Market timing and market valuation

Excellent article from Morningstar on market timing and valuation.

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.

Market timing and market valuation

The long road back

The stock market has rallied strongly since March, and this has a lot of investors feeling optimistic again.

A lot of the numbers touted by the press (with Wall Street’s careful nudging) foster this cycle of optimism. For example, the S&P 500, on a price-only basis, is up 56% from its ominous intra-day bottom of $666.79 (March 6, 2009). 56% sounds very impressive, indeed!

But, the context of that 56% number is important. If you bought a company for $100 a share and it fell to $1 (99% decline), and then rallied to $1.56 (up 56% from the bottom, but down 98% from purchase price), you’d have a 56% “gain.” Not as impressive when put that way.

The same context should be included in any analysis of the S&P’s meteoric 56% increase.

The S&P 500 peaked on 10/9/2007 at $1,565.15. That means, on a price-only basis, the S&P 500 is down 34% even after it’s 56% increase. It’s not very impressive to have gained 56% when 1/3 of your wealth is still missing in action.

This is where most investors get confused because percentage changes aren’t intuitively obvious (why, oh why, do teachers spend so much time on trigonometry and calculus and so little on the math of compounding!?). Percentage changes must be put in context and looked at over longer time periods, otherwise they can give an incomplete impression and perhaps even deceive.

Let me illustrate. My clients’ growth accounts were down 24% from the end of October 2007 (the month when the market last peaked) through the end of August 2009 (including fees and dividends, consult my notes on performance for full disclosure). Down 24% sounds bad, but not when you compare it to the S&P 500 total return (includes dividends): down 31%.

Down 24% may not sound much more impressive than down 31% because they are both down a lot. But, when you’re down 24%, it takes a 32% gain to get back to breakeven; when you’re down 31%, it takes a 45% gain to get back to breakeven. It will likely take less time to climb 32% than 45%.

Stretching these number out over time illustrates why a broader context and longer time periods are important.

My clients’ growth accounts are up 5.76% since inception (4/30/05) versus down 3.30% for the S&P 500. If “big-whoopledeedoo” is your response, I don’t blame you–it might not sound impressive at first glance.

But, from a broader context, that means my clients were 9% ahead of the S&P 500 after 4 years and 4 months, and that’s worth a lot over the long run where even small out-performance adds up. 2% out-performance (which I am by no means promising) means 50% more wealth over a 20 year period. That can really make a difference.

Even with its recent climb, the market still has a long road back.

Another factor in thinking about the 56% climb is valuation–what is the market likely to do going forward? If the market were dramatically under-valued, then that 56% climb may keep going. But, what if that 56% climb started from fair value or over-valuation? Then expecting the dramatic rise to continue wouldn’t make sense.

By my calculations, the S&P 500 is very close to fair value right now. Assuming underlying growth of 3%, inflation of 3%, and a 3% dividend yield, the expected return going forward is around 9% a year. At 9% a year, it would take the market another 5+ years to climb another 56%. Just because the market has risen a lot doesn’t mean it will continue to do so.

I’m not making a market prediction. I’m just trying to illustrate that the market’s recent rise must be kept in context, must be looked at over a broader time span, and must be looked at with respect to underlying fundamentals.

Given that, the market could rise, fall or remain flat. I have no idea what it’ll do. But, it would not be reasonable to take the 56% rise and extrapolate that performance going forward.

It’s a long road back, and it’ll likely take some time to cover the distance.

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.

Comparing apples and oranges

What would you say if I told you the market was over-valued by 30%? Would you think I was full of it?

What if I told you that this over-valuation were based solely on market commentators comparing apples and oranges?

When someone says the market is fairly valued or over-valued, what do they mean by that? What standard are they comparing it to? This may seem like a pie-in-the-sky question, but it’s very important.

Why? Because market commentators are frequently saying the market is fairly valued by comparing apples and oranges! And, the two are off by 30%.

You see, many say the S&P 500 is fairly valued because they are comparing the S&P 500’s forecast, operating earnings to the S&P 500’s actual, reporting earnings. But that’s comparing apples and oranges.

This may seem like technical minutia, but it makes a big difference. In fact, operating earnings of the S&P 500 have been 20% higher than reported earnings over the last 5 years. And, forecast earnings for the S&P 500 have been 10% higher than actual earnings.

In other words, when commentators say that the S&P 500 is trading at its historical average, they are comparing apples (forecast, operating earnings) to oranges (actual, reported earnings). And, those apples are 30% overstated compared to the oranges.

