InvestorsFriend Inc. Newsletter September 4, 2011
Bloodied and Bruised Investors
As of early September 2011, most investors are feeling bruised and bloodied by the stock markets this year. The Dow is down 3% this year, the S&P 500 index is down 7% and the Toronto stock index is down 6%.
And, the Dow is down 12% from its high for the year on April 29. The S&P 500 is also down 13% from its high which was reached on May 10. The Toronto stock index is down 11% since its high on February 28.
These markets have declined roughly 10% in the past 6 weeks alone.
These are very scary times in the stock market. There is speculation that we are entering another recession despite not having recovered from the 2008 recession. Worse, there is speculation of European countries defaulting on debts. The U.S. government’s credit rating was down-graded. The U.S. apparently came close to a catastrophic refusal to approve an increase in its borrowing limits in August. There are fears of deflation while others fear runaway inflation. There are fears that all western counties face insurmountable debt issues due to pension liabilities and health care liabilities as their populations age.
And these are just the mainstream fears. On top of that we have fringe groups warnings us of all manner of doom ahead. These range from the end of the world at the end of the Myan calendar next year, to starvation as the world runs out of the ability to feed 7 billion inhabitants to all manner of floods, fire, disease and pestilence.
Bond investors have pushed the yield on a ten-year U.S. Treasury bond down to just 2.0%. And the 30-year bond is at 3.3%. Now surely these investors are not buying these bonds because they like the idea of earning just 2 or 3% per year. They are buying these bonds because, among other reasons, they are scared to invest in stocks.
It is often said that investors emotions oscillate between fear and greed. Surely fear is the dominant emotion in the stock market at this time.
So what is a beleaguered stock investor to do?
Well, I can’t predict the future. But I can point out some data that suggests that stocks are cheap.
If you buy stocks when they are cheap, they may get cheaper still, but ultimately you are likely to make a good return.
STOCKS ARE CHEAP BASED ON P/E RATIO
The most basic indicator of whether or not stocks are cheap is the the Price / Earnings or P/E ratio.
Here is some recent data that shows the P/E ratios for the S&P 500 Index: (The P/E ratios below were calculated when the S&P 500 index was at 1159 but these numbers still apply today as the S&P 500 index is relatively unchanged at 1174)
| S&P 500 Index Earnings Type | Annual Earnings on Index | P/E Ratio at 1159 S&P | Earnings Yield |
| Actual latest year (trailing four quarters) GAAP earnings | $83.90 | 13.8 | 7.2% |
| Latest year “operating” earnings (removes “unusual” items) | $90.89 | 12.8 | 7.8% |
| Forecast forward GAAP earnings for the next year (next four quarters) | $93.75 | 12.4 | 8.1% |
| Forecast forward operating earnings for the next year (estimates summed by individual company) | $105.45 | 11.0 | 9.1% |
| Forecast forward operating earnings for the next year (estimate for the group of companies) | $99.34 | 11.7 | 8.6% |
| For Comparison here are S&P 500 Earnings in prior years: | Earnings | Historical P/E | Historical Earnings Yield |
| 2010 Actual GAAP Earnings | $76.97 | 16.3 | 6.1% |
| 2009 Actual GAAP Earnings | $50.97 | 21.9 | 4.6% |
| 2008 Actual GAAP Earnings | $14.88 | 60.7 | 1.6% |
| 2007 Actual GAAP Earnings | $66.18 | 22.2 | 4.5% |
| 2006 Actual GAAP Earnings | $81.51 | 17.4 | 5.7% |
| 2005 Actual GAAP Earnings | $69.93 | 17.8 | 5.6% |
| 2004 Actual GAAP Earnings | $58.55 | 20.7 | 4.8% |
| 2003 Actual GAAP Earnings | $48.74 | 22.8 | 4.4% |
What this table demonstrates is that the S&P 500 index P/E ratio is relatively low at about 12 based on forecast earnings. This is low compared to the historic average P/E of 16.
Furthermore today’s extremely low interest rates would support a P/E ratio that is higher than could be justified at a time of high interest rates. At else equal, you would think the P/E rtio today would be higher than the historic average.
The last column of the table indicates that these companies are expected to earn about 8% on the price paid for the stocks. This is substantially higher than the amounts these companies were earning compared to the price paid at the end of each year since 2003.
It is true that even if these companies do earn the projected 8%, their stock prices might still fall. But if they continue to earn the 8% (and in fact they tend to earn more than 8% on retained earnings), the stock prices will rise over the years.
