Not Expensive vs cheap

This quote is typical of sell side rationalization:


“One of the things that makes this
market confusing is that some valuation gauges clearly indicate this market is
cheap. James Paulsen, chief investment strategist at Wells Capital Management,
recently brought up the "Rule of 20." According to this, the market is fairly
valued if its price-to-earnings ratio is equal to 20 less the inflation

Right now, the rule suggests that
the market’s P/E should be about 17.7 — or 20 minus the core inflation rate of
2.3%. But the S&P 500’s multiple is actually a mere 14.5 times analysts’
2006 earnings estimates and 13 times analysts’ 2007 estimates of
$95.64.”     -Barron’s, 6/12/06


One of the issues that seem to be
confusing to investors is the difference between “not expensive” or "fairly valued" and “cheap.”  I think its from years of massive overvaluation that has led some observers to think that Not Absurdly Expensive somehow = cheap.

First, let’s start with not expensive:  A P/E of 17 or so is not
terribly expensive – especially after the prices paid in the 1990s. That 17 # is
the median trailing P/E for the past 50 years (See this chart).
I suspect the 17 number may be somewhat skewed by the gogo years in the 1990s.

If you take the data going all the
way back to 1871, you end up with a trailing P/E of 11. That data, in turn, may
be skewed by the Great Depression.

Either way, however, the present P/E
hardly qualifies as “cheap.”  It is at best fair value, which does not exactly
make stocks a compelling bargain. Have a look at this chart (via Jeremy
Grantham) for a better sense of how cheap P/E is at present:

“Fairly valued” is just the snapshot
of where we are; What happens if we look at the moving

“If the P/E expanded to 17.7, the
S&P would trade at 1529 on analysts’ 2006 estimates or 1693 on their 2007
earnings estimate. Those would be gains of 22% to 35% — something investors can
only dream of after last week’s miserable

Not only are P/E’s not expanding,
they are going the opposite direction – we are in a period of cyclical P/E
multiple compression. Recall that during the last secular Bull market, P/E
expanded from 7 in 1982 to the 30s in 2000. By that measure, this multiple
expansion was where 75% of the bull market gains came from.

Now, we are on the other side of the
mountain. P/Es are compressing, meaning investors are increasingly less willing
to pay for that dollar of earnings. This helps to explain why despite all the
share buybacks, dividend increases, double digit year over year earnings gains
and M&A activity, stocks have been unable to make much headway.





The Trader: No Mood for Shopping   
The Dow drops more than 3% on the week — but cheaper stocks may not be bargains.
Barron’s 6/12/06

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What's been said:

Discussions found on the web:
  1. ss commented on Jul 3

    The S&P 500 has gone NOWHERE since 12/98 yet:

    -Earnings have doubled

    -Interest rates have dropped -even after 17 rate hikes

    -Cash on corp balance sheets has NEVER been higher
    (consequently corporations have never been more
    healthy — note the corp spreads)

    – Earnings QUALITY has never been higher (SarbOx)

    Investors are just now getting over the shock from the ’90’s era of lies (bubble), a recession, and 2 wars.

    The Fed Model clearly shows stocks are ~ 30% undervalued to Bonds. Cheap?…you be the judge.

  2. JoshK commented on Jul 3

    What I don’t get is that a lot of bears are predicting moderate (but slowing) growth and inflation. Wouldn’t that lead the market higher anyways? Earnings should rise then with inflation. Lower risk stocks might be a good place to be now while your dollar is whittled away.

  3. rick commented on Jul 3

    where is all the earnings growth and valuations at
    these days ?? oil and commodity stocks,
    they are growing their earnings, so stick with
    the right sector, not the GE and GM’s of the

  4. ss commented on Jul 3

    That’s like buying yesterdays “hot dot”. They’ll do well, but I think there’ll be many other huge opportunities. Citigroup’s stock has gone nowhere since 2002, yet earning are estimated to be up 57% from that time to next year. PE of 12?

    There are many large cap (not crap) stocks whose earnings have been ramping, but stocks have gone nowhere for years. That will be the surprise of ’07-’08…imho.

  5. rick commented on Jul 3

    the trend is your friend.
    esp when earnings in other sectors and
    pe’s are inferior.
    I kinda like Jeff Saut’s approch
    to this market.

