Wednesday, 15 October 2008

Why the Market Isn't Cheap

There is a cacophony of opinion currently doing the rounds that stocks are cheap, dirt cheap in fact and that there are bargains everywhere. Now I certainly don't think after a -40% decline that stocks are expensive, they aren't and if pushed to make a call one way or the other I'd have to say they are on the cheap side but there is no reason that they couldn't get cheaper from here.

I wish I had a chart for the ASX All Ords PE ratio but unfortunately I can't get the data. The above chart of the S&P500 12 month trailing PE shows that stocks as at the end of September were not particularly cheap trading at 16.8 times and keep in mind that is based on earnings expectations for 3Q08 of -2.6%, a forecast that will turn out to be too optimistic in my opinion.

Of course, since the end of September, stock markets have declined significantly in the first two weeks of October. Based on yesterday's close of the S&P500 and earnings for 4Q08, the 12 month trailing PE drops to 13.0 times. Then looking out to the end of 2009 the 12 month trailing PE drops to just 10.0 times and that is certainly very cheap.

However as mentioned many times before the E in the PE cannot be trusted looking ahead. Especially given what has happened in the last few weeks as the credit markets have seized up and earnings of all types of companies are coming under pressure. Of note recently was Pepsi coming in light on earnings and Intel's guidance for the 4th quarter is looking a little wobbly.

For example, 6 months ago 4Q08 earnings were forecast to rise more than 74%. At the time I said that was ridiculous. As the chart below shows estimates have come down to a forecast growth rate of 49.6%. That will also prove to be ridculous although I do expect them to be up given the very easy comparsions from 4Q07.

The point is that a PE of 10 on the S&P500 based on current earnings is a pipe dream. Earnings for FY08 for the S&P500 are currently forecast at around $76.70 whilst FY09 earnings are forecast at more than $103 or 35% higher. Given the hole the economy fell into in October those earnings need to come down substantially.

Personally I doubt FY09 earnings will exceed $80 and indeed they could be substantially lower, however using $80 as a base case, that would put the PE for the S&P500 based on yesterday's close at around 12.5x. That is still reasonably attractive but remember that multiple sank to around 7 times in the early 1980's. Of course we are not in the 1980's but it is an indication of how depressed multiples can get.

One final note. Regardless of whether we have hit bottom or there is further to go, it is important to remember that not all stocks bottom at the same time. Some have seen their bottom already and some have yet to see it. There definitely are some cheap stocks out there at the moment which will prove to be good long term buys and whilst I still expect the overall market to make new lows in the coming months, I also hope put some money to work.