Why are equities considered highly over valued today?

[qcomer]

Hi,

I am 26 and new member to this site. I have been investing in stocks/equities for 1 year and have been reasonably sucessful and it has been great learning as well. When I look at housing, I see an unnatural price boom and hence the reason for busts are understandable.

However, many a folks are predicting to exit equities due to housing bust (reduced spending), declining dollar or simply being over valued. However, with stocks, I don’t see the price boom in last 5 years as seen by housing and hence not sure why the bust is expected. S&P500 is at P/E of 14.5 which as per Hussman should be the entry point (around 14) and exit at 19. Also, as Hussman says, S&P has hardly moved up in 5 years so why do we consider it over valued? Inflation adjusted, I personally think major large caps are under valued. I see lots of big cap blue chips are between P/E of 10-20 and close to 5 years lows so why are they over valued? Also, I didn’t see the effect of increase in consumer spending in the earnings reports of many big cap blue chips. I know the whole domino effect of reduced spending should come in when spending decreases but the same domino effect should have boosted the stocks with increased onsumer spending. I don’t see that +ve effect in the price charts or earnigs reports of Citi, JNJ, MSFT, etc over last 5 years. Is it because stocks were so over valued even 5 years ago that even now they should be considered over valued?

I don’t think reduced spending will hurt ALL stocks. But inflation and higher rates sure will and is the biggest factor I can see taking stocks down. However, that can be overcome by adding some silver/gold ETFs to your portfolio as well as by adding some big cap stocks that collect >75% from exports or from international sales(Coke,JNJ,Nokia,etc). Or is it just too risky outright to stay in stocks right now because of the bearish sentiment? If so, when to head back in and how to know we have reached the bottom (P/E, rates stagnate, CPI comes down, deficit decreases? What is the time frame we are looking at?

Please post your commments. I am looking to learn all the time.

[powayseller]

I subscribed to the Yamamoto Forecast. Irwin Yamamoto says the S&P500 is 40% overvalued, and the housing market will have a negative effect on the stock market, so put 100% in cash (money market). He has a good track record, so I forked over the $350 annual fee.

Zeal does extensive research, and upon suggestion from Rich and leung-lewis, went to their site. I decided to join,and the newsletter tells me the following about the major indexes:
Name P/E Overvalued
S&P500 20.8 49%
Dow30 16.5 18%
NAS100 34.4 146%

I don’t know how much to trust the numbers put out by the big companies. Think Enron and Worldcom, and today’s options exposure. They can hide their pension obligations, etc.

I do know that 2/3 of GDP is due to consumer spending, and as consumer spending slows, the entire economy will feel the pinch. Who will not be affected? Perhaps our government is large and powerful enough to take on more debt and ramp up spending. Perhaps you have knowledge of certain sectors or companies which will prosper, and have a good valuation. I do not have this knowledge, so I am sitting out.

I made an exception and purchased a lead mining company recommended by Zeal. I am also going to start purchasing bond futures with Chris J’s service. I already signed up for his service.

I checked into companies which I thought would do well in a recession, but they all have PEs over 25.

I would like to take a gold position, and am waiting for all the factors to be lined up just right. I am taking my lead from Chris J, who has shown the importance of making sure that the COT report shows the commercials are long. Zeal also has advice on this, and while they are long term bullish on gold, suggested not buying during the parabolic uptrend.

The big question I have about international and large caps is: how will they do when the US consumer, which powers the economy, pulls back? Can China switch from export to internal consumption? I don’t have the answer yet.

I also would like to learn, and will consider any advice shared by others.

[davelj]

Hussman hits on two of the three critical issues: profit margins (which will mean revert negatively) and the distinction between reported earnings and operating earnings (use of the latter makes the P/E appear lower than it really is). (Although Hussman doesn’t mention the more pervasive use of stock options these days as compared to decades ago which dilutes the real P/E.) I think there’s one more issue to think about (with respect to the S&P specifically): dividends.

Prior to the late-1980s, dividends comprised almost half of the 10% annualized long-term return on the S&P. Well, the current dividend yield is about 1.5%. If you assume 6% nominal long-term earnings growth (3% inflation + 1.5% population growth + 1.5% productivity growth), that gets you to a return of 7.5% annually on the S&P over the long term IF MARGINS AND VALUATIONS REMAIN HIGH, as they are currently, which has historically been a bad bet. The other issue is that the risk-free return on the 10-year treasury is about 5.25%. If you’re willing to accept the volatility of the S&P (standard deviation of about 20% per year) to get a 2.25% premium over risk-free treasuries (standard deviation of about 5% per year), then you’ve got a very unusual appetite for risk. And, again, that 7.5% is a very optimistic projection.

Assuming some mean reversion on margins, the S&P probably won’t return more than about 5% or so over the next decade. That’s not particularly exciting considering that you can get 5.25% risk free owning treasuries. Stocks generically are a sucker’s bet right now.