  6. Robert Cote commented on Jul 3

    Let’s see $1000 in the S&P 500 in 1998 is now worth $1150 in stock and dividends before fees. $1000 in 10 yr constant maturity notes would be worth $1550 and no fees. Stocks are massively overvalued relative to dividends.

  7. blue herring commented on Jul 3

    i get that the Great D skews it down and the Clinton Years skew it up… but for the moment, just look at the last 50 years or less (as skewed by the 1990s bull).
    is it ‘just’ a skew? or is it something more?

    What happened in the 1990s that Changed Things, and could those things continue to change?

    In 1992 Timmy Lee created the internet on Steve Job’s
    NeXT cube. In 1996 people started to put their email address on their business cards. In 1998, a bunch of people bought computers for their home. In 1999-2002
    a bunch of American companies took massive loads of CPUs due in part to the Y2K tax breaks and the Sept. 11th depreciation adjustments.

    I remember Jack Welsh talking to Maria Bartiroma on CNBC in 2000 saying that he didn’t think the tech boom could last (at least as far as CPU delivery was concerned) because as the CEO of GE he had purchased a massive upgrade of CPUs for the company to prepare for Y2K and in a sense overbought CPUs because of the tax break and as a result many departments wouldn’t need a massive CPU purchase for something like 5 years.

    Well. it’s the middle of 2006. I’m not saying that companies are going to do a massive CPU purchase cycle right now, but perhaps the natural refresh rate is actually upon us now organically as caused by the somewhat artificial existence of capital expenditure goosings?

    In other words, are we just getting started with the
    productivity enhancements that the internet brings to some companies… or is this as good as it gets? bring on
    interplanetary travel cuz this network is done?


  8. rick commented on Jul 3

    Let’s see $1000 in the S&P 500 in 1998 is now worth $1150 in stock and dividends before fees. $1000 in 10 yr constant maturity notes would be worth $1550 and no fees. Stocks are massively overvalued relative to dividends.
    again, if you bought the oils and commodities in 1998,
    you would be one hell of a rich fella now. Overvaluation
    exists with the dogs of the s&p, but can you really
    say COP or XOM etc are overvalued ??
    I am not saying that their multiples could contract, but
    heck , if it contracted from 7 to 4, I’d buy more.

  9. ss commented on Jul 3

    I’m not following your logic here.

    12/31/98 S&P closed at 1229. The low of the S&P this past month was 1219. Earnings have doubled. Interest rates have been falling since then (have gotten more expensive). The earnings yield of stocks are dramatically higher than the earnings yield of the 10 year treasury (Fed Model) by ~ 30%.

  10. grodge commented on Jul 3

    Jonse-ing for some Faber.

    Is it just me, or am I the only one heartbroken that Marc Faber is now a pay site?

    Not only do I have to shell out clams for Barry, but now Marc.

  11. Lord commented on Jul 3

    Long term real returns of 6.9% imply an average PE of 14.5 but to be the average means it must be lower than that about half the time. So when is it going to be lower if not now? Stocks are cheap compared to bonds, but bonds are far from cheap.

  12. muckdog commented on Jul 3

    Another way to look at it is how much money do folks have to invest? Americans’ net worth is at the highest levels ever, baby boomers are approaching retirement, and money has to be put to work in some sort of instruments to make a rate of return.

    With the number of folks and the amount of wealth available to invest, where is it going to go? Real estate? Bonds? Money market accounts? Stuffed in the mattress? Stocks? I think a lot of it has been going into the latter, which accounts for a higher PE multiple than what we’ve seen historically.

    Maybe the PE multiple will regress as the baby boomers pass and there is less money to invest. But that will be gradual (I’d think)…

  13. drey commented on Jul 3

    “Lower risk stocks might be a good place to be now while your dollar is whittled away.”

    Substitute “October” for “now” and I would agree but for the moment there’s too much excess that still needs to be wrung out of this market and most if not all sectors will suffer.

  14. Jordan commented on Jul 3

    Anything that refers to “core inflation” to gauge the inflation rate is worthless, imo. I almost punched the computer screen when I read that.

    BTW, does anyone know how to pay “core” prices on groceries, gas, tuition and everything else.

  15. julie commented on Jul 3

    blue herring, thank’s for the classic troll. I don’t think anyone will bite, but it a brilliant comedic mixture of misifo and cliche.

