive and below $700 being a bit cheap. As such, a more defensive stance is still warranted at current levels near $950.

That said, I am not convinced that the latest stock market rally demonstrates "green shoots" or real economic recovery. As I argued last month, I think much of the current policy path is misguided and will extend our recovery time. I view the current rally as mostly technical in nature and unrepresentative of the real economy. Economic growth takes time, and expecting a quick turnaround with all of the debt problems still remaining is too optimistic.

I have no strong view on whether March 2009 represents an intermediate stock market low. I'm honestly about 50/50. But if we do have a new bull market, I would expect at least some return near the March levels for an adequate basing period. Mike Swanson eloquently explains:

"Many people are wondering whether or not this is the start of a bull market and whether they should buy now...My view is that it is one thing to try to play a rally like this but another thing to buy into it as an investor who wants to buy and hold. In no way do I think it is time to start to do that yet...

If this rally represents the end of the bear market I would expect the market to perhaps rally a bit more over the next 4-8 weeks [from mid-April], but then to make a major top and dive down to at least give up half of its gains on this move or even to fully retest its March lows. It would then bounce back up and enter a trading range for the rest of the summer - and maybe even into the end of this year. It took a full eight months of base building after the July 2002 stock market bottom for the stock market to enter a bull market and with volatility even more extreme this time it may take even longer for the market to enter a new bull market if it bottomed last month...

In the most bullish of scenarios the market would simply enter a trading range. What this means for you is that there is no need to buy stocks now with the intention of buying and holding for a long time. You would be better off to be patient and to see what happens once the current rally comes to an end."

- Is this a new bull market?, Mike Swanson, April 15, 2009

The only point I would add is that regardless of your view, you might want to reconsider if your stock market strategy is either "all-in" or "all-out" (see March 2009). I wish I could give a less ambiguous recommendation. Writing in August 2007 and March 2008 was a lot more fun. But successful investing does not always require a strong view one way or the other.

Next month I will try to do a more broad review of investing cycles as a long-term investment thesis (see Asset Class Rotation from June 2008 for a preview). Best wishes until then.