"Slow Down; There May be Value in Stocks"

Sydney M. Williams

Thought of the Day

“Slow Down; There May be Value in Stocks”

September 14, 2010

“Today, the old attitude of buying solid stocks as a cornerstone for one’s life savings and retirement has simply disappeared.” Those words, so apt today, appeared in the August 13, 1979 issue of Business Week and were part of a cover story, entitled “The Death of Equities”. More than seven million people had abandoned the stock market, following the 1974 bear market – at the time, the worse market decline since the Great Depression.

There is temptation, during times like these, to invoke the classic French phrase, “Plus ca change, plus c’est la meme chose.” Looking backward, in order to peer ahead, has validity and certainly a knowledge of the past is important. George Santayana, the Harvard philosopher, famously said: “Those who cannot remember the past are condemned to repeat it.” But things do change. In investing, change is the one constant we must live with. Each economic and stock market problem is unique, yet policy responses too often mimic those that were used in the past.

On August 30 of this year, the Wall Street Journal headlined an article, “The Decline of the P/E Ratio”. The piece by Ben Levisohn began: “As investors fixate on the global forces whipsawing the markets, one fundamental measure of stock market value, the price/earnings ratio, is shrinking in size and importance.” The very fact that the article was written at a time when multiples have been contracting, in my opinion, says more about the author than it does about the market.

A P/E ratio is a function of price and earnings, either reported or estimated. Mr. Levisohn writes: “Based on profit expectations over the next twelve months, the P/E ratio has fallen to 12.2 from 14.5 in May.” As to what explains the decline in multiples, Mr. Levisohn adds, “In short, economic uncertainty. A steady procession of bad news, from the European financial crisis to fears of deflation in the U.S., has prompted analysts to cut profit forecasts for 2011.” The statement, as written, just doesn’t read right. Stocks, at the end of August, were down just over 10% from their highs in May, yet Mr. Levisohn has the multiple down 16%, indicating that estimates for 2011 are higher than they had been four months ago?

Despite the lemming-like nature of analysts and their earnings estimates, the anticipatory nature of markets may well mean lower 2011 earnings. I don’t know. However, as a man of simple beliefs, I prefer lower multiples to higher ones, especially in terms of estimated earnings. The future is unknowable, but writing the obituary for the P/E ratio as a measure of value seems a tad presumptuous.

Similar to the 1970s, investors have been defecting from stocks. Terry Kennan, in Sunday’s New York Post, wrote: “Recent figures from the Investment Company Institute note that investors have taken out more than $33 billion from U.S. mutual funds in the first seven months of the year. If the trend continues, 2010 would be the biggest year for withdrawals since the 1980s.”

It is not my intent to imply that we are on the cusp of a new bull market, similar to the one begun in 1982. My guess is that we have not yet paid the full price for the exuberance of the late 1990s or for excesses in leverage endemic to the mid 2000s. But there is little question that stocks today are more attractive than they were eleven years ago, when investors were pouring money into them. On December 31, 1999 the S&P 500 closed at 1469.25 and earned $48.00. Today the Index is 24% lower, with consensus earnings estimates for 2010 70% higher than they had been in 1999.

Adding to traditional investor’s difficulties, a proliferation of indices, a growing number of ETFs and an expanding population of quantitative, algorithmic traders have caused markets to become increasingly correlated. Last Friday, Strategas issued a White Paper, “Beta as the new Alpha”. They point out that retail investors have been leaving a market that “has been dominated by professional investors whose time horizons have become increasingly short.” Thus, “returns to the stock picker appear to us to be increasingly dependent upon the returns of the average investor…” There is little wonder, then, why individual investors have been vacating the premises.

Uncertainty in Washington and the economy, along with more tightly correlated markets are pressuring multiples. Academics would argue that low interest rates should cause multiples to expand. Perhaps stocks, with contracting multiples, are suggesting we are nearing the end of the twenty-eight year bull market in bonds? Again, I don’t know, but it seems possible.

Augmenting the problem – what is an investor to do? – is the rapid-fire, ubiquitous proliferation of information. Hundreds of insistent e-mails and IMs are received daily; cable television has channels numbering in the thousands; there are more bloggers in the world than there are people in the United States, and there are still half a dozen newspapers that demand to be read. One feels one is on a treadmill, on which an invisible hand is constantly increasing the speed and raising the incline. We are out of breath and unable to push the hold button. The ability to stop and reflect is only a distant memory. We are experiencing what Douglas Coupland, in Sunday’s New York Times, termed “frankentime” – what time feels like when you realize that most of your life is spent working with and around a computer and the Internet.

An op-ed in this weekend’s Financial Times wrote of Jonathon Franzen and his new, highly acclaimed novel, Freedom. The article states that Mr. Franzen has “a reputation for near-monastic isolation” and wrote using “an old laptop that has had its Ethernet socket filled with glue.” According to the op-ed, Mr. Franzen retreats from the real world by bird watching.

As investors, we can learn something from Jonathon Franzen – not that we need to become ornithologists or muck up our computers, but reflection is an important ingredient in determining investments. It helps clear the brain. It behooves us all to slow down, turn off the talking heads on cable television, and look for values.