Tuesday, September 6, 2011

S&P 500 at Reagan Recession Values

From a Bloomberg article published early last week:

Investors are paying less for equities than they have during every recession since Ronald Reagan was president amid growing concern that the economy is on the edge of another recession.

The article added that the price-earnings ratio is now 12.9x:

That's 3.5 percent less than the average multiple during the 10 contractions since 1949 and a level last reached in 1982, according to data compiled by Bloomberg.

The market is even lower now.

Some of those that are bearish believe the serious systemic and structural problems warrant these low valuations. The counter to that way of thinking comes from Howard Marks...

"Skepticism is usually thought to consist of saying, 'no, that's too good to be true' at the right times. But I realized in 2008—and in retrospect it seems so obvious—that sometimes skepticism requires us to say, 'no, that's too bad to be true.'" - Howard Marks in his book 'The Most Important Thing'

Those that are bullish believe that valuations have gotten to extremes on the low side and the direct result of indiscriminate selling. The counter to that is...

"We've had collapses in the past, but never so broad-gauged and systemic...it stems from the broad application of the techniques I've been discussing: leverage, securitization, tranching and derivatives. Because Wall Street applied those techniques in so many ways, the current problems are generalized and pervasive and have the ability to cause losses in a wide variety of areas, irrespective of the underlying fundamentals." - Howard Marks: The Tide Goes Out

My own view is this. Whether bullish or bearish about the market in general, quite a few individual marketable securities do seem priced low compared to a conservative estimate of intrinsic value.

More from the Bloomberg article:

The last time stocks in the index were cheaper on average during a recession was the early 1980s, a decade when the index surged 227 percent, or 403 percent including reinvested dividends.

In the short or even intermediate run this doesn't mean much of anything. Earnings could come in much lower. The broad systemic issues could get even worse. Still, at the very least, current valuations are closer to the low side of historic valuations instead of the high side.

Of course, none of this means prices won't go even lower, but buying sound assets at a discount price relative to value reduces risk of permanent capital loss and increases the likelihood of favorable long-term outcomes (even if the near term gets even uglier).

Market valuations were certainly rather expensive compared to the norm for a good chunk of the past decade plus (especially in ~2000). Paying high prices relative to intrinsic value meant investors were willing to take on more risk for less return.

In the long run, paying a low price relative to intrinsic value (assuming value is frequently judged reasonably well) is the key to managing risk.

Since it's impossible to know what the future will look like the best defense (and, in the long run, not a bad offense either) is buying at a large discount to value at a time when others are most pessimistic. A favorable price environment is usually the direct by-product of that pessimism and fears about what looks like a dangerous and unknowable future.

Investor psychology need be at or near its most negative.

You don't usually get great prices during the good times.


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