Almost no one wants to hear about stocks. Ordinary investors have been taking money out of equity mutual funds for two years, the conventional wisdom holds, and pouring the money into bonds.
So is all this a contrarian buy signal? Is this the time to invest?
Hardly. When you look below the surface, the picture’s nowhere near so clear.
According to the Investment Company Institute, a mutual fund trade association, the public still has more than twice as much invested in stock market funds as it does in bond funds. It has more in equity funds than in bond and money market funds combined. So much for a bond mania.
Even if ordinary members of the public are gloomy, their portfolio managers often aren’t. They’re sticking to the modern portfolio theory’s formula that worked so well during the bull market: “Shares outperform; you can’t time the market, so always stay fully invested.” Average equity fund cash is 3.4%, very much on the low end of the range.
Furthermore, if “everyone” were preparing for a crash, short-sellers — speculators who bet on falling share prices — would already be out in force. But they are missing in action. The percentage of stocks sold short is well below the levels seen two years ago.
The current shtick on Wall Street today is to say shares are cheap in relation to forecast company profits, the so-called price-to-earnings ratio. Today, the P/E on the market is about 12. In other words, share prices are 12 times forecast earnings. By historical standards, that sounds pretty low. The average has been about 15.
But the numbers should be treated with caution.
First, those earnings forecasts are unreliable. Analysts are usually too optimistic. Even in an average year, actual earnings across the market typically come in well below the forecasts. David Rosenberg, an economist at Gluskin Sheff in Toronto, estimates the average miss is about 20%.
And this isn’t an average year. Profit margins spiked to record highs coming out of the crash, as companies slashed costs and ran down inventories. The future is obscure, but margins seem more likely to contract than to expand further. Historically, corporate profit margins have shown a strong tendency to revert to their averages.
Take the so-called cyclically adjusted price-to-earnings ratio, which compares share prices, not simply with one year’s profits, but with average earnings across an economic cycle of about 10 years. (This is often known as the Shiller P/E, after Yale economics professor Robert Shiller, one of its leading proponents.)
The cyclically adjusted P/E ratio has been a pretty good guide for investors over a long period. It suggested, correctly, getting out of stocks in the late 1920s, the mid-1960s and the bubble of a decade ago. It suggested buying aggressively after World War II and in the “death of equities” period of the 1970s and early ’80s.
Over the past century or so, the stock market has, on average, been about 16 times cyclically adjusted earnings. Today, it’s about 20 times. Make of it what you will. But it’s not cheap.
Or take the lesser-known “Tobin’s q.” It’s a calculation, named for the late economist James Tobin, that compares stock prices with the replacement cost of company assets. Its track record is similar to that of the Shiller P/E.
The q on the market is about 1 today, says economic consultant Andrew Smithers. The historic average is just 0.64. By this measure, the market would have to fall a third just to reach its average. Again: This is cheap?
Still hungry for more? Consider enterprise value to EBITDA. This compares the value of all company stocks and debts with earnings before interest, taxes, depreciation and amortization — a key measure of operating cash flow. Many companies recently have been leveraging themselves up, borrowing more in the bond market. But all shares and bonds must, ultimately, be supported by cash flows. By this measure, share prices are still way above levels seen before the past 13 years.
Finally, you could try comparing the market value of equities with total U.S. gross domestic product. Once again, that’s been a reasonable guide to some of the great buying and selling opportunities of the past. Data from Ned Davis Research show that U.S. stocks are valued at about 85% of gross domestic product today. The historical average, says Ned Davis Research, has been about 60%.
So maybe today stocks are very expensive. Or maybe they’re just no great bargain. But it is almost impossible to argue that they are very cheap. If this were a great contrarian moment to buy stocks, they’d be very cheap.
Brett Arends September 8, 2010