The stock market is down, but is it cheap?

Caution: please remove sharp objects from arms reach before you read this!

The S&P 500 is almost in bear market territory, down just short of 20% since its most recent high.

This fact leads market commentators to question if the market is getting cheap.

My answer: looking at long term, historical evidence, the market is not cheap. In fact, it would have to drop another 23% from current levels or remain flat for 4 1/2 years before trading at historical, fair value.

Before you read my reasoning below, please keep in mind that you don’t have to invest in the market as a whole. In fact, there are times when it’s better to invest in active managers who are trying to beat the market (but make sure they really can beat the market). Because I believe we are in a secular bear market that started in 2000, I think this is one of those times.

I’m finding some of the best bargains I’ve seen in my 12 1/2 years of investing. I’m absolutely giddy about the great companies I’m finding at great prices. This evaluation does not, however, include the stock market as a whole.

Why do I think the market is expensive. In a word, history. Looking at the history of the S&P 500, you can clearly see that earnings per share grow at around 6% a year over the long term. A plot of S&P 500 earnings per share with a simple exponential fit is a wonderful thing to behold (send me an email if you want to see it). Every time earnings per share deviates from the long term average, it regresses to the mean. Every time.

Using such a plot, I can see what the average, forward price to earnings ratio has been since 1948 by simply dividing year end price by the one year forward estimate of earnings (using the 6% growth rate fit on historical S&P 500 earnings per share).

Since 1948, the forward price to normalized earnings ratio has been 14.85. Let’s keep things simple by rounding up to 15. That allows for the fact that price to earnings ratios have been creeping up over time.

Using my plot of normalized earnings per share for the S&P 500 of $65.70 (June 30, 2009 normalized earnings per share for the S&P 500) and an historic price to forward earnings of 15, I come up with a fair value for the S&P 500 of $985.50, or 23% below current levels ($1,280 at the time of this writing).

By my reasoning, the S&P 500 wouldn’t be at fair value unless: 1) it drops another 23% tomorrow or 2) remains at $1,280 for the next 4 1/2 years.

I don’t mean to scare anybody with my forecast, I’m simply showing that, in the long term, price follows earnings. And, if earnings grow at historic rates and the market is willing to pay in the future what it was in the past for those earnings, then the S&P 500 is anything but cheap right now.

I wouldn’t assume a lot better results if you’re invested in the market, or with a professional investor who is so diversified as to essentially be mimicking the market (a lot of them are, a whole lot).

Take heart, though. You don’t have to invest in the market. Look for stocks that are better quality and cheaper than the market and you’ll do just fine. Or, better yet, find a professional who can do it for you.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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If the economy is limping along okay, then why are FedEx and UPS down so much?

It’s always interesting to watch reports about the broader economy and compare them to what’s happening to large corporations, like FedEx and UPS, that may more clearly indicate what’s really going on in the U.S. economy.

This week, people claiming unemployment insurance declined. Also, leading economic indicators were up for the second month in a row. Perhaps things aren’t so bad?

But, at the same time, FedEx reported its first quarterly loss in 11 years and reduced expectations going forward.

The stock of FedEx is down over 20% during the last year. UPS is down around 10%.

How can the economy seem to be motoring along when companies like UPS and FedEx seem to be doing poorly?

When given the choice between economic statistics (that get revised over and over again, and are heavily dependent on many shaky assumptions) and the performance of large corporations, I’ll take the performance of large corporations any day.

I think UPS and FedEx are indicating what’s happening in the economy better than broad economic statistics, and it isn’t pretty. Growth is slowing or declining, and you can see it in the volume and profits of the shippers.

In time, economic statistics will reflect this. In the meantime, I’m watching the major companies and what they’re saying is happening instead of focusing on the economists.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

It’s a great time to invest!

As pessimistic as many of my blogs sound about the stock market as a whole, I must admit I’m very bullish about the specific investments I’m making today.

You see, the market as a whole can be over-valued, or in for a rough ride, and yet you can find specific, long term investments that are very enticing.

I’m finding the best investment opportunities I’ve seen since the 2002-2003 market trough (when we were coming out of the 2001 recession).

Not only are the investments I’m finding likely to provide excellent returns, they are also higher quality companies than I usually get the opportunity to invest in.

Usually, large, high quality companies are priced at a premium to the market. Today, though, many great businesses are selling at prices that are at distinct discounts to the market and to my assessed business values.

I can’t remember a time in the last 12 years where I’ve been able to buy such premium companies at such low prices!

I don’t know when the market will turn, or when my specific investments may out-perform, but I do know I’ve spent a lot of time assessing their value and I’m very confident that high returns are quite likely over the next 3 to 5 years.

Now, I just need to be patient and wait for the seeds I’ve planted to sprout and grow. This is a high quality “problem” to have.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What’s next for the banking sector?

What’s made the stock market so jittery lately? Was it oil prices or commodity run-ups? I don’t think so. I think what’s bugging investors is: will something bad happen in the banking sector?

So far, the banking sector has suffered from defaults on higher risk mortgage investments. Some of these were subprime, some were Alt A (a step up from subprime, but not prime), and some have been home equity loans. All were bad loans and bad investments to begin with.

Because many market participants were buying mortgage investments with other people’s money (read: borrowed money), this part of the market really suffered when it became clear that almost no one knew what the mortgage investments they bought were worth.

But, so far, the banking sector hasn’t really suffered from major defaults on business loans, credit card loans, auto loans, prime mortgages, etc. In other words, the banking problems that started in March of 2007 have almost entirely been an investment phenomenon, not a broader bank lending problem, per se.

The question now is: could that change? Could the problems seen so far be the tip of a broader loan default problem? Could the economy be rolling over into recession and signaling that loan defaults will increase across the board?

If the answers to these questions are yes, the the problems in the banking sector, and the rest of the economy for that matter, may only be getting started.

Can the Federal Reserve fix these problems? Many people believe they can, but some strong dissenting opinions, even from within the Fed, are starting to question the validity of this premise.

The Fed may control interest rates and be able to bail out banks, but not without cost. The cost, in most cases, is higher inflation. With soaring energy and food prices, this will not be welcome news.

The other problem is that Fed actions are creating moral hazard. When you bail out stupid risk takers, they learn a bad lesson: they either make a ton of money making risky bets or they get bailed out. “Heads I win, tails you lose.” This may be leading to even more bad lending and highly levered investing.

What’s next for the banking sector?

It all depends on fundamentals at this point. Either banks have made good loans and have enough reserves to weather tougher times, or they don’t.

If they don’t, then expect the banking sector to hit new lows as more and more news comes out that broader loans–like credit card, auto, business, commercial real estate, prime mortgages–are hitting higher default levels.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.