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Playing the Valuation Game

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Analysis suggests earnings are on their way up.

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After several months of glorious advances, stocks have stagnated of late. Trading in a largely narrow range, stocks appear to be searching for a reason to move. Some expect them to advance, while others anticipate, at best, a long-overdue (meaningful) correction, or, at worst, a test of the lows we saw last November and in early March of this year. Both camps can find plenty to support their points of view.

The bears point to surging oil prices (see USO), surging US Treasury rates, fears of future inflation, a weak US dollar, fears of US socialism (i.e., health care), a mountain of government debt, fears of regulatory overkill, government intrusion in the market (of which payouts to banks like Wells Fargo (WFC), Citigroup (C), and Bank of America (BAC) -- as well as buyouts of GM (GRM) and Chrysler -- are just some examples), and so on. The list is long. On the other hand, the bulls point to more normalized yield spreads, signs of economic stabilization, and the normal digestive process of strong market action over a relatively brief period as an explanation for the stagnation of stocks.

Yet, as interesting and beneficial as such a debate may be, this talk places the what-I-believe cart in front of the what-is horse. The "horse," in this case, is valuation.

What makes valuation analysis so useful is that it incorporates the key elements of economy and markets --earnings, growth of earnings, and risk -- while, at the same time, placing in context the real and financial economy issues note above (and others). Perhaps more importantly, what valuation analysis is beneficial to the investor in the same way that technical analysis is: it provides the investor with the message of the market, thereby enabling them to decide whether the message makes sense.

Allow me to illustrate:

At current levels, the S&P 500 is trading at approximately 21 times trailing the trailing year's operating earnings (940 divided by $44). The bears howl that this is evidence of a severely overvalued market. After all, 21 is well above the average of 15 for large-cap stocks. While this backward-looking, what-should-have-been exercise has some value in itself, it distracts you from looking forward to expected returns and P/E.

Here's what I mean:

Taking the above fact that the average P/E for large-cap stocks is 15, the message of the market appears to be the following:

  • 940 (current S&P 500 level) x 12% = 1052

  • 1052 divided by 15 = $70 operating earnings

I'm using 12% as the historical return for large-cap stocks but, if you wish, you can use 10%, the lower expected/required return/cost of equity. It's the forward-looking process which conveys the message of the market that matters
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No positions in stocks mentioned.
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