Blogs & Comment

Stocks: bargains or value traps?

For the first time in decades, the S&P 500 is trading at fair value, according to several sources including the Financial Times of London.That is to say, the cyclically adjusted price-earnings ratio (popularized by Robert Shiller) has dropped to its long-run average. So too the Q ratio (invented by economist James Tobin), which compares market values to replacement costs. Consequently, some brave value investors, including well-known permabears Jeremy Grantham and Steve Leuthold, are now buying stocks.
But valuations have a tendency to overshoot on the downside during bear markets. As economist Andrew Smithersnotes, Shillers cyclically adjusted price-earnings ratio bottomed out an average 50% below fair value during the six major bear markets from 1920 to 1982.
The unadjusted price-earnings ratio tells a similar story. It got down to a low of 7 in the bear markets of 1973 and 1982. Applying this valuation to strategists projected 2009 earnings-per-share of $70 for the S&P 500, the market would need to decline by more than a third from where it is now.
If the current recession is more of the common garden variety, valuations are not likely to overshoot as much. Over the past 14 recessions, the trough in the cyclically adjusted price-earnings ratio averaged 11, which would imply a drop of nearly a quarter from current levels . Of course, an overshoot is not necessarily inevitable. Indeed, Shillers ratio remained well above fair value during the 2002 recession. As it did in 2002, perhaps the massive monetary and fiscal stimulus on its way from governments around the world may keep valuations from sliding to their lower boundary.