Will Cheap Stocks Get Cheaper?

Yesterday, we looked at a discussion showing that stocks are relatively cheap.

However, that doesn’t mean they cannot get even cheaper; Today, we go to Scott Frew of Rockingham Capital Partners, who looks at that exact issue, and considers where stocks could go:

"Markets around the world rallied last week; this should not have been unexpected, given the length and severity of the recent decline.  But I wouldn’t take yesterday’s action as a signal that it’s safe to get back in the water, and in the event that the rally continues for another week or two, I’ll use it as an opportunity to raise cash by selling more speculative holdings, and incrementally adding to short positions.

Pervasively bullish investors and commentators have puzzled over the market’s decline, searching to explain the seemingly inexplicable.  They view the market as genuinely cheap, and the economy as sound and strong.  One can always torture statistics (comparing forward operating earnings to trailing GAAP earnings, and the like) to make markets look cheap.  But by the methodologies that have most consistently predicted future returns, Tobin’s Q and some version of a cyclically adjusted (adjusted to reflect the fact that earnings are enormously cyclical and mean-reverting) P/E, stocks are anything but cheap.  The chart below is taken from Robert Shiller’s website, and uses trailing ten year earnings in order to adjust for the fact that we are, at the moment, in a period of unusually high earnings.  As you can see, the market only looks cheap when compared to the previous peaks in 1929 and 2000.  This does not bode well for future returns.


Trailing 10 Year Earnings
click for larger graph


Source:  Prof Robert Shiller, Yale


To my view, the big issue is not why the market has fallen over the last several weeks, but rather how it has managed to stay as elevated as it is for as long as it has.  The answers, I think, are threefold, all related, and all emanating from reason number one—the liquidity that has flooded the markets lo these many years, and particularly at every moment that has hinted at the possibility of severe dislocations.

Reason number two relates to the intense competitive pressures in the world of institutional investing.  I know I’ve stayed longer in my small fund than I’ve wanted to be, feeling the need to squeeze every last basis point of return out of this dying bull, and the pressure only increases as funds get bigger.  Witness that Iraq—Iraq!—was able to sell bonds at a 9% yield, and that even with the problems in stock markets around the world over the last several weeks, the junk bond market barely budged—spreads remain at record lows.

Lastly, the market is dominated these days by what I like to think of as “bull market babies”, which is to say people who have only invested since the early 1980s, and therefore have only known a world of falling interest rates and rising stock prices.  The tumult the markets have experienced since that time have hardly been insignificant, but they’ve been swallowed up and overwhelmed by the larger secular trends toward lower interest rates and gushing liquidity.  Investors have developed a touching faith in the ability of the central banks, magician-like, to pull one chestnut after another out of the fire—moral hazard reigns, and with it a hugely complacent view of risk.

But the world is changing, and our economy is not on sound footing.  Bill Gross recently reported the comments of Charles Gave, who’s the opposite of a perma-bear, at Pimco’s just-concluded Secular Forum.  “An economy dependent on asset appreciation which in turn is dependent on low yields, is more vulnerable than one based on income. … Gave then went further to suggest that changes in any one of the following five areas have historically had long-term influences on asset prices: 1) monetary policy, 2) protectionism, 3) taxes, 4) regulation, and 5) war.”

I’d say that all five of these forces are at least “in play”, to use Gross’ delicate phrase.  The Gaves are also fond of noting that economic changes happen first at the periphery, moving from there to the center.  The crashes in the Middle Eastern stock exchanges, and in Iceland, were indeed peripheral.  The dislocations over the last several weeks in larger emerging markets, Russia, Brazil, and others, as well as in the commodity markets, move things closer to the center.  (Let me note here that stock market bulls these days harp continually about the bubble in the commodity markets.  Stephanie Pomboy noted in her most recent weekly missive that the CRB is up 44% since the beginning of 2003; the S&P is up 39% over the same period, excluding dividends.  While there’s certainly been speculative activity in some of the commodities, I’m not certain those results are quite of the magnitude of Nasdaq 5000.)

The emerging markets sure seem like canaries in the coal mine to me.  As John Hussman said in a recent commentary, expensive markets alongside rising interest rates is not a combination that, on average, has produced favorable stock market returns in the past.  Dennis Gartman is fond of paraphrasing or quoting  Grantland Rice to similar effect: The fight is not always to the strong, nor the race to the swift, but that is the way to bet.

