Look at Stocks’ Future Prospects, Not Their Past Performance

Tuesday, September 29, 2009

SunriseWe’re in an interesting place in the stock market. The economy seems to be improving with economists thinking we are leaving the recession behind. The stock market has risen 50% off its March bottom as pessimism waned and corporate earnings came in better than expected. But many investors are not biting and continue to sell their stock mutual funds. There is a general concern that the stock market has risen too much and too fast. However, now is a great time to consider stock investing, and here’s why…

The stock market was at an abnormal low in March because of the combination of terrible economic numbers, great uncertainty about the financial markets and high pessimism about the future. Then, as those declines moderated and corporate earnings began to stabilize, the stock market rebounded. The size of the rise reflected both those improvements and the depth to which the market had sunk.

Importantly, the stock market is not now being buoyed by robust economic growth or optimism about the future. Rather, it is in a readjustment period. Such a time has uncertainties and gyrations, so it does not breed excess bullishness. At 9,789, the DJIA is still well below its peak close of 14,165 reached almost two years ago on October 9, 2007.

But there is cause for us to think about being bullish:

First, the stock market and stock indexes are healthier. The old saw, “It’s not a stock market; it’s a market of stocks” is alive and well. And that market of stocks has gone through a natural evolutionary process that occurs during any shakeout. Weak companies disappear or shrink to a fraction of their previous value in the market. The creators of the indexes (like Dow Jones and Standard & Poor’s) capture these changes by replacing the losers in order to keep their indexes more relevant. For example, here are the DJIA changes made since last September:

Out: AIG, GM and Citigroup
In: Kraft Foods, The Travelers Companies and Cisco Systems

Second, companies are getting healthier, with financial strength and earnings improving. Third quarter earnings reports are about to be reported, and they are expected to be good. More importantly, investor focus is shifting to 2010’s growth forecasts.

Third, valuations remain conservative, The median price/earnings (P/E) ratio for the 30 DJIA stocks is only 14 times 2010 estimates. This is an especially low valuation in a time of low interest rates and recovering earnings. Also, analysts are not in an optimistic state of mind, so forecasts don’t have heady expectations. In the more normal times during much of this decade, the DJIA often traded at a P/E of 20 or higher.

So, ignore the stock market’s gains from March. Get ahead of other investors by focusing on company fundamentals and prospects now.

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