The Real Question

(Excerpted from John Reese’s May 15 Validea Hot List newsletter)

The big question for the market continues to be whether or not the recent rally is for real. Given the cooling off of the past week or so, the weaker-than-hoped-for April retail sales data, and the fact that we’ve just gone through one of the steepest bounce-back inclines in history, a number of pundits are saying that the run is over. Whether they’re correct or not is anyone’s guess; the market is too fickle in the short term for anyone to know for sure.

The question for me thus remains one of valuation. And, just as I addressed some bearish myths last newsletter, I think there’s an important valuation myth that merits attention this week.

When the market began moving upward on March 9, many said it was too soon. Value metrics like the 10-year P/E ratio showed that stocks were undervalued, but still significantly pricier than they were in past downturns. While the 10-year P/E fell to around 12 earlier this year, it was down in the single digits in the mid-1970s and early 1980s, bears noted. Given the depth and breadth of the current crisis — arguably it has been as bad or worse than those of the mid-’70s and early ’80s — it seemed too good to be true that P/Es would bottom around 12 this time around.

The bears forgot to include two critical factors in their analysis, however: interest rates and inflation. Back in the mid-’70s and early ’80s, inflation reached into double digits, and interest rates soared. Treasury bonds yielding in excess of 10% looked pretty good to many investors, especially given the fact that their nominal returns — unlike those of stocks — were safe. Stocks thus had more competition than usual from bonds, part of why, as value guru Jeremy Grantham recently noted, “high inflation rates typically come with lower than average P/Es and vice versa”.

Today, interest rates are exceptionally low, and deflation — not inflation — is the concern of the day. And, as Alan Reynolds, a senior fellow at the Cato Institute recently pointed out for Forbes, that is quite significant in terms of valuations. “It is not hard to envision future earnings disappointments as a result of higher tax rates on companies or shareholders, health care price controls or cap and trade schemes. But these are threats to earnings, not to multiples,” Reynolds wrote. “Any big drop in P/E multiplies, by contrast, requires a big increase in bond yields. It is certainly possible to envision massive federal borrowing and aggressive Fed easing culminating in a sizable increase in long-term interest rates. Yet such a future of “reflation” and “crowding out” presupposes faster growth of overall demand, gross domestic final sales. In that case, earnings would be rising so the net effect on stock prices might well be positive.”

Reynolds notes that bearish economists typically assume depressed demand and deflation — “forecasts impossible to reconcile with the double-digit interest rates required” to get to P/E ratios of 10 or lower.

“The height of today’s P/E ratio relative to the past tells us nothing except that (1) interest rates are far below average and (2) future earnings are very likely to rise from today’s depressed base,” Reynolds concludes. “Unless those who have spent the past two months predicting P/E ratios of 8-10 are also predicting a tripling of long-term rates, their forecasts of stock prices are inconsistent and unworthy of the slightest attention.”

Along those lines, keep in mind that we are coming off a few quarters of very depressed corporate earnings. Given that low starting point and the massive stimulus injections that have been pumped into the world economy by the U.S., China, and other nations, we may be more likely to see lower P/E ratios because the “E” part of the equation rises than because the “P” goes into a nosedive. And a declining P/E resulting from short-term earnings increasing faster than stock prices seems like a fairly nice predicament for investors.

Of course, all of this isn’t to say that the market isn’t going to pull back a bit, or even a lot, after this recent surge. If you’ve read the Hot List for any amount of time, you’re well aware that I don’t try to predict what the market will do in the short term. The reason that I raise these points about valuation is to highlight the uncertainty of where the market will go in the coming months. For every short-term bearish argument that seems reasonable on the surface — like the notion that P/Es must go lower — there seem to be plenty of reasons why it might not be correct.

That short-term uncertainty is always present in the stock market. It’s why the great mutual fund manager Peter Lynch — one of the gurus who inspired my models — once said that investing in stocks “with a one-year horizon or a two-year horizon, that’s silly. That’s just like betting on red or black at the casino.”

Because no one knows for sure how the market will move from day to day, week to week, or month to month, I believe the best approach is one that comes back to value. And right now — regardless of how stocks have performed in the past two months and how they will perform in the next few months — I see a lot of long-term values in the market. And Warren Buffett, Kenneth Fisher, and other gurus I follow have recently expressed similar views. So while the pundits spend time continuing to debate whether or not the rally is for real, I’ll keep picking up undervalued stocks of solid companies. In the end, I think the Hot List will reap the rewards.

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