As I said at the outset, rallies seem like great selling opportunities at the moment.  I’m betting that our markets follow the lead of Iceland, Saudi Arabia, Turkey, Brazil and Russia.  And that when the Fed comes again to our rescue, we discover to our dismay that when Mr. Greenspan went home, he took his famous put with him.      


Frew is a general partner with Rockingham Capital Partners, a Long/Short Global Equity fund. Send him email here.

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What's been said:

Discussions found on the web:
  1. Jim commented on May 30

    Gordon Harms report said last week “the market” is historically 22% over valued.

  2. Bynocerus commented on May 30

    Something I’d like to see, and something I can’t find, is the P/E ratio of the Nasdaq back in 1974. I have a very clear idea of where my ultimate downside targets are on the S&P and Dow (if earnings were to stay frozen here, Dow 5500 and S&P 450), but it’s hard to know what kind of overshoot I should look for on the Naz if I don’t have some kind of historical measuring stick. Help from Barry or anyone else would be greatly appreciated.

  3. Roger Nusbaum commented on May 30

    This is excellent commentary. It does not have to be correct to have a lot of value. The value is that it is a through exploration of one side of the debate.

    Thanks Barry.

    (Your welcome!)

  4. B commented on May 30

    Lastly, the market is dominated these days by what I like to think of as “bull market babies”, which is to say people who have only invested since the early 1980s, and therefore have only known a world of falling interest rates and rising stock prices.

    BINGO! That includes the majority of Wall Street and fund managers. Even our President fits this bill as he believes it is our God given right to see equity prices go up annually as he tries to axe the social contract for the poor and move our Social Security into equities. Btw, if he had his way, it would be happening as we speak. What a great time to invest! Maybe 100% emerging markets funds?

    These are also the same people who are saying the new world of real estate is our safe haven from the bear. Schiller has stated the housing market is likely the biggest bubble we have yet experienced in modern America…..or something like that. I don’t want to put exact words in his mouth. And, regardless of what NARI says, the US has experienced housing price declines many times in history if you subtract out inflation. And, even if you don’t, the BIS study I posted on here a while back shows historical real estate bubbles in 14 economies over the last thirty years lead to negative GDP on average. What’s different than their studies of prior real estate bubbles?

    Oh nothing much. Except that this real estate bubble is not in one country, it is in Australia, Spain, Korea, China, Spain, England, the US, Canada, blah blah blah. So, what happens when the American consumer takes a dirt nap? These deep cyclical earnings that are propping the markets up collapse, the PE is no longer 19 but much higher and we get to see that chart revert closer to the mean as earnings take a turd.

    The Fed is in a box. Keep going and kill the consumer even more to fight the inflation ghost (They are likely already dead.) or stop? It likely doesn’t matter any more what the Fed does. The game is likely over as the data is starting to support it. So, if GDP falls precipitously, what will the Fed do? Cut rates in a panic with commodities at all time highs, crater the dollar even more, drive inflation higher and kill global trade? Not as likely as the other outcome. Hard assets at all time highs and already cutting into global demand for such. Can you say deflation? Ever heard of the “paradox of thrift”? Understand what happened in the 1930s and you’ll know.

    Pax Globalia. The last time we had three years of such high sustained global growth? How did it end? Can you say 1974?

    The time to worry is when no one else is worrying. Or as Minsky stated. Periods of stability create instability.

    We, human beings, create instabilities in our never changing cycle of irrational behavior. We, in effect, self destruct when things are the best. Whether that is in our personal lives or our irrational behavior that creates housing bubbles, commodity bubbles, tulip bubbles or the South Sea bubble. Now a friend of mine lectured me yesterday on how we have learned so much from the past that the Fed will “save” us. And there is too much wealth to keep the market down. And, China and India are experiencing unprecedented wealth. Maybe. Just maybe we’ve reached human enlightenment.

  5. Bynocerus commented on May 30

    Ahh yes, the much-maligned dirt nap. Still think that canned food is a bad idea (lol), B?

    And I found out the answer to my own question: The lowest P/E for the NASDAQ was 15 in 1974. Extrapolating from that gives us a downside target on the COMP/NDX of approximately 900 and 600 respectively. Talk about gut-wrenching fun for Joe and Jane six-pack.

