Are stocks cheap?

Definition: S&P 500. A group of stocks that frequently appears in “stocks are cheap” discussions. http://en.wikipedia.org/wiki/S%26P_500.

If you are a casual observer of the financial markets, you will from time to time, see discussions that “stocks are cheap”. I will not hide my bias. Right now I think that stocks are expensive. With that admission out of the way, I want to review what goes into that “stocks are cheap” discussion.

Whenever people talk about stocks being cheap, that means that they are talking about the price/earnings (PE) ratio. This is the price of the stock divided by its earnings. So, if a stock with a price of $100 had earnings of $5, then the PE is 20. Now the first place that the the discussion gets fuzzy is that the earnings can either be trailing earnings or forward earnings. Trailing earnings are good because they reflect actual performance. Forward earnings are less good, because they reflect predicted performance. Most folks who declare that “stocks are cheap” use forward or predicted earnings. Right now, the consensus forward earnings forecast is that they will be better even though the economy is slowing. So, if the consensus forward PE of the S&P 500 is 14 and the average of the last 10 years is 15, then “stocks are cheap”.

The other issue in the “stocks are cheap” discussion is that the PE is a per share number. So, even if earnings are declining, the PE can be increased if the company buys back stock. Since investors (see Debt bubble Part 1) have a lot of money to lend, many companies have borrowed money to buy back stock. So, when deciding whether stocks are cheap, the quality of the earnings are an important considerations. As you might expect, the “stocks are cheap” analysts are great fans of the practice of borrowing money to buy back shares. BTW, this is called reducing the float. Per share earnings are also important to the compensation of many corporate executives. This also increases the tendency to borrow money to buy back shares.

There is another dimension to the quality of earnings. This gets a little convoluted. Going back the the S&P 500, it turns out that banks and other financial institutions and oil companies are a large part of that index. These companies tend to have lower than average PE ratios, so they drag down the overall index. Their PE ratios are lower because folks are skeptical about the quality of the forward or predicted earnings. In the case of the financial institutions, this skepticism has proven to be well founded as many have taken huge write downs and reported reduced earnings or losses. These write downs are, of course, related to the dynamics of the imploding debt bubble. They reflect the reality that the quality of the reported earnings were not as good as originally reported. Since these write downs are one off events, the forward earnings forecasts do not include provisions for future write downs. This effectively inflates the forward PE. The “stocks are cheap” tend to believe that “all of the bad news is out”. I put that in quotes because “all of the bad news is out” is a very common phrase used by analysts; especially analysts who believe that “stocks are cheap”.

One of the other things that drives me crazy is that many of the “stocks are cheap” analysts are also fans of certain high PE stocks. They tend to like companies like Amazon (AMZN) with a PE of 90, Research in Motion – the Blackberry folks (RIMM) with a PE of 49. Google (GOOG) with a PE of 44, Chipolte Mexican Grill (CMG) with a PE of 67. The list goes on. These are called momentum (or MOMO) stocks and their lofty PE multiples are justified for a variety of reasons. DO NOT BUY THESE STOCKS. Unless, of course, you are a very active stock trader and can get in and out very quickly (which means that you are likely not a reader of this blog post). If your financial advisor recommends that you buy any of these high PE stocks as a long term holding, then you should find a new financial advisor.

So what is somebody who has money in the stock market to do? If you have time to do more research, then these folks publish a lot of good information and have a couple of mutual funds. http://www.hussmanfunds.com/index.html. I have not purchased these because I am aggressively invested in the stocks are not cheap thesis. When I get to a point where I stop obsessing about what is happening in the financial markets and want my life back, I expect to put a lot of money in these funds.