Last weekend, we suggested that it was time for investors to decide which team they were backing in this year’s stock market contest. We opined that if you believe the U.S. will find a way to get through the current financial crisis without a banking system failure, then you needed to be looking at the scary down days as opportunities to buy. And while we did not suggest that we were out of the woods or that wouldn’t see new lows in the major averages or even a recession, we argued that with the Fed on your side, the downside risk in the market might be relatively limited.
One week later, nothing has occurred to change our view. Although volatility in the market remains prevalent and is likely to stick around for another couple of months or so, the technicians argue that the major averages are currently in a basing pattern. Sure, stocks pop up or down in response to each and every news story. But, from a big picture standpoint, the bottom line is the risk/reward relationship appears to be improving.
From a short-term perspective, the game is still all about the economy and whether or not we will see more shoes dropping from the credit crisis. For example, Friday’s pyrotechnics made it clear that the worry over the monoline insurance companies remains significant. And of course, this week’s plunges in response to the weaker than expected Philly Fed data as well as oil’s push over $100 showed that any bad news is good for a couple hundred points on the Dow.
However, if we can put aside the day-to-day gyrations in the market and find the time to put a pencil to the valuation numbers, the outlook going forward becomes a lot less scary. Although valuation indicators have proved to be really rotten timing mechanisms, they do help us to determine the likely path the market will take in the future.
Putting a Pencil To The Risk
To be clear, I am not suggesting that historical P/E levels can act as a crystal ball. But, this broad brush approach to determining risk and reward for a given year IS helpful – especially when things get dicey and emotions are running high.
So let’s take a look at the facts on the valuation front. According to Ned Davis Research, over the past 36 years, the median P/E Ratio for the S&P 500 has been 16.4. However, since 1991, this level has actually represented the low end of the range due to the big bull run we’ve enjoyed. And if one removes the spike in P/E’s which occurred in 2002 (which was a result of the bear market), the range of the P/E on the S&P has been between 16 and about 24.
Thus, with a current reading of 17.2, it is clear that we are close to the low end of the range we’ve witnessed over the past 17 years. And since stocks are at the lower end of their valuation range, it should be pretty easy to understand why we are suggesting that the downside risk is limited.
How limited, you ask? Well, unless the credit crisis takes a turn for the worse, it would be logical to assume that stocks could find their way to the low end of the historical range before improving. (Remember, stocks tend to overdo moves in both directions.) So, if we put a pencil to the numbers, we come up with 1300 as the downside risk level on the S&P 500. This would put the market right at the median P/E for the past 36 years and at the low end of the range over the past 17 years. And with the S&P closing Friday at 1353, the projected downside risk at this point would be a hair under 4%.
The key to this type of analysis is to understand that these numbers assume the current crisis does not suddenly get worse. Investors have had a full year to come to grips with the subprime mess and unless another shoe drops, everybody now has some numbers to work with in terms of the total damage. And as such, we can argue that the current levels in the market reflect the bad news that we know about.
What’s The Upside?
And while we’ve got the earnings projections and calculator in hand, we might as well turn this thinking upside down and take a look at the upside potential. For starters, the good folks at Ned Davis Research tell us that since 1972, the P/E on S&P 500 has been below 18 (currently 17.2) fully 57% of the time. And during this time, the S&P has gone up at an average annual rate of 11.2%.
While an average annual return of 11.2% may not sound like much reason to celebrate, let’s remember that (1) the average return for the market has been closer to 10% since 1900 and (2) when the P/E is over 18 and under 21, the S&P has grown at just 5.7%. (And then when the P/E is over 21, the market loses ground at an annualized rate of -2.8%.)
We will admit that trying to identify an upside target in this environment is tough. However, if we stick with the statistical analysis we used to look at the downside potential, we find reason to be hopeful. A P/E reading of one standard deviation above the median has historically been a pretty good indicator of where stocks become overvalued and prices two standard deviations or more above the median P/E has indicated that stocks are very much overvalued.
If the bulls can get their act together, we could argue that stocks might be able to find their way into the overvalued zone. Thus, based on current earnings projections and the overvalued zone being about 22 times earnings, the upside potential would be somewhere in the vicinity of 1725. And given Friday’s close; this means that the “reward” potential would be about +27.5% from here.
So, with an upside potential of +27.5% and a downside risk level of less than -5%, it should be fairly easy to understand why we are currently in the glass-is-half-full camp when looking ahead.
Can things get nasty from here? Undoubtedly yes, because this continues to be a market that is fixated on the news. And given that we’ve got an awful lot of news coming up this week, we will need to continue to be on our toes. But, if we can look ahead a few months, there might just be a reason to smile.
Wishing you all the best for a profitable week ahead,
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