Are Stocks Cheap? {Part I}
Today I'm beginning a series that will run between now and the end of the year which will take a look at certain projections for 2011. Today I'm going to start with the basic methodology and a review of some of our prior forecasts.
I've discovered over the years that the best way to think about the valuation of stocks is to ask two very simple questions. These are:
1. What is the status of the economy? {Improving, stagnant, declining}.
2. What are the end of year earnings projections of the S&P 500?
Being able to come up these two metrics gives us an idea of the basic environment we are in. It is not the total sum of all analysis. For example investors still need to understand what industries and sectors are poised to benefit in whatever is the current market environment. Investors must also factor in that unexpected and sometimes very bad events occur. Banks, for example fail, wars breakout and natural disasters happen with depressing frequency. These sort of things will affect over time how risk assets such as stocks are valued and perceived.
Never-the-less being able to answer my two questions has served me well over the course of my investment career. In particular this analysis has helped me navigate the investment environment we have found ourselves in post the 2008 crash. Let's review how we've used this analysis in the past several years.
We first broached the subject of what could go right by partially taking valuation and applying it to the markets back in November, 2008-Mr. Positive . In March of 2009 with a variant thought we briefly touched on the possibility that stocks could rise substantially from their then very depressed levels. At both of these times such analysis was very much a minority view. We further refined those numbers in the investment letter we sent to clients in May of 2009. At the time we wrote that letter stocks were trading around 900 on the S&P 500. We felt valuation levels would end the year between 900 {assuming lots of things went wrong} and 1,100. The S&P ended the year at. 1,115.10. In that letter we also introduced a 2010 year end trading range of 1,100 to 1,250.
We gave a bit more depth to analysing valuation back in February of this year when we discussed how we value the stock market. In that post we discussed how we were deriving a 2010 year end valuation target of 1,250-1,350 on the S&P 500. We revised that estimate somewhat lower here and here over the summer as the economy slowed down a bit. That revised lower number is now beginning to look conservative.
This is not a post where I am trying to tout my own record. This is a very humbling business and while we may have used our tools to client's advantage it is not a foolproof method of analysis. Using this analysis for example did not help us invest client assets into retail stocks which have been on fire this fall. Nor did this analysis help us with our bank stock ETF investments. While I think financials are finally going to move higher, we have been early in our views on how they might trade. Valuation for instance did not predict the 2008 crash. Nor does it tell us for instance what might happen to stocks if the Korea's continue taking pot shots at each other.
We first broached the subject of what could go right by partially taking valuation and applying it to the markets back in November, 2008-Mr. Positive . In March of 2009 with a variant thought we briefly touched on the possibility that stocks could rise substantially from their then very depressed levels. At both of these times such analysis was very much a minority view. We further refined those numbers in the investment letter we sent to clients in May of 2009. At the time we wrote that letter stocks were trading around 900 on the S&P 500. We felt valuation levels would end the year between 900 {assuming lots of things went wrong} and 1,100. The S&P ended the year at. 1,115.10. In that letter we also introduced a 2010 year end trading range of 1,100 to 1,250.
We gave a bit more depth to analysing valuation back in February of this year when we discussed how we value the stock market. In that post we discussed how we were deriving a 2010 year end valuation target of 1,250-1,350 on the S&P 500. We revised that estimate somewhat lower here and here over the summer as the economy slowed down a bit. That revised lower number is now beginning to look conservative.
This is not a post where I am trying to tout my own record. This is a very humbling business and while we may have used our tools to client's advantage it is not a foolproof method of analysis. Using this analysis for example did not help us invest client assets into retail stocks which have been on fire this fall. Nor did this analysis help us with our bank stock ETF investments. While I think financials are finally going to move higher, we have been early in our views on how they might trade. Valuation for instance did not predict the 2008 crash. Nor does it tell us for instance what might happen to stocks if the Korea's continue taking pot shots at each other.
However I have found it to be a pretty accurate tool in my career for framing the basic forward looking outline as we develop the game plan for the year ahead. Next in this series I'll give you my basic framework for looking at 2011.
posted by CR English at 8:43 AM
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