  6. B commented on May 30

    I believe the PE in 73 was 18 if memory serves me well. Is that correct? 74 was the beginning of the end and equities were already cratering along with commodities.

    And YES I do think canned food is a bad idea but you did say it was for hurricanes and such so I won’t poke too hard. I’d likely do the same.

  7. wcw commented on May 30

    Canned food and bottled water are a good idea if you live in earthquake country. The state is running a nice ad campaign in the buses right now. I don’t see anything short of earthquake or similar cataclysm interrupting food distribution, though.

  8. Bynocerus commented on May 30


    My comments about the canned food were from a previous post in which I mentioned I had some from the hurricanes last year (live in the South, had some disruptions). What’s funny to me is that we stocked up after Katrina but never got around to eating the stuff in the pantry during Rita. Maybe this year we’ll finally get around to all those green beans – lol.

  9. wcw commented on May 30

    Yeah, you’ve got to cycle through the stuff. My folks taught me that. Luckily, I am lazy about shopping, so I often have to break out a can or three when I get peckish late at night.

  10. clunk commented on May 30

    Yeah, they’ll get cheaper. They are cheaper today.

  11. david foster commented on May 30

    Earnings (as a percent of revenues) are also higher than long-term average, and based on what I’ve read, this is a number with strong mean-reversion tendencies.

  12. Mark commented on May 30

    There’s going to be a rally?

  13. Nathan commented on May 30

    I think that given massively lower transaction costs and much better financial disclosure, stocks are unlikely to ever sell at 1920, 1930-1950, or mid 1970s P/Es again, but who knows? I agree that risk is way overpriced (emerging markets, highly cylical industries, low quality stocks and junk debt). However, I think that high quality US stocks (healthcare and staples) are pretty darn cheap, and I don’t think their earnings are at cylclical peaks.

  14. Bynocerus commented on May 30

    How many times must a man raise rates
    Before you call him a man…

    I feel like I’m watching a Harry Potter movie and the bottom callers are the students at Hogwarts practicing magic for the first time.

    Rally NOW! (nothing happens)

    Rally GO! (nothing)

    Market UP(zilch)

    !Levante te! (crickets)

    We are (Penn State)

  15. B commented on May 30

    Yes I do. We aren’t finished scaring the bejesus out of everyone. Likely a failed rally that Barry was talking about but once it starts, who knows where it ends. Markets just don’t fall off of a cliff. Or at least they usually don’t. lol. Lotsa dumping though. Lots of dumping since January. And most of it on the NAZ so those who say this is just a commodity corection and we are goint to see rotation from commodities to technology as capex accelerates appear to be living on Lovetron.

    Wall Street is sneaky, so sneaky. I am still not getting a buy signal but I see some things today which lead me to believe I soon will. May not actually come to pass but this market deserves patience.

  16. B commented on May 30

    Much better financial disclosure? You mean when the SEC was formed after Wall Street duped people in the 20s? Or you mean after Enron? Or you mean since they started playing with earnings and now the S&P actually reports three different types of earnings you get to pick from? Or maybe after the back dating of options? Or maybe after we find out Big Bob Nardelli has made a quarter of a billion dollars while the stock price is down over his tenure? Or maybe that GM executives have cumulatively made over a billion dollars over the last thirty years while laying off 800,000 people or outsourcing them? Or maybe you mean that you didn’t know Exxon paid its chairman a half a billion in retirement until he actually retired. Or maybe the cozy but likely shady deal to spin off Delphi while not disclosing the obligations GM still had? Or you mean …………….. Uh, what do you mean?

    So, do you mean that you are willing to pay eighty years of earnings for Google when they pay you nothing to park your money there? And, they were a figment of your imagination just a handful of years ago and could be a figment a handful of years from now? Or maybe you mean Dividends are still near 100 year lows.

    Hmmm………..Why have PEs? I think you should just buy a stock if it feels good. Isn’t that what most people do?

  17. Bynocerus commented on May 30

    Lovetron, not to be confused with Planet Funktron (ruled by George Clinton) Megatron, leader of the Decepticons, Tron, dice rolling multibillionaire, Trans, the album Neil Young made for his disabled son, or Transamerica, in which a Desperate Housewife gave me the heebie jeebies, sounds like a cool place. Sometimes I think B sends in his post from GDMFTron (figure it out, geniuses).

