It’s Value Time Again

Is the market overvalued? Fairly valued? Or are there really rocket boosters underneath the trading floors? We will look at the data, some historical charts which I think you will find very interesting, and some of the recent economic numbers which are important, all in an attempt to answer these questions.

This week's letter was prompted by a very fair question from a reader. I got in late Tuesday night to Orlando where I would speak to the Investment Management Consultant's Association the next morning. I went to the bar to get a glass of wine and see if I could meet anyone from the conference and get a feel for what was happening.

Coincidentally, I immediately met two readers who were attending the conference, and we struck up a conversation. One had been reading me for quite awhile and has read my books. It did not take long before he asked, "Do I still believe we are in a secular bear market? And if the market makes new highs, what will happen to my belief in that premise?" As if to underscore that thought, today the Dow closed at 11,577, a six-year high. Various small-cap markets are at actual all-time highs.

The quick answer is, "Yes, I think we are still in a secular bear market;" but the real answer is more complicated, as these things always are.

First, let's look at what I mean by a secular bear market. I argued in Bull's Eye Investing and this weekly letter that secular market cycles should be looked at in terms of valuation and not in terms of price. Looking at them in terms of valuations makes the cycles far more clear and also offers some suggestions as to how to invest within the cycle.

Markets, at least historically, have always gone from high valuations to low valuations and back to high valuations. These long-term cycles average about 13 years, with a short cycle of 8 years and a long cycle of 17. Each cycle has bull and bear markets (in terms of price) within them, and the market moves can be quite volatile.

To date, there has never been a market cycle that stopped halfway and then completely reversed. We have not seen a period where we were at high valuations and stopped at some mid-point on the way down and then rose back to a new valuation high. Ultimately, we have always ended up with low valuations that became a springboard for the next bull market.

But right now, it looks like things could be different, at least to listen to many commentators. It is a new era, we are told, and guys like me just don't get it. Well, maybe.

Why is this important? Because valuations are the primary driver of stock market profits! 80% of the last bull market came from the valuation multiple rising by 8 times! We went from a P/E (price to earnings) of 8 in 1982 to well over 40 in early 2000. Throw in some increased profits and inflation, and you have the largest bull market in history, not to mention a bubble.

What Will the Stock Market Return over 10 Years?

I use the following chart in nearly every speech I give. It comes from work done by the venerable Jeremy Grantham. Grantham breaks down historic P/E ratios into five levels, or quintiles, from level (or quintile) 1, which represents the 20 percent of years with the cheapest values (lowest P/E ratios) in history, right on through the fifth quintile, which represents the 20% of years with the most expensive values.

What kind of returns can you expect 10 years after these periods, on average? Interestingly, the first two quintiles, or cheapest periods, have identical returns: 11%. That means when stocks are cheap, you should get 10% over the next 10 years. The last, or most expensive period, sees a return over 10 years of 0%.


This basically squares with data from Professor Robert Shiller of Yale. To ignore it, they must show why "this time it's different." In order for someone to predict, as many do, that stocks will return 6 to 7% over the next 10 years, that person must show that values lie between the second and third quintiles--or that investors will somehow start putting more value on stocks, and thus a floor on the market.

The problem is that the average overrun of the trend in a secular bear market is 50%, which is why stocks get so undervalued. By that, I mean stock market valuations do not stop at the trend. They tend to drop much lower. For the bulls to be right, we would have to see something that has never happened before. Stocks would need to drop to values 25% higher than the long-term historical average and no further.

Which is about where we are today.

This puts into perspective all the debate about valuations, and why so many suggest valuations are "fair" today. And indeed, as we will see, if you look in the right places, you can find numbers which kind of, maybe, support the case. So, let's go to the numbers and see what we find.

First, let's go to the Standard and Poors web site, where you can see the actual valuation numbers for the stocks in the S&P 500. (You can go there yourself by clicking here.)