  16. Bynocerus commented on Jul 3

    Over the last 200 years, the market’s trailing P/E has been 14. No bull market has ever ended on the nose, and the same holds true for bear markets. Nearly every bull market has ended with stocks above 20 p/e. and nearly every bear market has ended below 10.

    Glad to know that Wells Capital Management is using “looked what I pulled out of my ass just now” rationalization for managing their clients’ assets. By the same rationalization, if Chewbacca lives on Endor, you must aquit. Or, similar logic:

    Sir Bedevere: What also floats in water?

    Crowd: Bread? Apples? Very small rocks? Gravy? Churches?

    King Arthur: A Duck

    Crowd: Oooohhhh!

    Bedevere: Exactly! So, logically-

    John Cleese: If—she weighs the same as a duck (scratches head)—she’s made of— made of wood?

    Bedevere: And therefore?

    Crowd: A Witch!!!

  17. Alaskan Pete commented on Jul 3

    There are a few cheap stocks out there…that said, they will get cheaper between now and the fall lows. For my work, it doesn’t matter much. Aside from the yearly additions to the Roth, P/E valuations don’t really matter much to my trading.

    You have to wonder if structural changes have added a sort of floor to P/Es. The fact that 401Ks have replaced pensions (perhaps triggering a greater % of retirement funds going to stocks vs. fixed income) and a large % of the population owns stock today, coupled with the boomers having their “oh shit!” moments where they realize it’s time to get crackin’ on retirement savings and ramping up their 401 contributions…just might be a sort of structural change that supports slightly higher marketwide P/E than historical norms (exluding the go-go tech bubble years). I’m not claiming this is the case, just that there is a possibility.

    I’ve not seen any work on this that I recall. There are several folks arguing about the post-retirement boomer asset liquidation, who will absorb the selling, etc…but not much on the pre-retirement period we’re in now.

    Now feel free to punch gaping holes in that thought process.

  18. konaman commented on Jul 3

    Is that the same fed model tht created ll the excess liquidity and drove the cascade of asset bubbles? If so, STRONG BUY!

  19. Lord commented on Jul 3

    With the number of folks and the amount of wealth available to invest, where is it going to go?

    As it is their net worth, it is already invested. It may shift or it may remain in place.

  20. jkw commented on Jul 3

    The time to buy stocks is when stock ownership is at record lows. At that point, nobody is going to sell anymore. The time to sell is when stock ownership is at record highs. Who is going to keep buying stock if everybody already owns it? Stock ownership is an overbought/oversold indicator, not a trend indicator. Like all oscillators, you never know how high or low it can get or how long it will take to return to neutral. But record high stock ownership levels should not be considered a sign that it is time to buy.

    The changeover from pension funds to individual accounts means that more individuals are managing their money instead of institutions and professionals. Most individuals tend to not know what they are doing and tend to follow a herd mentality. Which means market cycles will be more extreme but probably last longer. That could be why the recent bull market lasted so long without a correction. As long as stocks were going up, every 401k and IRA was going to get more stock funds. Now that they have dropped for a month, it is possible that people will start selling their stock funds. The people who sold out at the top (mostly by luck) are currently bragging to their friends about how they avoided the 5-10% drop. The next time the market starts dropping, those friends will sell too. Unless the market can break new highs and stay there for long enough that people who sold at the top will feel foolish.

  21. Steven commented on Jul 3

    The expected return on stocks:

    2% dividend yield +
    2.25% real long term earnings growth +
    1.75% inflation (if Bernanke can be trusted)
    6% grand total returns on stocks long term from here…

    OR you can pick up 6.28% 10yr Corporate AAA bond fund from Vanguard with far less volatility than stocks and slightly higher expected returns…. If I were a pension fund I would do the math and act accordingly.

  22. ~ Nona commented on Jul 3

    “But record high stock ownership levels should not be considered a sign that it is time to buy.”

    Thanks for your comments, jwk. As a novice, my question is: How does one identify a good time to sell? (High stock ownership might be yet another indicator.)

    I left techs about a year before the Tech Wreck. I don’t deny that I’m glad that I vamooshed when I did, but would have done much better if I had stayed at the party at least six months longer.

