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Up She Goes, Down She Goes

S&P TodayDouble Click on Any Image for a Full Size View

It was a wild day in the market to say the least.  We were up almost 3% on the day then started to trail off, ending down 1.5%.  Tomorrow you will hear that we lost 550 points on the Dow Jones Industrial Average in the last half hour.

The market has disconnected from the fundamentals and is being whipsawed by the computers.  I reviewed the fundamentals in yesterday’s post – we were over-valued and needed to correct to bring pricing in line with earnings.  No more no less.

Today, we had a big move higher at the open on news that China had moved to flood its economy with liquidity in order to push economic growth higher.  BOOM!  Our market rocketed higher erasing much of what was lost yesterday.  Then, as the day moved on, you saw people begin to lighten up on stocks – then 3pm New York time hit and the computers kicked into gear selling lots and lots of large cap S&P stocks as well as certain small cap names that had been weak going into last weeks beginning of this move lower.

As I look at the names of companies that were sold off – Verizon down 3%?   Exelon down 7%?    EMC down 5%?    Merck down 5%?    AbbVie down 4.5%?    Monsanto down 4.5%? – it just baffles me.   Look at these names:  will we stop using our cell phones if the Fed raises interest rates by 0.25%  Will we stop using electricity if China’s economic growth slows from the projected 7% to 4%?  Will we stop Will our doctors stop writing prescriptions?  Will our farmers stop planting corn?

If China isn’t successful in stimulating their economy what is the extent of the impact directly to the US?  China accounts for only 9% of the total US exports which equates to 1.2% of U.S. GDP, meaning that if they stopped importing 100% of everything we export to them, our economy would not even go into recession.

This is clear to me that the computers were executing programs to sell to capture quick gains made after yesterday’s down day.  The fundamentals are sound enough that we should not see a secular bear market – definitely a correction but we’ve had that already in MANY stocks.

So I want to make sure we focus on the future and not the craziness happening at this moment.  So lets look at where, from a fundamental basis, the S&P 500 should be priced at right now.  In other words, what is its fair value.  To do that, lets look at a variety of ways to calculate it based upon the $115 earnings estimate for next year:

1.  The historic mean P/E for the S&P 500 is 15.55.   Using the estimated earnings for next year at this multiple, we come up with a fair value of 1,788.25

2.  If we use the Shiller P/E ( a normalized 10 year rolling P/E that can provide a better valuation) it’s mean is 16.62.  This gives us a fair value of 1,911.3

Today we closed at 1,867.08.  By my cowboy mathematics, that falls in between these two valuations albeit toward the high side.  But still within a fair value range.

Lets go for another valuation method not based upon earnings but upon asset values.

3.  The current book value per share of the S&P 500 is 729.29 giving us a price to book of 2.56.  If we use the mean historic price to book value ratio of 2.74, we get a fair value of 1,998.25

 And lets look at a final valuation method based upon sales.

4.  The current sales per share of the S&P 500 are 1,156.54 giving us a price to sales ratio of 1.66.  If we use the historic mean price to sales ratio of 1.4, we get a fair value of 1,619.15

That last one is a scary number, but since it seems to be an outlier we won’t give it as much credence as the others which are more in line.  The reason I am downgrading its importance is S&P 500 sales have been suppressed sue to the strong dollar (see yesterday’s post) which is due to the threat that the Federal Reserve would raise our interest rates.  That may or may not happen – or it may be a one and done – so the dollar’s strength is probably more than it really should be at this point.

So, lets come up with a composite of the valuations to see what a likely fair value would be.  I’ll weight them as follows:  30% P/E + 30% Shiller P/E + 30% Price to Book + 10% Price to Sales.   This composite gives us a fair value of 1,871.25 which is pretty much spot on with today’s close.

Now is not the time to panic and sell – if we go down some more, this means the market is undervalued based upon our fair value computation and you should be a buyer not a seller.  Warren Buffet has a saying that goes approximately:  be greedy when everyone else is scared and be scared when everyone else is greedy.  That applies here, there is no doubt in my mind.

I want to leave you with this last graph of the Bull and Bear market cycles since 1949:

S&P Bull & BearYou can see that the bear markets, although painful, retrace only a small portion of bull market gains.  If you want to be a seller, you sell during the bull market phase, much like we did earlier this year to raise cash in client accounts.  You don’t sell during the bear market phase because human nature makes it hard to jump back in to ride the next leg higher.  You are historically better staying in the market, enduring the few down days, and reveling in the many up days.

I am not sure what tomorrow or the next day will bring.  With the computers in charge, anything can happen.  However I feel good knowing that we are at fair value and any more selling presents a prime opportunity to outperform the market even further than we have so far – remember, you can’t catch the absolute bottom and you can’t catch the absolute top – don’t fret if you sell a few percent early and don’t if you buy a few percent early. In the short term you could be wrong but if you are in the stock market you are by definition a long term investor or you are in the wrong place with your money.

In the long run, by following this strategy, you will be better off than those invested in index funds and those that bought high and sold low.  I have 35 years of investment history that proves it.

Mark