So, the FACTS indicate that stocks are at least better value compared to earnings than they have been in many years. Even at the lows in the Spring of 2009 the S&P 500 index P/E ratio was higher than it is now because the earnings were depressed.
I have found that this examination of the P/E ratio of the stock index has accurately indicated when the market was over-valued and when it was under-valued. This past accuracy is documents in the table at the bottom of the linked article regarding the valuation of the S&P 500 index.
The FACTS based on the price of the S&P 500 index and its current and projected earnings indicate that stocks are about fairly valued, meaning that they are priced such that we should expect to achieve a long-run return that averages about 8% per year. (And they would be considered under-valued if you would be satisfied with even a 6% return per year, given today’s low interest rates). Note that this 8% per year can be expected to vary wildly in individual years and it is by no means guaranteed.
There are only two things that could cause an investment in the S&P 500 index today to fail to earn a decent return over the future.
First, the P/E ratio could decline due to investor fears. But even if that occurs, it is likely to be a temporary situation. We have demonstrated that today’s P/E ratio is low compared to historic values. Over the future the P/E ratio will vary, but there is probably a higher chance that at any point in the future it will be higher and closer to its historic average rather than lower. But, yes, there will no doubt be some periods in the future where it is lower.
Second, the forecast earnings could fail to be achieved. In fact if recent fears of a renewed recession materialize, then it is likely that corporate earnings will be depressed for a time. But that is also likely to be temporary. Recessions tend to end and in the longer term earnings do rise. It is plausible that in five years or ten years from now corporate earnings will only have risen by say a few
percent per year rather than by the hoped for 5% or more per year used in our S&P 500 valuation article. But it’s really not very plausible that corporate earnings will fail to grow at all or will shrink over a five or ten year period. Anything is possible, but it just does not seem plausible.
My conclusion, based on my S&P 500 valuation article, is that stocks are about fairly valued on average. Most of the past decade they have appeared over-valued. Despite that I was able to select individual stocks that gave me a good return. With the market now looking fairly valued on average, I like my chances of being able to continue to find stocks that offer a good return over the years.
At the same time I recognize that stocks would likely decline if we do get a renewed recession. My strategy will be to remain invested in stocks and to be positioned to add to my investments over the years and particularly at times when they fall in price.
Not everyone has the emotional tolerance or the financial ability to take the risk of investing in stocks. But those that do should consider that the occasional bloody nose is the price we pay for the fight to accumulate wealth through stocks. This is a battle in which the average fighter does win in the end, based on history, but where the average fighter certainly does sustain some bruises and does some bleeding along the way. Only you can decide if you wish to stay in or enter this battle or whether you prefer to take a permanent or temporary break from it.
BORROW TO INVEST?
Borrowing to invest is not for the faint of heart. Most investors have neither the emotional nor the financial ability to tolerate the risks of borrowing to invest.
But certainly some investors do have the incomes and net worth such that they can withstand the risk of borrowing to invest.
With the cost of borrowing at record lows and with stocks appearing to be fairly valued (and hence offering long-run expected returns in the 8% range) it may make sense for more affluent investors to CONSIDER borrowing to invest in stocks.
Anyone doing this should be very careful not to over do it. Also, there should no hurry to race into the market. A rational strategy might be to borrow a small amount of money to invest each month and ramp up to maximum level of borrowing over six to ten months.
SINO-FOREST (Accused of Fraud)
I owned Sino-Forest shares from 1999 to late 2005. The company was recommended as a Strong Buy on this site at the beginning of each of 2000, 2001, 2002 and 2003. It went no where most of that time but soared 341% in 2003. For 2004 we rated it a Sell and it did fall 34%. For 2005 we rated it a Buy and it rose 44% that year.
However by late 2005 I had become uncomfortable with the company and lost trust in it. I even speculated it might possibly be a fraud. This is fully documented here. After I abandoned the company it subsequently soared some 400% or so. But I never added it back to this Site because I had lost trust. It appears I was years ahead of my time in smelling a rat at Sino-Forest. The fact is that it is very difficult for investors to detect fraud. But sometimes the warning signs are there.
Investment Basics and Math
In investing as in most things in life, you can never review the basics too many times.
Here are a few of my basic articles that explain some of the fundamentals of investing.
The Only Two Sources of Money from Stocks.
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END
Shawn Allen, President
InvestorsFriend Inc.
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