    Do you –or anybody — have thoughts about how to identify a good time to bail (and follow Steven into 10-year AAA Corporates!)?

    Thanks to Barry, I’ve been introduced to cycles (which I consider to be another form of reversion to the mean). Thus, I’ve been moving into short-term bond funds and cash since January. (I don’t know enough to trade the way Alaskan Pete, Bynocerus and a lot of youse guys do!)

    Naturally, I wonder if equities is yet another party that I’m abandoning too early.


  23. HT commented on Jul 3

    News flash: Stock prices do not follow earnings, they follow P/E expansion and contraction. Actually, the data I have seen has shown slightly higher EPS annually in bear markets than bull markets. Whether P/E’s expand or contract depends on 1. valuation–which now is still high, but admitedly lower than in 2000, and 2. whether there is inflation or deflation brewing of of normal monetary expansion.

  24. HT commented on Jul 3

    Oh– and the majority of the gains in the 1982-1999 bull market were from P/E expansion, not earnings growth.

  25. donna commented on Jul 3

    Uh, the internet was around WAY before 92. Lee just made it more accesible to image data.

  26. Kevin commented on Jul 3

    This piece on Chinese domestic credit markets is of interest. The most salient point for investors is that, despite what the author says he wants, his description makes it seem quite unlikely that China will be able to shift from an export-centered economy to one centered on domestic demand.

    “As well, the conference heard, insurance companies as well as banks must put their funds to better work financing prudent and worthy projects. Such projects so far are mostly state-owned enterprises, producing about 20% of total gross domestic product, but sucking in about 70% of all outstanding bank credit. The SOEs are responsible from almost all non-performing bank loans. But pension money has to be put to good use, neither wasted on risky businesses that could lose the fund, nor invested with undue caution, thereby providing returns that are too low.

    Non-state companies, if possible, try to avoid taking money from the banks, even if interest is relatively low. They do not want to be exposed to possible financial and tax controls, and are willing to pay 30% interest or more to moneylenders, loan sharks and pawnshops, to whom they can reveal their wealth without fear that the information will be passed on to some state officials.

    Banks are also unwilling to lend to private firms: if an SOE doesn’t pay up, the bank official will not be held responsible – the bank will extend the credit terms. But if a private company doesn’t pay up, then the official could be go under review to establish if he had any dealings under the table with the failed company.”

  27. blue herring commented on Jul 4

    yes of course it was around before 92. and so, the potential
    for the new worth that it became with widespread use was around before 92 also, but that widespread use released that potential energy. the question is, at what state of that release are we?


  28. Ricardo commented on Jul 4

    Subtracting the CORE rate from 20? — Why core??? Oh, that’s right, no one eats or drives to work in the USA! Doh — let’s get real about inflation and start using the headline number (which by the way also under-estimates inflation) But then I am not the all knowing FED now am I? In any case the CORE rate is a sham just as Enron was. When will people wake up?

  29. Jason commented on Jul 4

    Don’t forget that trailing P/E ratios and projected (earnings estimate) P/E ratios are different beasts.

    All the reputable research I have read shows a significant difference between the average trailing and average projected P/E ratios, with the projected P/E ratios being several points lower!

    Comparing today’s 14.5 projected P/E and the average trailing P/E of 17 is an invalid comparison.

  30. scorpio commented on Jul 4

    ricardo has it right. let’s do the formula the other way: take 20, subtract the PE of 14.5, and we arrive at true inflation of 5.5%. isnt it funny how the market often gets these things right? dream on, bulls

  31. rick commented on Jul 4

    COP pe = 7,
    why do we even bother talking about
    stocks with pe of 14 in other sectors ??

    If we do get a recession, only the commodity sector
    will be hit ??

    What about the other sectors with pe of 14
    than may really look expensive ??

  32. A Dash of Insight commented on Jul 4

    Not Expensive vs cheap

    Barry once again has his finger on the key stock market issue. (And congratulations on the recogition by a major trading publication.) Why have we had several years of excellent economic growth accompanied by reduced budget deficit projections, stellar…

  33. A Dash of Insight commented on May 7

    Not Expensive vs cheap

    Barry once again has his finger on the key stock market issue. (And congratulations on the recogition by a major trading publication.) Why have we had several years of excellent economic growth accompanied by reduced budget deficit projections, stellar…

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