This is an easy one for me….
A lot of perma-bulls out there want to believe the market is cheap right now, and that people should be buying equities because there has been a rash of sell-off’s and bad news in recent weeks.
First, let’s define “cheap” and then let’s look at the facts.
What is “cheap?”
It depends on who you ask. If you asked a sell-side equity analyst in 1998 if internet stocks were cheap, you would have probably been given an answer to the affirmative (the could only go up, right?). If you were to ask a perma-bear in early 2009 if stocks were cheap, you would have probably gotten an answer to the negative.
I think it’s difficult to define cheap on a broad market basis. At any given time, certain equities may be overvalued or undervalued. On the whole and over long periods of observation, publicly traded equities are typically fairly valued, usually skewing slightly toward bullish or bearish at any given time.
But if we MUST take a look at the market as a whole and make some kind of prognostication, then it’s useful to look at the price/earnings ratio of the various market indices (yes, I know, GAAP earnings multiples are highly flawed metrics, but at least we get some kind of apples to apples here….roll with it for right now).
As of today’s WSJ, the multiples for major US indices are as follows:
Dow Jones PE: 12.15 (trailing), 11.55 (forward)
S_P 500 PE: 13.36 (trailing), 11.73 (forward)
Looking at these multiples – even on a forward basis – it’s hard for me to conclude the market is “cheap.” For instance, on a simplistic basis, to pay 12 times earnings for the Dow implies that I better believe in some brisk uninterrupted earnings growth or I won’t be making very much on my money.
Are these market earnings multiples overpriced? No. I don’t they are bloated. The Dow is yielding 2.79 and the S_P is yielding 2.27 right now. These are not bad numbers, either. But they aren’t terribly juicy, either. Will they ever get there? I don’t know.
Sometimes you hear things on TV or read commentary in a print publication where it is claimed certain events are “over-priced” or “under-priced” into the market. You’ll hear a talking head say something like: “the news on sovereign credit risk in Europe is already priced into the market, so anything moving the market today will come out of Asian or US economic data.”
Market forecasts are a dime a dozen. People should know this. Especially those with fiduciary duty to clients.
It’s extremely arrogant to assume you know what is and what is not priced into the market as a whole at any given time. To evaluate single equity or debt issues, you can surmise that a mis-pricing (which are usually temporary) has occurred. However, to know the input and variables into the billions of shares moving each day is quite a stretch. A guess is perhaps the best way to phrase it, but the sound bite comes across well and sells advertising space for day trading platforms.
Ugh…let it be if it will be.
A dangerous mindset to get in is one in which you try to guess what events or possible outcomes are “priced into” the market at any given time. If you’re serious about making money, leave this to the CNBC talking heads.
Another issue the talking heads bring up is the sound profits of US companies. In particular, how well large US multi-nationals are doing overseas generating business. How much “dry powder” US companies have (that, which is not ‘trapped’ overseas waiting for tax law changes to be repatriated). This is all well and good.
However, caution is the word of the day with corporate management. All of this huge cash war-chests these companies have built up could come in quite handy in the (formerly) unlikely event of global macro economic deterioration.
Being someone likely categorized as in the ‘value’ investing camp, it’s hard for me to get excited about equities as a group until I start seeing REAL panic. Fall 2008 type panic. October 1987 type panic. Or, even better, the type of despair you see when magazine covers come out like this:
Right now, there is nothing happening that gets me very excited about equities as a group. Individual issues here and there, but nothing I’m borrowing against my house so I can buy more of.
Why You Have To Be Careful
From a portfolio management standpoint, the old Pareto 80/20 rule applies – 80% of your gains come from 20% of your total positions. This means if I hold 10 equity issues, 2 of them will be outsize gains over time. There might be some other winners sprinkled in there, but for the most part the 80/20 holds true. From 2008-present, in a personal portfolio of just 8 carefully selected equities, 2 of them have made up 90% of my total gains and 1 of these two is responsible for a huge gain.
If you aren’t careful and if you don’t scoop up absolute BARGAINS, your portfolio will suffer. You’ll get dragged into mediocrity where you’d be darn close to coming out ahead by just sticking your money in the SPY. This is why you must take care to manage your cash so you can pounce when – and only when – the deals are really good.
This year I have made only a few select equity purchases. I’ve left a good amount of idle cash sitting at the ready. I’m fully prepared to sit on that cash for a long time to come.