Why markets can go lower -Valuations

The following is the first of a series of write-ups that explains why it is that I believe markets can (over time) make their way lower. It will hopefully provide some sobering thoughts to those concerned with missing the next big bull market. As I point out in the write-up, despite the potential for markets to move higher in the short-term, now is not the best buying opportunity of our lifetimes. That honor goes to 1982 when the S&P traded at 7 times earnings.

In this, the first of a series of letters discussing why markets can go lower, I take a look at what I believe to be at the core of a successful long-term buy and hold strategy; valuations.

The S&P 500 is the most followed market on the planet and represents five hundred of the largest American companies. As such, I will look to it in order to get a sense of where valuations stand today.

Warren Buffet, in his 2008 letter, commented that the expected return on the S&P over a very long time frame, say one hundred years, should be roughly 6%. The 6% would equal gross domestic product growth plus inflation. That makes a lot of sense. After all, as a whole, earnings from companies cannot grow more than the economy. Of course, some companies will grow faster than others but on a combined basis, as expressed by the S&P 500, growth will be that of the economy.

So why is it that certain time periods will see equity markets return 10% year after year (think 80s and 90s) and during other periods, we’ll be lucky if markets come out positive (today?). A good chunk of the answer can be found in valuations.

The most commonly referred to valuation metric is the earnings multiple. It is a simple computation derived by dividing the price of a stock by its earnings. The higher the multiple, the more expensive the stock. For example, a stock trading at $10 and earning $1 a year is said to be trading at 10 times earnings. A stock trading at $30 and earning $1 is the more expensive of the two as it trades at 30 times its earning. Assuming all else is equal (the earnings growth rate for example) one should choose the $10 stock.

Now that the earnings multiple is understood, let’s grasp where valuations stand today. According to the S&P, the market currently trades at about 17 times next year’s earnings. Alone, that doesn’t tell us much so let’s delve in deeper. First, a little historical context:

If we go back all the way to 1900, the history of S&P valuations goes somewhat as follows:

1901 – 23 x earnings

1920 – 5 x earnings

1929 – 28 x earnings

1932 – 8 x earnings (following the crash from the beginning of the depression)

1936 - 19 x earnings

1942 – 9 x earnings

1965 – 23 x earnings

1982 – 7 x earnings

2000 – 42 x earnings (remember the dot com and Nortel above $100)

2007 – 27 x earnings

Expected for 2010 – 17 x earnings

To keep from putting in over one hundred years worth of data, what I did was highlight the peaks and troughs in multiples. For example, from a peak 23 times earnings multiple in 1901, the multiple attributed to the S&P never stopped going lower until it bottomed out at 5 times earnings in 1920.

Here’s what’s important to glean from this. Until now (and hoping that this time will be different can be very dangerous for one’s portfolio) every time the valuation peaked, it did so above the 20 level (1936 is the sole exception at 19 times). The trough was never higher than 9 times earnings. Again, once the markets start their way towards lower valuations, never have they not gone down to at least 9 times earnings. Given a 17 times projected multiple, that implies the potential for a serious downside.

Again, it makes sense. Never would you as a business person, go out and pay 20 times earnings for a private business in which you would take on all of the risk and which, if you happened to be wrong, would be your financial undoing. Yet, we as investors, at certain times in the cycle end up paying over 20 times earnings for equities. Good names or not (think Procter and Gamble), one cannot expect to do well via a buy and hold strategy when the underlying stock is purchased at peak valuations.

Once the world embarks on a path to lower valuations, it does not stop until it reaches the other extreme. This is when true bear market bottoms are made. The last bear market bottom was in 1982 when the S&P traded at 7 times earning and yielded near 6%. At such low valuations, it matters not how bad the economy is because investors are willing to take on any and all risk given true, once in a lifetime valuations.

We’re currently in the middle of earnings season in the US and markets are moving higher as companies report better than expected earnings. In my next write-up, I’ll explain why these numbers are misleading.

If you have any questions on this, or anything else, feel free to contact me.

Have a great day

Robert T. Moore is an Associate Portfolio Manager and Wealth Advisor with ScotiaMcLeod in Pointe Claire, Quebec. Opinions expressed in this column do not necessarily reflect the views of ScotiaMcLeod or any of its affiliated companies. It is recommended that individuals consult with their own financial advisor before acting on any information contained in this article. Robert Moore can be reached at www.moorerasponi.com

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