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Wednesday, April 22, 2009

Fasten Your Seatbelt

In January I noted how cheap stocks were at that time in relation to interest rates. In what appeared to be the best value since the mid-1950s, a dollar invested in the S&P; 500 represented, in earnings, almost 2 ½ times the interest rate on the 30-year US Treasury bond. Nonetheless, the market fell an additional 25% by March 9 before staging the recent record breaking rally.

The whirlwind of the last couple of quarters changed the landscape. As observed in my February 16, 2009 blog (TheMarketsValue.com How to Avoid the Next Lost Decade), the market got more expensive as it declined. This was because fourth quarter earnings declined 35%, though the market, after an historic rise in the last few weeks, is only down only about 10% this year.

It ain’t gonna be pretty. First quarter earnings reports look like a second consecutive decline of 35%. Should investors focus instead on how earnings might look a year from now versus the horrible number companies report in the depths of the current recession? History, though no guarantee of future events, suggests not.

From December 1946 to July 2004 (18 months after the last bottom in earnings) the compound annual rate of return for the S&P; was 7.7%. Since 1946 there were 14 distinct instances when earnings declined, bottomed and began to recover. From those bottoms, the market rose on average 0.7% over the next year and annualized 4.6% over the following 18 months. Apparently it is not enough to pinpoint the actual lowest point in earnings.

It is better to buy stocks when the market is cheap (highlighted above in bold). Sometimes earnings turn around and pick back up when the market is cheap. Sometimes this happens when the market is expensive. When the market was inexpensive relative to prevailing interest rates, and earnings began to recover, on average the market averaged +3.3% and +7.2% (annualized) 12 and 18 months later respectively. Conversely, when the market was expensive, though earnings began to recover, the market averaged -1.2% and +2.7% (annualized) 12 and 18 months later.

There are ways for stocks to get expensive other than the stock market going up. Another way is for earnings to collapse. Because the market is a way of valuing earnings in a given interest rate environment, a third way for the market to get expensive is for interest rates to rise. So far in 2009 earnings are shrinking faster than the market is declining, and despite the Federal Reserve’s efforts, long term interest rates have been rising. Other than those brief moments of market panic, it is doubtful long-term interest rates can decline much from the 3-4% range of late.

S&P; earnings are currently valued at only 87% of the interest rate on long term bonds. That ratio will probably go lower as companies report lower earnings in the next few weeks. The estimates are for at least another quarter of declining earnings. Though possible, it is probably premature to call April the bottom for earnings.

To put that 87% in perspective, the last time the market was this expensive was September 2008 when the DJIA was 13400. The following months were not pleasant.

Everyone’s a genius. Over the last few weeks the market has made an historic advance. Almost all stocks have been going up. For example, from March 6-19 AIG rose over 550%. But I daresay no one is really happy owning that stock—it is still down 96% from a year ago. Ford has more than doubled. Citigroup has tripled to 3 ½. Not long ago people thought they were geniuses for buying that falling knife at $30/share. Buy such stocks on Monday and it’s fat city (if you sell on Tuesday). Buy on Tuesday and you’re clobbered.

Every week ValueLine updates research on 1/13th of the stocks in their universe. As one source of ideas, I look at each stock, first to see which are going up in price. These days about 95% of the stocks mentioned are rising. Everyone’s a genius—throw a dart and find a rising stock. By looking at earnings and estimates I quickly drop most from further consideration. Next by insisting on stable or accelerating growth rates in sales, cash flow, and earnings, I eliminate the bulk of the remaining candidates.

In the Value-Priced Growth Strategy, I’m only interested in finding a couple dozen companies in which to invest. I want more going than just the momentum of a rising market. I want stable or accelerating earnings so I have reason to think earnings also might be higher down the road. Finally, the ideal candidate is priced low enough up front so that if earnings are delivered, the price should also rise.

A word of caution. Does the DJIA now bounce to 9000 or even 12000? People may be feeling a bit better about the market. By itself that could inspire further buying. There is certainly a mountain of money on the sidelines not earning anything in money market. People are now more fearful the train could be pulling out of the station without them. This may not be a time to be overly confident, but rather cognizant of the reality that sometimes stocks go down. Caution is still the name of the game.

Just because a stock is way off of its once upon a time price does not mean it’s a good value today. There may be very good reasons why it’s down. Recall the once great names of Enron and WorldCom and remember some stocks that go down even go away. Often in a bankruptcy the common stock is eliminated in favor of the bond holders who get a few cents on the dollar in new stock in exchange for their bonds.

The last few weeks have been exhilarating. But don’t cast caution to the wind. Fasten your seatbelt, please.