Comstock Partners, Inc.October 16, 2008
Market Now Fairly Valued--But Not Cheap
For the first time since we started writing these comments in early 2000 the market has declined to levels where it is reasonably valued on all five of our major parameters-not cheap, mind you, but reasonable. This does not mean that the market can't decline significantly to bargain levels as it has done at a number of past bear market bottoms. In fact there's a good chance that it does exactly that. But it does mean that forecasting a much lower market is no longer the layup it was at far higher levels. Based on data provided by Ned Davis Research, we note the following.
As we stated in last week's comment, we advised you to view the article on the right side of our home page, "Limbo, Limbo, How Low Can it Go?" in order to see the overvaluation of the stock market. Well, since the market dropped so much since early Thursday when we wrote the comment, things have changed. If you now view the charts, we would advise you to plug in the latest values of the various indicies that are displayed by NDR research. The charts on "Limbo, Limbo" show the market at still extreme valuations in every metric except price to book value. However, if you plug in the latest values of each of the indicies displayed (S&P 500, DJIA, and S&P Industrials) you will see that all the metrics have fallen to normal or close to normal valuations. The NDR charts that we use cannot be updated to show the latest valuations so you have to use the latest market indices' prices to adjust the valuations. The S&P 500 and the Dow are easy to find the latest prices for, and the S&P Industrials are displayed in Barron's each week (last weekend it ended at 1118).
On reported (GAAP) earnings, the metric we prefer, the S&P 500 is now selling at 15.9 times trailing 12-month earnings compared to a an 82-year average of 16. At a number of past bottoms the index has troughed at P/E multiples between six and ten.
The Dow Jones price-to-dividend ratio has dropped to 26 (yielding 3.85%) compared to a 93-year average of 27.2. Note, however, that on numerous occasions the ratio has bottomed at less than 17.
The S&P Industrials price-to-cash flow ratio has declined to 8, compared to a 50-year average of 9.6. It's significant ,though, that the ratio lingered between 4 and 7.5 for the 7 years between 1947 and 1954, and for 12 years between 1974 and 1986..
The S&P price-to-sales ratio recently dropped to 0.8, compared to a 54-year median of 0.92. The ratio bottomed at 0.38 in 1974 and 0.35 in 1982.
Finally, the S&P 500 price-to-book ratio recently fell to 1.5, well below the 30-year norm of 2.4. However, the ratio troughed at slightly below 1.0 in 1982.
It is evident from the above-mentioned metrics that the market, for the first time in a long while, is now in a zone of fair valuation, although it is far from cheap. If history is any guide the market can still go a lot lower, and probably will. The credit crisis is the greatest since the depression, while the recession looks as if it will be lengthy and possibly deep. The global authorities have gone to great lengths to avert a financial meltdown through nationalization, massive lending, asset purchases and buying equity. Their actions and statements indicate that they will do anything necessary to avert a systemic breakdown of the financial system, and they will probably succeed, although not without some serious bumps along the way.
A serious recession, however, can't be avoided. The economy was slowing perceptibly before the credit crisis, and has now fallen off a cliff into the unknown. We are seeing significant slowdowns or outright declines in consumer spending, employment and production, and this will get worse as the effects of the credit freeze show up in the current quarter and beyond. The market has been so busy reacting to events on the credit front that it has not, until the last few days, paid much attention to the declining economy we see ahead. The fact that the market is now in a fair valuation range means that bear market rallies are more likely and that we will have to be more alert in looking for a cylical bottom. However, we do not sense that the market has yet discounted the potential length and depth of the recession, and history tells us that stocks can still decline significantly from current levels.