Is the Stock Market a Value Trap? Part 1
Understanding "acceleration station."
Editor's note: Prof. Rob Roy also contributed to this article.
"Like all Wall Street rules and theories... there are a great many times when a security will decline in market price while its intrinsic value and earnings power are shrinking even more swiftly."
-How I Trade and Invest in Stocks and Bonds, 1924 (Richard Wyckoff)
Beware the Value Trap
Stocks in the United States and Europe began a secular bear market in stocks in mid-2000. (A secular market trend is a long-term trend that usually lasts five to 25 years (but whose distribution is more or less bell shaped around 17 years, in the stock market), and consists of sequential 'primary' trends.)
At the peak in March 2000, the market capitalization weighted S&P 500 Index was selling at an eye-popping 35 times earnings, the highest on record. Underneath the surface of the index however, were a plethora of values. In fact, the median stock in the Value Line Index sported a price/earnings ratio of just 13.3 times earnings. It should come as no surprise then that as the bear market in the S&P ran its course from 2000-2003, the median stock outperformed by a large margin.
Fast forward to today and the S&P 500 Index trades again at a rich 21 times earnings (I use the trailing earnings number, including those pesky hundreds of billions of dollars of write-offs). The median stock in the S&P 500 has a P/E today of approximately 16 times trailing earnings, a relatively neutral valuation from an historical perspective.
So the big question, and what the legendary Mr. Wyckoff was talking about in his book from 1924, is "Is the market one big value trap?" A value trap is a stock that has experienced large price depreciation, is currently thought to be a "value stock," and then experiences further dramatic declines in value. (A value stock is a stock that tends to trade at a lower price relative to its fundamentals (i.e. dividends, earnings, sales, etc.) and thus considered undervalued by a value investor. Common characteristics of such stocks include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio.)
Just take a look at the chart of the KBW Bank Index and you can get a sense of the amount of pain that has been endured during the nasty decline that began last summer. All the way along, I've heard that "Financial company stocks are cheap, a refrain I've steadfastly disagreed with. It's been my opinion that the fundamentals in bank and other financial stocks would continue to deteriorate much more than most believed. Many investors, some of which are notable value investors, have been smashed "trying to catch the falling safe."
I can't think of a stock I would like to own less than one with the following characteristics: extreme leverage, balance sheet assets that are depreciating rapidly, increasing cost of capital, and greater regulation, all within a slowing economy.
So the question I ask is, "Are banks and other parts of the stock market a value trap or are they value stocks?" For now my answer remains "Value trap."
KBW Bank Index (in logarithmic terms) - a move from $121 (Feb-07) to $59
Click to enlarge
The decline we have witnessed has been horrific, to be sure. All the way down, this index looked like a value opportunity to many who bought, only to claim more and more victims that tried to pick the bottom. The index could easily bounce from here, but it would likely be just another oversold bounce within the context of a longer-term bear market.
Remember, there are two rules to bear market investing:
- Bear markets tend to get oversold and remain oversold; and
- In bear markets, support exists to be broken.
I've been working hard to determine when the coast will be clear to invest in financial stocks and the only clear-cut way to see when a bank stock is approaching value territory is tangible book value (the amount per share of tangible assets - not including intangible assets, such as goodwill). Many have tried to call bottoms in banks and other "would be" value stocks as they've approached and then dropped below book values that includes intangible assets. A developing trend is that banks tend to bottom near tangible book value.
This KBW Bank Index Constituents table lists all of the banks that comprise the BKX Index. Note how far apart some of the tangible and intangible book values are.
As you can see, many of the troubled banks that I have been highlighting for a while, like Fifth Third (FITB), Huntington (HBAN), KeyCorp (KEY), Regions (RF) and Zion (ZION) are quickly approaching, or are now below, their tangible book values. When they trade below tangible book, they are either cheap, have more write-offs coming, or are value traps. I would offer up that once they have taken more write-downs/write-offs, they may become values and be absorbed by stronger banks like Bank of America (BAC) and J.P. Morgan (JPM).
The next question we must ask ourselves is whether or not Bank of America, Citigroup (C) and JPMorgan may have a date with destiny, to trade at tangible book value, or if we can believe that the tangible book value is properly accounted for. My guess is that both the tangible book value has yet to be reduced by further write-downs, and that the share prices will move lower toward these new tangible book value.
This twin-barreled shotgun lower is what I'm calling "Acceleration Station."
We've been moving along the path of investor emotions from euphoria at the top all the way down to despondency at the bottom. My sense is that we're currently entering the 'fear' part of the cycle and that there are a few more stops along the path before we finally reach 'hope'. The last few emotions lower along this path will tend to move the fastest and hurt the most.
Remember how technology stocks were loathed in 2002 after an 85% bear market. Banks are already lower by 52% from their peak and maybe they represent value, but we I'll wait and remain defensive as I believe their ability to finance themselves may now be all but impossible.
Cycle of Market Emotions
Click to enlarge
This article concludes with Part 2, which can be found here.
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