Labor Day Stock Market Thoughts

Labor Day Weekend is prime time for big-picture discussions in the financial press. With the cultural end of summer, and the heightened feeling of NYSE-Mod-Small seriousness of the back-to-school and back-to-work season, Labor Day is a good time to review where we are and where we are going. Also, articles on broad topics can be written far in advance so that journalists can take the weekend, or entire week, off.

Thus, The Wall Street Journal recently treated us to a spate of pieces on basically the same topic, the wisdom of investing in the stock market.

Brett Arends kicked off this festival of tea leaf reading mid-week with Why Stocks Still Aren’t Cheap. Then over the weekend we got Is It Time to Scrap the Fusty Old P/E Ratio?, covering some of the same ground as Arends but with a less bearish spin, and Thinking Outside the Stocks, discussing off-beat non-stock investments.

The Arends title caught my eye because I wondered what he could mean by “still.” Did he mean that stocks were not cheap even though the market was then down 12%+ since its late April high? Is a drop of that size over that period supposed to inspire the urge to swoop in and grab bargains?

The market is up nicely from a year ago and up rather spectacularly from March of ‘09. I would have been less surprised to see a bearish article entitled “Why Stocks are No Longer Cheap.”

Turns out, Arends’ angle is that stocks are not cheap even though lots of people are saying that they are expensive. He is employing that rarified tool of market analysis, reverse reverse psychology.

I am not so sure about that second reverse, but the first one seems sound enough. Arends tells us that “Talk has been growing all summer of a crash.” Assuming that is true, and I am willing to take his word for it, then it is indeed a bullish sign. One of the things about crashes is that they only happen when just about everybody dismisses the possibility. A crash is a violent shift from the top of the optimism scale to the bottom, from blissfully confident greed to irrationally paranoid fear.

If the emotional state of the market is in the middle of the scale, as it is now, with cautious optimism mixed with disaster planning and a nagging fear of the sky falling on our heads, then we do not have far enough to fall to make a crash. Of course stocks can go down from here, but expectations are currently so muted that it is hard for me to imagine that much disappointment in the near future.

Arends has more imagination than I do. He does not provide a specific prediction of disaster but argues that stocks are now not as cheap as you might think given all the pessimism you hear. Yes, the price earnings ratio on forecast earnings is now around 12 and the historical average is around 15. Do not let that fool you.

You see, those earnings forecasts are unreliable. And 2011 earnings will be disappointing.

I agree that earnings forecasts are not as accurate as we might like, particularly on a stock-by-stock basis.  But aggregated to the whole market they work pretty well. Sure, there is an optimistic bias in estimates in general, analysts tend to like the companies they follow a little too much, but that is not an issue here. The market is trading at 12 times (too optimistic) earnings forecasts which is lower than the average level of trading at 15 times (too optimistic) earnings forecasts.

Both Arends and Ben Levisohn, the author of the fusty PE piece, tell us that earnings projections for 2011 are more shaky than usual. Neither makes a particularly strong case. Arends tells us that, despite the economic environment, corporate earnings are currently abnormally high and will have to come down. Levisohn just quotes an analyst saying that 2011 estimates are too high.

And both authors offer an alternative to fusty old PE. They suggest a variation on the same theme, the ratio of enterprise value to free cash flow. That is a ratio I have used a lot, alongside PE, and I agree that it works for picking stocks. In fact, the two are nearly interchangeable and in the case of more than a few stocks literally identical.

Interestingly, the authors put different spins on the same data. Bearish Arends tells us that based on EV/CF “share prices are still way above levels seen prior to the last 13 years.” More bullish Levisohn tells us that “The enterprise-value-to-free-cash-flow ratio for the S&P 500 is currently 20, a 10-year low.” (Then again, Levisohn loses credibility when he misspells the name of the largest US stock broker. Surely “Merrill” is in the WSJ spell checker?)

On balance, I think that Arends is too bearish. The fact that stocks are now as cheap as they have been for a decade has to mean something. Granted, stocks are more expensive than they have been in the more distant past. Arends trots out Shiller’s PE10 and Tobin’s q to demonstrate that in the scale of a 100 years the current market is no bargain.