[powayseller]

Another analyst who recommends entering the stock market with caution at this time, is Joseph Elliott.

His website regularly updates the chart in his book Ahead of the Curve. Historically, back to 1966 bear markets start when year-over-year growth in consumer spending falls. Given the consistent history of rising Discount or Fed Funds rate (green line, inverted scale) leading bear markets, investors should approach the stock market cautiously at this time.

One of the most important concepts in the book is the leading indicator chart. Even Richard Duncan, in the Dollar Crisis, makes the mistake of thinking that rising employment leads the economy. Employment is the most lagging of the indicators. It all starts with wages, which drives consumer spending. Government spending is 1/3 of the economy, and it is the hope to pull us out of the recession. Our government is large enough to spend its way out of the recession, unless the derivatives market falls apart. Not even our government is a match for that.

qcomer, I figure with CDs paying 5% now, why risk losing money in the stock market, which historically pays 7-9%? In today’s economy, with a falling dollar and a recession ahead, I’ll go with the safe 5%.

[powayseller]

Here’s an answer to the investing question from my brother, a brainiac attorney with a masters in computer science, a law degree from one of the top law school and who worked on Wall Street before coming to SD. He also reads an hour or two every day, economics and politics.

He recommends diversifying in a porfolio of commodities and East Asian and European mutual funds. If the yen goes up, so wil the East Asian funds. If the euro goes up, so will the European mutual funds. When the dollar falls, all three will go up. This way, you are betting against the dollar on top of making good investments.

Warren Buffet is making his new investments outside the US. He bought an Israeli company. So people who believe the dollar will fall, invest in non-US companies.

My brother and I disagree on whether the anticipated reduced US consumption will effect Asian and European stocks. He says Asia doesn’t need us; they’re selling us goods in exchange for IOUs, worthless paper (Tnotes). Since they’re not converting our dollars to their currency, they are not getting paid anyway. So when the US consumer slows down on Chinese goods, the Chinese will selling those goods to themselves. This does make sense, but if they don’t need us, then why do they continue selling to us with these supposed worthless dollars?

A reason that stocks/equities globally can decline somewhat in the next 6 weeks has to do with the yen carry trade. some guess that the Japanese carry trade, which put $200 bil of liquidity into the system and is unwinding by end June 2006, was used to buy equities and bonds. As these positions are liquidated between 3/06 and 6/06, the equity and bond markets where the investments were made, will go down. You can read more at atimes.com. They wrote that “the end of quantitative easing will pull an enormous amount of liquidity from Asian and US stocks and bonds, prompting widespread asst price depreciation and yen revaluation”.

Have you talked with Chris J about trading bond futures? I just subscribed to his service. You make 1-2 trades per week. Get in, hold for several days, get out. He makes his living at this, and has done well. Check out his blog.

I would love to know some good ideas for investing. I have made many posts about this, but don’t get many responses. I’m glad you are bringing up this topic.

What have you found out from the other sites?

[Stu949]

Zeal is a pretty good investment newsletter. They will be a good source of information for the next 5 to 10 years.

Foreign currency, gold/silver, and commodity stocks will be it for the next few years. When you hear CNBC talk about how gold is now done with it’s run, it is time to buy. Don’t let all these fools in the investment world tell you that the commodity bull run is over. This is the next investment; it will run up like real estate has. Gold should surpass $2,000 eventually – buy on the dips. A good time to buy gold will probably be early fall of this year.

At this point, preserving your wealth from losses and inflation will be just as important as getting a decent return!

[4plexowner]

The manic phase* in this commodities / precious metals bull market will likely make the dot-com mania look tame by comparison.

There is no fever like GOLD FEVER!!!!!

We are still a few years away from the mania stage, IMO. I can tell by the reactions I get when I talk about silver and gold.

When everyone agrees with me that silver and gold is the place to be, I will be selling.

*Bull markets have three phases
1. accumulation by smart money
2. institutional investors recognize the new trend and start buying
3. mainstream investors / joe public recognize the “new” bull market and rush in – this is the mania phase – every stock with ‘gold’ or ‘silver’ in its name will be soaring

see http://www.zealllc.com – Adam Hamilton provides a wealth of information for free – he updated his “Gold Bull – Stage Two” analysis on 5/5/06

[powayseller]

Why do you think that fall will be a good time to buy?

[Anonymous]

Fall is generally a good time to buy stocks. A very high percentage of the historical gains of the stock market have come between Nov and April 1. This is the time of the year to be looking for a rally. Timing it is another discussion. However, assuming the circumstances are right at the time, approx. Nov. 1 is the seasonal low spot.

This year with the mid-term congressional election cycle, and a larger scale 4 year cycle supporting it, there is a good backdrop to look for a rally in stocks.

[powayseller]

Stu, why do you think fall is a good time to buy gold?

[Author]

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