They offer us multiple ways to find a P/E ratio. You can look at operating earnings, as reported earnings or core earnings, plus trailing 12 months and looking forward as far as 20 months.

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Operating earnings are the ones that bull market proponents like the most. They ignore things like one-time costs, special problems, pension liability, and options. I put them in the Earnings After Excuse and Hype category.

Now, I will admit, you can make a case for using operating earnings when evaluating the value of an individual company. Perfectly valid, as sometimes bad, one-off things happen, which should not alter your long-term view of a company's prospects.

But when looking at a market as a whole, it makes no sense. "Bad things" will always happen to some of the companies in any given index. Bad things are the norm when looking at large groups of companies. Next quarter, or next year, a different set of bad things will happen to a different group of companies. So, statistically, using operating earnings for a group of companies or an index is like assuming that bad things will not happen to any of them in the future. Which we know not to be the case.

Reported earnings are just that. They are the earnings the company reports to the various authorities and have to take into account those bad things. And historically, reported earnings are what we use to compare today to last year or last decade.

A few years ago, S&P did a very good thing and started to report something called "core earnings." These are earnings which take into account pension liabilities and options. Of course, bulls argue against this new core earnings concept. I argued in Bull's Eye Investing that it makes sense, as not only are these real expenses, but I felt the market would demand changes in the accounting rules to reflect them. As it turned out, I was right.

Now, let's look at the numbers. First, let's go back to December, 2001. If you looked at P/E ratios on an operating earnings basis, the number was "merely" 29.55. On an as-reported basis, the P/E was 46.5, and a core P/E was a nosebleed 71.75.

Fast forward to today. The numbers are approximately 17 (operating), 18.7 (as reported) and 19.6 (core), based on today's close of 1325 on the S&P, and using first quarter earnings data. Historically, the average is in the 14-16 range, depending upon when you start counting.

Notice that the core and reported numbers are much closer. This has been the trend for the past few years, as more and more companies take into account options and pensions in the reported numbers. Eventually, I would expect those numbers to get even closer.

Now, let's project earnings into the future. The analysts at S&P expect the P/E ratio on an as-reported basis to be 17.5 (I adjusted for today's close) at the end of the year, and less than 17 at the end of 2007. On an operating basis, they expect the P/E to drop to under 15 by the end of 2007. That, of course, assumes that the market does not move from this point and earnings keep right on growing as they have in the past.

One quick note about analysts' projections. They are closely tied to recent performance. In fact, the best predictor of what a professional analyst will predict is recent past performance. That is why they are so often wrong.

As an example, take my Texas Rangers. We started the season with a miserable 1 and 6 record. I think I wrote something about them not bothering to wait until August to disappoint the fans. I projected the then-current trend and saw us losing 100 games. But things have changed. We have won 8 straight. We are in first place. The Yankee game starts in a few hours, and an opportunity to make it 9. Now I am thinking of a 100-game win year. But past performance does not indicate future results.

As human beings, we instinctually project current trends into the future. It is just the way we are hard-wired. It is VERY difficult to overcome. It is why we jump into funds that have already gone up a lot. We project those returns as a "what if" into the future, as in "What if I invested and I could get returns like that for the next 2-4-6 months?"

That's why it is so important to have discipline in our investment styles. I like using value as a baseline. And one way to look at valuation is price to earnings (P/E).

What is the average P/E? If you start from 1900, it is 14.8. Starting from 1920 it is 14.4, and starting from 1950 it is 16.8. So, average depends upon when you want to start counting. Using only the last 56 years, we are close to the average P/E. The Grantham chart suggests we should see a return of 8% a year for the next 10 years.

By the way, if you exclude the years 1997-2002, the average P/E ratio drops by more than a full point! Prior to 1997, the average P/E was 13.8.

So, which is it? Are we in high valuations or about average? As we will see, you can torture the numbers and make them say just about anything. But I think they are telling us the best we can expect is average, if you hold you head just right when you look at the numbers. And from my angle, they still look quite high.