But the inevitable result of that sort of analysis is that, with the possible exception of a few weeks last spring, the stock market has been overpriced for decades. I have a lot of trouble with a schema that says I should have been out of the market for most of my adult life. Moreover, the implicit but unspoken assumption that the long term average is meaningful, that it is some kind of revealed truth about the universe, strikes me as particularly bogus.

Which is not to say that I am an unrestrained stock market enthusiast. I think most people should have a healthy chunk of their savings in stocks, but what I have in mind is something like half the kitty, give or take. That is a lot less than has been typically suggested by investment advisors and gurus, some of whom used to recommend allocations as high as 100%.

For reasons that should be obvious, many people are now backing off their allocations to stocks. And when they do, they often run into a problem. Fewer stocks and more bonds decreases the risk level, but it also decreases the expected return of the portfolio. So you either have to increase your savings rate or adjust downward your retirement ambitions. Yuck.

Or you can find other investments that have expected returns similar to the stock market but are not the stock market. Hence the topic of the third WSJ item, Thinking Outside the Stocks. It discusses several offbeat places to put your money. All turn out to be exotic corners of real estate, from cellular towers to student housing and abandoned rail beds.

It is an amusing holiday weekend story, but the investments mentioned are not really practical for most people. First, because the minimum buy-in for most of the schemes is too large for ordinary folks. Second, many of them are more like starting a part-time business than making an investment. And thirdly, I am not convinced that they are really as unlike the stock market as is claimed.

The returns from real estate are not perfectly correlated with the returns from the S&P 500, but that is true of any industry. Own a basket of airline stocks or drug companies and you will get roughly similar expected returns as the whole market but will not follow it lockstep. Owning self-storage facilities or cell towers is still, after all, investing in a business, just like buying stocks.

The truth is mundane and sobering. The stock market is currently on the cheap side, but not a once-in-a-lifetime opportunity. It is more risky and likely less profitable than many people thought it was just a few years ago. But it is still the best thing going. The grass may seem greener in some alternative investments, but that is largely an optical illusion.

Welcome back to work.


  • By Stagflationary Mark, September 7, 2010 @ 10:35 pm

    “Own a basket of airline stocks or drug companies and you will get roughly similar expected returns as the whole market but will not follow it lockstep.”

    Robert Crandall would beg to differ.

    “For a variety of reasons, including very intense competition, which limits any one carrier’s pricing power, the airline industry has consistently failed to earn adequate profits; cumulatively, the industry has lost money since its inception.” – Robert Crandall, former head of American Airlines

    I wish I could share your optimism about the stock market being cheap. I’ve been out of the stock market since 2004 for a variety of reasons and have no intention of returning any time soon. We just keep digging our country’s hole deeper and deeper. Long-term exponential trends are breaking down and it is taking massive unsustainable government borrowing and spending to keep the illusion alive.

    We’re at risk of doing what Japan did, only worse since we are a net importer. Virtually nothing in my house says “Made in USA” on it.

    Banks no longer have to use “mark to market” accounting. It has been replaced with “mark to fantasy” accounting. Sweeping problems under the rug does not solve our debt problems. We criticized Japan for creating zombie banks and yet here we are doing exactly the same thing.

  • By Parker Bohn, September 11, 2010 @ 1:46 am

    Stocks look a bit expensive, based on trailing earnings (ie real numbers). Also, corporate profit margins are quite high (ie more likely to go down than up). Unlike many people, I think this is a rational sort of expensiveness, given that bonds are very expensive.

    Unfortunately, it looks like there is nowhere to run, and future returns look meager (by historical standards) for stocks, bonds, & cash.

    Even though I think US stocks are about 20% overvalued, there is no better place to put my money. I’m not foolish enough to gamble on timing the market, so I’m sticking with a large equity allocation.

  • By Craig, September 14, 2010 @ 7:26 am

    I share a healthy scepticism about earnings forecasts, but trailing earnings, as the expression goes, involve driving by looking in the rear-view mirror. Yes, you see what the road behind you _really_ looked like, but it is, after all, the road behind you. Trailing earnings are at this moment dominated by the largest financial crisis since the Second World War; I therefore think they send the wrong signal.

    I sold stocks earlier in the year, not because I had lost my faith in them, but because they’d gone on a mad year-long tear from their lows and it was time to rebalance. I remain about two-thirds in equity and one-third in debt, and I feel roughly equally nauseated about every part of my portfolio, which I hope is a good sign.

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