Next time you hear someone say the market is fairly valued, ask them if they are comparing apples to oranges. Are they comparing forecast, operating earnings to the historical average of actual, reported earnings? If so, tell them to adjust their numbers and get back to you when their figures are fairly comparing apples to apples.

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.

Does everyone believe the market will continue to climb from here?

Not John Hussman. Hussman makes his case in his latest Weekly Market Comment.

Although Hussman gets very close to attempting market timing, which I don’t believe anyone can do successfully, he does make some very good points about why the market’s returns from here may not be very exciting.

Luckily, we don’t need to invest in the market per se, and it’s possible to get significantly better returns in the right investments.

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.

Stick to the fundamentals

Although I tend to write here about the economy and markets in general, I must admit such opinions affect my investment process very little.

I don’t buy and sell based on what the market is doing or might do. I don’t buy and sell based on my assessment of the overall economy.

I buy when I find businesses selling significantly below assessed value and sell when the businesses I’ve bought are selling significantly above assessed value.

I pay attention to secular trends, such as energy prices and the expansion of cable into phone and broadband Internet, but I don’t use such trends as a starting point in my investment process.

I spend my days researching individual companies. I look for businesses with good economics–with sustainable competitive advantages. I look for businesses with great management, who are competent and rational, act as trustees for shareholders, and hold a significant stake in their company. Then, and only then, do I assess business value.

When the market is tanking or roaring ahead, it’s important to keep this in mind.

The best way to succeed in investing is to buy good businesses below their assessed business value and sell only if price exceeds valuation. To do this, you must stick to the fundamentals–you must primarily focus on business economics, management and valuation.

When the market is diving, it may be an opportunity to buy, but only if prices go below assessed value. When the market is rising, it may be an opportunity to sell, but only if prices go above assessed value.

The focus is always on the business fundamentals primarily, and only secondarily on prices. What the market and economy are doing should take a distant, and almost completely unimportant, third.

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.

Monday’s articles

I read several enjoyable articles today that put the market’s current situation in context.

The first is by John Hussman of Hussman funds. In it, he takes the Fed Model to task. The Fed Model says that the stock market’s earning yield can be compared to the yield on 10 year US Treasury bonds. As he clearly shows, this model looks great from 1980 to 1998, but would have given terrible investing advice from 1948 to 1980 and from 1998 until now. Does that sound like a good guide to investing–a method that worked during only 30.5% of post WWII stock market history?

He also takes to task the current practice of saying the stock market is reasonably priced by looking at forward price to earnings ratios and comparing that to historical trailing price to earnings ratios. Not only is this comparing apples and oranges by comparing projections and history, but it also ignores that profit margins are at all time highs and will almost certainly come down over time. As usual, his analysis brings a broader historical context to the situation.

The second is by Edward Chancellor (author of Devil Take the Hindmost: A History of Financial Speculation) and appeared in the Washington Post. His title is, “Look out. This crunch is serious.” In it, he argues that comparing current market problems to the short term problems of 1987 and 1998 may not be valid. His warning is that credit splurges have turned into major market problems in the past, and this one may look more like 1929 when everything is said and done.

The third article, in the Financial Times, is by Gillian Tett. In it, Tett argues that bond insurers, like MBIA and Ambac, may be in for serious trouble because they’ve insured so many structured financial products that contained bad credits. As he suggests, it’s very hard to know what these bond insurers have backed, so holding on to them as investments may prove foolhardy if it turns out they must actually support the insurance they’ve underwritten.

The last is by Bill Gross, of PIMCO, and appeared in Fortune. Gross compares current market turmoil to playing Where’s Waldo. Everyone seems to know a lot of bad credits are “out there,” but no one seems sure who is exposed to such fallout and by how much. Problems keep turning up in unexpected places, like German and French bank’s books. These problems were created by financial wizards on Wall Street who believed they could turn lead into gold, and, unbelievably, some people actually believed them!

In my opinion, it will take a long time to fully understand the severity of the current situation. This may turn out to look like 1987 or 1998, but it could also be much worse. For those who believe that credit excess always ends badly, it’s a great time to play defense and bet on those who can benefit from debt implosions.

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.

Is now a good time to invest in the stock market?

To see a historical take on where we are now, read John Hussman’s latest.

Using historical analysis, he shows that today’s valuations do not bode well for long term returns on the overall stock market.

Enjoy!

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.