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One way to look at it comes from those clever people at The Leuthold Group in Minnesota. Steve Leuthold sends me a large book every quarter called The Benchmarks , which is full of historical data and comparisons. It is a treasure trove of data. (I should note that Steve does not torture numbers. No numbers were injured in the development of his charts. He simply looks at the data in scores of different ways and puts it all into that marvelous book.)

Let's look at some of his charts. First, he tracks what he calls the median normalized P/E ratio. By normalized, he means the P/E ratios are based on a five-year normalized earnings figure. Normalized earnings are employed to smooth out distortions related to the business cycle. Basically, the normalizing procedure is a five-year average of earnings (16 quarters of reported operating earnings and four quarters of future estimates).

This keeps you from getting the wild swings like we had in December of 2001, which I mentioned above. That was an outlier, and the years before and after were coming back into more familiar territory. Further, he uses the median valuation for 3,000 stocks to keep the large companies from distorting the picture.

Let's look at his table:


Today, we find we are in 9th decile, or at 86% of the most expensive periods. Given the rather significant move since March 31, I would hazard a guess that we now clearly in the top decile, or over 90%! Not very good from the perspective of the chart from Grantham that we started with. That seems to suggest prospects going forward are not optimal, to say the least.

But if you look at the S&P 500, and normalize the P/E ratio as Leuthold does, things may look better, depending on which data set you use. We are merely in the 71% range, where the Grantham chart suggests that we could be seeing 5% annual returns over the next 10 years. Not exciting, but not a bust. But that is if you start from 1957. Starting from 1926, we find we are in the 90th percentile.

But let's be bullish. On an operating earnings basis, things look even better. We are at the 57% percentile, much more comfortably ensconced near the middle with brighter prospects for future returns.

Now, to the original question: Are we still in a secular bear market? And if I answer yes, how can I maintain that, given the market moves we are seeing? Am I just a boring old perma-bear, like good friend David Tice? (Ok, David is not boring, but he is always bearish.)

Back to the Bull Market of 1972

First, let's look at this great chart sent to me by Ed Easterling at Crestmont. He notes: "In 1972, P/Es were almost 18, the market was approaching and exceeding new highs, volatility was low, and the market was in the first half of a secular bear market ...what happened next is now history--if it happens again, it won't surprise the old sages..."


Note something on this chart. Most of us start the secular bear market of the 1970s as actually beginning in 1966. The Dow then made an historical high in 1972, only to retreat to 600, run back to 1,000, fall to 750, run up and then run down, etc...

The key graph on the preceding chart is the P/E ratio at the bottom. It just kept dropping over time. Prices went all over the board, but the P/E ratio went from the upper right to the lower left on the chart. A classic secular cycle. So, could we see a repeat? Another market high on the way to lower valuations in the future? Absolutely! Why would anyone think we are any smarter now than we were then?

Secular bear markets have never ended when the markets got to average P/E ratios. They have always overshot in the past. Could it be different this time? Want to bet your portfolio? Do you feel lucky, punk? Insanity is doing the same thing over and over and expecting a different result.

For a clue as to why the market could be going down, let's look at today's employment action. Philippa Dunne & Doug Henwood sent me the following comments on the April numbers:

"There was a whiff of stagflation about this month's employment report, with job gains slowing and earnings measures rising.

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"April's gain of 138,000 was the smallest since last October, and the back months were revised down. We've now had three consecutive months of downward revisions to the previous month's gains. Gains over the last three months have averaged 179,000, compared with 218,000 for the previous three-month period."

"Average hours were up and average wages were up. Average weekly earnings were up 0.8% for the month, and 4.1% for the year. This was the strongest monthly gain in 9 years.

"This combination of weakening employment gains and rising wage pressures presents a sharp challenge for the Fed. It's likely that the anticipated trajectory of policy won't be as clear as the markets would like in the coming weeks and months, so every twitch in the data will have to be read with unusual care."

