Saturday, October 18, 2008

A Look At Fundamental Valuation: How Low Could We Go?

An interesting recent article asks the question, "How much is this market worth?" It turns out that, over the last 30 years, the S&P 500 Index has averaged about 2.4 times the combined book values of the component stocks. At the market peak in 2000, we traded at almost 5 times book value. In 1982, we actually dipped below book value.

Periods of overvaluation and undervaluation can persist for a considerable time. We were over 3 times book value from 1997 through 2002. We were below 1.2 times book value for much of the late 1970s through 1982.

At an estimated book value of 615, we're trading around 1.5 times book value, not quite the level noted by Ned Davis as "undervalued". Should the current market and economic weakness prove as troublesome as the late 1980s--a conclusion surely implied by those who call this the worst economic period since the Great Depression--a move below book value would certainly be in order before we could say stocks are a screaming bargain. That could be a meaningful decline, given that book values themselves can move lower as assets held by companies (real estate, receivables, etc.) are valued downward.

Back in the Great Depression, as Jason Zwieg notes, stocks sold for less than their cash and marketable securities. Should the ratio of stock price to cash and marketable securities in the current market return to the level of 10 that we saw in the late 1970s and early 1980s, he notes, that would take us to about 600 on the S&P 500 Index--back toward estimated book value. If we overshoot to the ratio of the market low in 1982, however, the S&P 500 Index would be closer to 400.

Interestingly, this fits with the recent analysis of market valuation based on Tobin's Q. Based upon the replacement cost for assets of the S&P 500 companies, the index should be trading around 910--roughly where it stands now. At historic market lows since 1920, however, indexes have tended to trade closer to somewhat above half their replacement cost.

If we look at this market from a trading vantage point, it is hard to escape the sense that we're tremendously oversold and due for a rally. In the short-to-intermediate term, that would not be surprising. If, however, we focus on fundamental valuations and historical norms, we're not at all at historically highly undervalued levels. There is a disconnect right now between how severe we say the economic problems are and how we think markets will move from here: most investors I talk with say the problems are quite severe *and* they say, with more than a little hope, that they think the worst of the market decline is behind us.

If this is indeed the worst economic crisis since the Depression, we will likely see book value in the major averages before we make a long-term bottom. That is not an extreme prediction of doom; it represents a level of valuation we've seen within the last 30 years. I don't see average investors and investment advisors thinking through or planning for this possibility--and that could lead to sorry retirements for a number of baby boomers.


Jean-Francois said...

Good morning sir,

I agree there is the possibility that the market goes lower from here. But in the 70s the interest rates were high, so there was no point risking retirement money in the stock market. That is not the case today.

heywally said...

Thanks Brett - I think this was nice as a research exercise but for me, with the landscape we have now, and a totally different set of variables and needs, the comparisons aren't that actionable or meaningful. I'm open to the super crash but it is dependent on unknown future fundamentals.

bruce said...

When I see an article, like zwieg's, that talks about buying a stock for less than the value of it's cash and securities, I wonder if there is some reason that they don't tell you if the remainder of the assets and liabilities offset each other. It seems like if the rest of the assets were worth at least as much, or more than the liabilities, they would say so. They are implying that the cash and securities is a "net" figure, but never explicitly say so.
Leaves me with the impression that they simply think they can raid the company of it's cash and leave the creditors of the company hung out to dry.
Maybe if they gave a little more detail, I wouldn't be so suspicious. ;-)

Brett Steenbarger, Ph.D. said...

Hi Jean-Francois,

You make a good point, but I'm not convinced that this is or will be a low interest rate environment. Yes, Fed/Treasury rates are low, but the actual interest rates that businesses have to pay to borrow money are quite high.