The market continued its march downward and, even after a relatively large Friday rally, the S&P 500 still finished down 8.4%. The price-to-peak earnings ratio has again reached another low at 9.0x. Clearly, this valuation metric is closely following the market as we are no longer anywhere near peak earnings levels. In fact, by our calculations earnings at present are just two-thirds of record earnings for the S&P 500, a level that was reached in the summer of 2007. This is an extreme situation that does not occur often.
Many stocks are selling at or near book value. Think about the significance of that for a moment. Equity in the company is valued near what the company could sell its tangible assets (minus liabilities) for in a fire sale today. Now, remember that stocks are a claim on future cash flows, and those cash flows in the current market are almost completely discounted. We continue to believe that for long-term value investors, this is very enticing time to be cautiously investing in those stocks least affected by the credit and housing crises. We think it is reasonable to assume that companies which have continued to improve fundamental metrics–such as sales and cash flow–are a good place to start. Companies that have a lot of cash on hand (and little debt) will be in a great position to take advantage of the downturn either by protecting against a slowdown or by buying out competitors without the need for extensive financing. Every company will be affected to some extent by nationwide deleveraging but stocks that can produce strong cash flow will be the quickest to recover. Companies that fit this description include: Apple (AAPL), Boeing (BA), Google (GOOG), and Microsoft (MSFT).
The percentage of NYSE stocks selling above their 30-week moving average is again remarkably low at just 2.5%. When market sentiment reaches extremes like we are now witnessing, you can bet that the situation will not persist and is due for a rebound. That being said, we would never claim to be in the business of market timing because there are still many nasty turns that this market could take; over the weekend we witnessed another event that just a year or more ago would have been unthinkable as Citigroup (C) required a government rescue package. However, while the short-term market outlook is quite unclear, the market is much more predictable over the long-term. We continue to believe that their are greatly undervalued stocks in this market that have been unjustly dragged down in the wretched economic environment.
As you will notice from our asset allocation model we recommend that long-term value investors be bullish right now in this depressed market. As any student of finance will tell you, the return on an investment is inextricably linked to the risk the investor is willing to take on. Clearly, the stock market has plenty of risks associated with it, but its valuation is much less risky now than it was one year ago and the return that one can reasonably expect to make from the equity market is vastly improved over one year ago. We had told our EIG readers that the stock market was overheated for the better part of early 2007 because the risks of entering an already-expensive market were not going to be compensated by the return that an investor could expect. Well, now the tables have turned and we believe that investors can afford to take the current risk of the market because of the likelihood of improved long-term returns. As we’ve stated before, investors must do their homework but should be on the lookout for companies that are solid financially and are nimbly navigating this economic environment for when the market turns around (as it always has) these stocks will be the first to benefit.