Warren Buffett says buy. Jeremy Grantham says it will get worse. Both are celebrated value investors. Who’s right?
It all depends upon your view of the third derivative of investing.
Those Wild and Crazy Analysts
Quick review: Last week, I showed how consumer spending is falling. I then highlighted how analysts are dropping earnings estimates as time goes on. From projecting 15% earnings increases for 2008, they've dropped projections over 40% from March 2007 until today. Actual numbers will be much lower, as analyst projections for the fourth quarter are too high.
The same holds true for 2009. Since March of this year, just 6 months ago, earnings projections for 2009 have dropped 40% and are almost 10% lower than they were projected for 2008. However, estimates for operating earnings are still roughly double those for as-reported (or what's on the tax return) earnings. Analysts are still wildly over-optimistic.
Now, let's look at the rest of the presentation. I argue in Bull's Eye Investing that we should look at long-term secular bull and bear markets not in terms of price, but in terms of valuation. On September 26, 2003, I wrote about why we see long-term secular bear markets. The S&P 500 was then at 1,000. So, for the last 5 years, you're down over 10%.
Investing is more than price. It's about timing and valuations.
The Evidence for Investor Overreaction
It's my contention that we're in a decade-long secular bear market. It typically takes years for valuations to fall to levels at which a new bull market can begin. Why does it take so long? Why don't we see an almost immediate return to low valuations once the process has begun?
In short, it’s because investors overreact to good news and under-react to bad news. Past perception seems to dictate future performance. And it takes time to change those perceptions.
This is forcefully borne out by a study produced in 2000 by David Dreman (one of the brightest lights in investment analysis) and Eric Lufkin. The work, entitled Investor Overreaction: Evidence That Its Basis Is Psychological, is a well-written analysis of investor behavior that illustrates that perceptions are more important than the fundamentals.
In any given year, there are stocks that are in favor, as evidenced by high valuations and rising prices. There are also stocks which are just the opposite. Dreman and Lufkin (or DL) looked at a database of 4,721 companies from 1973 through 1998.
Each year, they divide the database up into 5 parts, or quintiles, based on perceived market valuations. They separately study Price to Book Value (P/BV), Price to Cash Flow (P/CF) and the traditional price-to-earnings (P/E). This creates 3 separate ways to analyze stocks by value for any given year, so as to remove the bias that might occur from just using one measure of valuation.
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