It’s Time to Look at Stock Valuations

Friday, June 25, 2010

Last month, I concluded a write-up by saying I would next be looking at stock valuations (Building on Current Earnings Foundation, Analysts Project Future Growth – May 20). Then the five baddies hit (Goldman, Greece, BP, Afghanistan and flash crash) and valuations became moot. Uncertainty took control of the stock market. So, I decided to postpone the valuation analysis until the emotional selling ended. I concentrated instead on how to invest in such markets – namely, remaining separate from the “crowd” and using a contrarian approach.

The focus on fundamental analysis is returning again, so it’s time to look at stock market valuations.

Perhaps surprisingly, the stock market’s decline has produced valuations as good as last year at this time – a period now recognized as offering a good investment opportunity. While the Dow Jones Industrial Average (DJIA) is up 28% since then, the forward (future) earnings estimates are also up by about the same amount (10% for 2010 and 15% for 2011, the new “forward” year).

Another way to look at what’s happened is to apply last year’s 11.1 price/earnings ratio (using 2010’s estimated earnings) to this year’s 2011 estimated earnings: 11.1 x $811 = 10,356. This means that last Friday’s close at 10,451 is only 2% higher than that valuation.

It’s informative to see how we got here. The crooked route below shows how short-term forces can take the market away from its fundamentals (or intrinsic value). Long-term, though, it returns when emotions are subdued.

Now, let’s look at a graph made for graph lovers. (It’s a bit complicated, but I believe I’ve got it as simplified as possible.) There are two estimated earnings lines: 2010 (for the entire period) and 2011 (beginning March 26). Overlaid are the DJIA closes, annotated with the price/earnings ratios. The dates represent key points:

  • July 10, 2009 – Clearly a good time to buy stocks, with attractive valuations, just preceding the 2nd quarter 2009 earnings reports
  • August 28, 2009 – After 2nd quarter 2009’s earnings reports, and just before post-Labor Day period in which Wall Street shifts focus to next year’s (2010’s) earnings
  • November 27, 2009 – After good 3rd quarter 2009’s earnings reports
  • February 26, 2010 – After 4th quarter 2009’s earnings reports, when all the focus is now on 2010’s earnings estimates
  • April 23, 2010 – Stock market peak in middle of good 1st quarter 2010’s earnings reports accompanied by investor shift from negative to positive flows. Then, multiple negative developments outweigh earnings reports, putting market into a decline.
  • June 4, 2010 – Stock market trough due to signs that problems are/will be moderating, the attractive valuations and anticipation of the 2nd quarter’s earnings reports beginning in about a month (on July 12, Alcoa leads off the DJIA companies)
  • June 18, 2010 – Last Friday’s close and estimates

Important note: There are investors, advisers and reporters who are focused on how risky the stock market looks because it has risen so much since last March 9. However, as we’ve seen, the rise is composed of two factors: the “V” shaped reversal of emotional selling in February/March 2009 and then the earnings improvements. The price/earnings rise from last July is virtually gone. Therefore, a dramatic fall from here, as some are projecting, would require the estimated earnings to be cut significantly. Could it happen? Of course. That risk always exists. But to bet on such a risk means taking on a big risk.

So… Based on estimated 2011 earnings, the stock market (DJIA) is selling at the same valuation as last year (July 10). That was a great time to invest even though there were projections of an imminent drop back to the March lows and even below.

Note: I used the Standard & Poor’s 500 Stock Index as the best stock market measure throughout my career. Now, however, I believe the DJIA is the best to use for this market. (See my article, “Dow Jones Industrial Average – An Index with a Cool Factor” – November 23, 2009).

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