But today, the market read it to mean the Fed is going to pause, and soared on the news. I must confess, I don't get it. Bernanke is telling us that he expects the economy to slow down in the latter half of the year. Now we get data that seems to indicate he may be right.

So, if the economy is going to slow, why is that good for stocks? Plain and simple, it isn't. We are watching the housing market slow down. Luxury homebuilder Toll Brothers Inc. on Friday said signed contracts for its homes fell 29% in its second quarter and that home deliveries for the year will be 20% lower than expected as the slowing housing market takes hold. March sales of homes were good, but anecdotal evidence shows prices are weaker, and inventories of unsold homes are rising rapidly in many markets.

Gas and energy prices are affecting consumer confidence. Eventually, that should affect consumer spending, but April sales at Wal-Mart and other retailers were up. Maybe the reason is that home-equity borrowing is still going strong. Evidently, we are not willing to cut lifestyles when debt is so readily available. This note from Bill King:

The Washington Post in "Reasons Change for Refinancing" writes, "A greater proportion of mortgage refinancers tapped their home equity for cash in the first three months of this year than in any other quarter in the past 15 years, according to an analysis released yesterday.

"About 88% of people refinancing their homes took out loans for at least 5% more than their original balances, according to the latest quarterly review of loans owned by Freddie Mac, a government-backed home mortgage company. However, more than half took loans at higher interest rates than they previously paid. In years past, refinancers chased lower rates."

Call me a bear, but I continue to believe we are going to get a chance to buy this market at a much lower level than today's close.

Talking My Book

And one final comment before we wrap up. I get a few comments here and there about having "missed" the market. I have not missed the market. I have chosen to avoid it. The real answer is more complicated. I have the luxury of having hedge funds and other absolute-return-type funds and managers available to me and my clients. I recognize that the vast majority of my readers do not. Thus, I can find places to put money to work that do not make me take what I think are the risks of a secular bear market and high valuations. I choose other risks.

(You never avoid risk, you just choose which of a wide variety of risks to take. Assuming, of course, that you have some idea of the risks. It is the #$%@ hidden risks that keep me up at night.)

Now, it could be that I am talking my book. By that I mean, since I plow in the field of hedge funds and alternative investments and managers, it is easy for me to suggest to people to do what makes me money. Just as managers who only have long-only investments always see the market as going up in the long run, and NOW is a good time to buy. I must confess, I also see now as a good time to buy, but just not long-only mutual funds.

For the record, I fully expect to turn very bullish - perhaps wildly so - at some point in the future. My next book is overall going to be a very positive book with respect to the markets. We just have to get to better valuations. I believe we get there. In the meantime, choose your risks carefully. And pay attention to the first graph in this letter.

Montreal, Yankees and Mission Impossible

I fly to Montreal on Monday to speak at a private investment conference. It is Tony Boeckh's Club X Montreal Family Office Investment Conference. It is quite an honor and I am really excited. It should be quite interesting, as there is a good line-up of speakers that I am looking forward to hearing. It should offer a few ideas for next week's letter.

It is graduation time. For those of you with graduates on your list, or recent graduates in your family, let me recommend a new book by good friend Michael Masterson, Automatic Wealth for Grads... And Anyone Else Just Starting Out . It is an easy read and one which will help, and maybe inspire, those who are beginning their business careers, or wanting to start over. I will be getting it for my kids and a few recent grads on the list. You can get the book at

The Yankees are in town tonight, and I have a group of good friends and some of the kids coming over for the game. I really look forward to friends, family, some good wine, and baseball, in that order. And maybe, in the spirit of projecting recent trends, we can continue to sweep in this home stand. Tomorrow night some of the kids and I will go see "Mission Impossible 3." I notice the Wall Street Journal gave it a real positive review. All in all, this is going to be a good weekend, I think.

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The trend is your friend, until it isn't. It is the first inning and the Yankees are already ahead 1-0. We'll see how it ends. It is good to have friends who are more constant than market trends. I trust your week will be as good as mine.

Your friend even if the trend isn't analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.


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