    Suppose earnings on the Naz fall 20% over the next three years and we get a correction to boot. That gives us a COMP bottoming around 700. Which makes me think: What if the S&P 500 pulls a repeat of 1974 and the Naz pulls a Nikkei? That puts us less than halfway through the Naz correction. What an ugly, ugly time to be an aggressive investor.

  18. Nathan commented on May 30

    How about having access to a statement of cash flows? That’s pretty major, I think. Investors used to value stocks mainly on yield, as it was about the only indicator of earnings quality.

    Your aggressive and I might add, somewhat shrill comment, makes you sound like an ideological, the sky is falling, chicken little bear. Yes, disclosure is better today than it has ever been. Are there examples of fraud? Of course, and there always will be no matter how good the disclosure.

    Risk is way overpriced; I said that in my comment, and GOOG certainly fits that bill. High quality big cap names – particularly in defensive sectors – look cheap to me, however, and that was my primary point – there are always underpriced areas of the market, exactly like there was in 2000.

    Get a grip man, this ain’t dailykos

  19. Lurker commented on May 30

    Geez Nathan, let me back up the truck on those cheap tech stocks, especially considering that, of the top 25 NDX holdings, MSFT, INTC and CSCO are the ONLY ones with P/Es less than 20.

    Unless Biogen has the cure for cancer AND HIV, I do not think 100x earnings is a fair price. Symantec @ 80 doesn’t quite sound right either. And I’m not paying 40+ times for a cable company (CMKA), a video game maker (ERTS) or an online auction company (EBAY).

    Qualcom @ 33, Apple @ 32, Paychex @ 33; relatively speaking, these companies have been around forever, so why do they trade like they’re at the midpoint of their rise to power? IMHO, risk is WAY WAY WAY underpriced, and considering that healthcare and staples have almost always been defensive plays, do their P/Es really have anything to do with anything in a down market?

  20. Nathan commented on May 30

    JNJ, ABT, MDT, PG, PEP, SYY, UPS, GE, VIAB, and big-cap tech like MSFT and ORCL, are the kinds of stocks I’m talking about. Stop knocking down your straw men (Biogen, PAYX, QCOM, GOOG, etc.). I’m in agreement with you on stocks of that ilk.

  21. B commented on May 30

    You remember Daryll Dawkins? That was my Lovetron comment. He was a Manster!

    I don’t see any way out of the mess without some pain and a Naz-Nikkei might be in the cards. I tend to think a Shanghei Index-Nikkei. It would be a fat tail and a worst case but could happen.

    Oh Nathan, if had ever read any of my comments you know I never have a grip. I’ll lay up on you if you are the owner of Nathan’s Famous and will ship me a few tons of those all beef dogs. That said, I do believe Vienna beef dogs have you beat hands down. No one knows how to make a dog like Chicago. Of course my comments are shrill. I am a shrill shill. And, since you haven’t read my medication-free posts in the past, I will tell you I am quite a bull on America’s future after we cleanse. And my next trade will be a long trade most likely. Although a temporary one till I get a better entry point to take your money. Yes, I expect the data to present a bearish outcome. But I don’t trade on the “data” nor am I clairvoyant.

    As as far as being chicken little……….You sound like a manly man who can prove he is a bull. Oui? When you look into your crystal ball of cash flows, what do you see? Btw, with such a low dividend yield, how do you realistically come up with an accurate DCF analysis of future returns? Mighty low probabilities there my friend.

    Might I recommend you invest in the Russell 2000 with a PE of 38? That will surely prove you are no chicken little bear. You’d impress me as having b*lls of steel. I’d be sure to stop you from jumping from the Empire State Building when your thesis about value returning to the markets turns out to be false and the mania driven R2K collapses.

    Get a grip man, this ain’t the Rush Limbaugh Show! :0) I’m just funnin. Relax.

  22. alex commented on May 30

    I concur with Roger Nussbaum – great comment. When do more people start to assess economic developments in the Barry-Ritholtz-manner? I think your comprehensive approach makes a lot of sense. Of course a single person can never do the complete job. But how about getting all the Ritholtz’s out there together and add the pieces of the puzzles…not so much trying to compete about who has the better forecast, but emphasize different aspects with the intention to make an effort putting in motion the collective intelligence applied to economics.

  23. Cephas commented on May 30

    One guy said: Oh nothing much. Except that this real estate bubble is not in one country, it is in Australia, Spain, Korea, China, Spain, England, the US, Canada, blah blah blah.

    Well, I’m sorry to say that the statistics over here show that this does not apply to Canada as a whole, only to the markets of Calgary and Vancouver. Elsewhere in this country there is no real estate bubble. But, what is more important to this discussion is that, as compared to US home owners, Canadians have not been borrowing against the increased value of their property in order to finance a more opulent lifestyle.


  24. B commented on May 30

    Well, I’m truly glad the Canadians are above the fray. Above human behavior as well.

    You have two bubbles. Commodity laden stock exchanges and housing. Canadians have borrowed against its own own mania. Ours is housing. Yours is your more of a stock market and commodity explosion creating a perception of wealth. (Not that Canada doesn’t have tremendous natural resource wealth. Just that it is priced at an imbalance IMO.)

    This is not an “American” issue. It is a behavioral issue. And, I can show you how people across the globe have responded with similar behavior. Australians, Chinese, Koreans, Brits, etc. While it is mighty appealing to believe America is a powerhouse of greed and decadence, you are in the game too. It’s psychology 101.

    Enjoy your wealth! What’s it like to have more oil than any country on earth and no one even knows it? :) That is, except for the US who has more oil than any other country on earth. We just like to keep it a secret so we can create oil bubbles and tell everyone how we are running out.


  25. toguy commented on May 30

    “But, what is more important to this discussion is that, as compared to US home owners, Canadians have not been borrowing against the increased value of their property in order to finance a more opulent lifestyle.”

    What source did you use for your data? Last time I checked the personal dept in Canada was going through the roof (both mortgage and home equity lines of credit). Pretty much the same ratio as in US. I will dig up a link…

  26. toguy commented on May 30

    oops, dept=debt :-)

  27. me2200 commented on May 30

    “Canadians have not been borrowing against the increased value of their property in order to finance a more opulent lifestyle.”

    The Canadian savings rate has been zero percent for a while. They are just as bad as Americans.

  28. RW commented on May 31

    toguy, those debt figures are pretty grim. Perhaps even scarier would be the notion that people might be leveraging like that just to maintain their current lifestyle, an exemplar of the ‘other inflation’ in Fischer’s “Great Wave” sense if you will. I’m not a big fan of cycle theories normally but when they tie into human behavior and history they provide useful context. The idea of people madly leveraging while saving nothing just to keep running in place is about as scary an image as I can think of; on a societal level of course, personal fears are something else.

    On a personal level I am not out of the markets entirely – my success rate WRT shorter-term timing is not good enough (everyone’s a timer from my POV, it’s just a difference in frame and tools) – but am hedged and have raised cash. Rallies will doubtless come but I can’t see any reason why they should succeed other than to set a lower high with a lower low to follow. IOW I do not expect to avoid pain nor locate the bottom accurately but I do expect to buy some good stuff wholesale in the foreseeable future. If I’m wrong, then I’d rather pay the opportunity cost than struggle back to break even after heavy losses; I’m old enough that the former bothers me a lot less than the latter.

    Bynocerus’ characterization of B’s planet reminds me of a license plate I saw on a big rose-colored, fur-seated, tassel bedazzled, pimp-mobile Cadi in Lost Angeles awhile back: “KMBMFA” (the CA license censors must have been slow on the uptake that year).

  29. Market Participant commented on May 31

    It’s the same thing as credit cycles. People who only know the good times, find the cautious people horribly stuffy.

    If you read Graham and Dodd (even the last 1962 edition) the key theme is safety. Don’t lose money. It’s not about risk adjusted returns, its about safety of capital. It’s a very different perspective than alot of people today have.

    A while back I did some statistical analysis of EEM vs EFA,SPX, and VIX to see if owning EEM would diversify.

    It doesn’t! EEM is very correlated to both EFA and SPX (which themselves are hopelessly co-correlated) and negatively correlated with VIX. So right when you need diversification the most (market stress on SPX) EEM fails.

    And given how dependent EEM economies are on EFA/US economies it’s not at all surprising that EEM would be tightly correlated.

  30. TEIRG commented on May 31

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  31. Sam commented on Jun 1

    Ok, so people think p/e is low, but it is still historically high. Can you superimpose hisorical interest rates as well?

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