“Com­pelling Val­u­a­tion, or Value Trap?”

by Jef­frey Saut, Chief Invest­ment Strate­gist, Ray­mond James

Feb­ru­ary 6, 2012

“Val­u­a­tions for U.S. equi­ties have been stuck below the five-decade aver­age for the longest period since Richard Nixon’s pres­i­dency; a sign investors don’t trust earn­ings even after a three-year bull mar­ket. Ana­lysts esti­mate prof­its in the Stan­dard & Poor’s 500 Index will reach a record $104.78 this year after increas­ing 125 per­cent since the end of 2009, the fastest expan­sion in a quar­ter cen­tury, accord­ing to data com­piled by Bloomberg. Amer­i­can com­pa­nies are boost­ing income so much that even after stocks dou­bled, the S&P 500 hasn’t traded above its 16.4 mean ratio for 446 days, the longest stretch since the 13 years begin­ning in 1973.”

... Bloomberg 1/30/12

I was inter­viewed for the afore­men­tioned arti­cle, and while those com­ments were not used, my response to the reporters’ ques­tions were pretty much along the same lines as the pun­dits’ words included in said quip. To be sure, investors have been freaked by the 11.9% decline in the S&P 500 (SPX/1344.90) since 2000 (aka, the lost decade), the 2000 – 2002 Tech Tragedy, the 2008 Finan­cial Fiasco, Euro­quake, the Flash Crash, Flash Trad­ing in gen­eral, Dark Pools, Hud­dles, etc. The result has left the aver­age investor with the feel­ing the game is rigged and the “lit­tle guy” doesn’t have a chance. Hence, they don’t par­tic­i­pate, lead­ing to the longest stretch where the SPX has not traded above its mean 16.4x P/E ratio in decades. Yet the real rea­son for investors’ fears is that they did not man­age the risk when they should have.

Indeed, the rea­son for investors’ “stock shun­ning” is sim­ple ... most do not adhere to the main ten­ant prof­fered in Ben­jamin Graham’s book “The Intel­li­gent Investor.” To wit, “The essence of port­fo­lio man­age­ment is the man­age­ment of risks, not the man­age­ment of returns.” Or as my father says, “If you man­age the down­side the upside will take care of itself; avoid the big loss.” “The man­age­ment of risk,” what a novel con­cept, yet it is unprac­ticed by many investors. Case in point, in March and April of last year my “call” was to raise some cash by sell­ing par­tial long stock posi­tions, allow­ing long-term cap­i­tal gains to accrue to port­fo­lios. The major­ity of responses I received to that strat­egy were, “Hey Jeff, the stock mar­ket is going up, why should I sell some of my stocks?” The real­ity is, that was pre­cisely why you should have rebal­anced some of your stock posi­tions that had grown into too big a port­fo­lio “bet” because they had ral­lied so much. But instead, what hap­pened? Most par­tic­i­pants failed to heed that advice and thus suf­fered through a 19.6% decline in the SPX between May and August. Regret­tably, because they didn’t man­age the risk, they pan­icked at the August “lows” and sold when we were actu­ally rec­om­mend­ing recom­mit­ting cap­i­tal to equities.

What inevitably hap­pens when a port­fo­lio begins to erode, investors are told, “No one can time the mar­ket; and that it is time in the mar­ket not tim­ing the mar­ket.” Or, “If you miss the 10 best days in the mar­ket your total return falls sig­nif­i­cantly.” Of course, investors are never told that if you miss the 10 worst days your returns swamp the return of investors who stayed the course and rode the “ups,” as well as the “downs.” Now I admit, n-o-b-o-d-y can con­sis­tently “time” the mar­ket on a weekly or a daily basis; yet, there are numer­ous indi­ca­tors that tell us when we should be aggres­sive, and when we should be defen­sive. More­over, you can pretty much count on me to sell 25% – 33% of any port­fo­lio posi­tion if it is up 100% to rebal­ance that posi­tion; and, I don’t care if the gain is long-term or not. You can also count on me to take some kind of defen­sive action (sell, hedge, etc.) when some­thing goes against me between 15% – 20%. Indeed, avoid the big loss.

Cir­cling back as to why the SPX has remained below its median P/E mul­ti­ple for the longest time in decades, in my opin­ion it’s because par­tic­i­pants failed to man­age the risk at the upside inflec­tion points, putting them­selves in a posi­tion of panic at the down­side inflec­tion points. So once again I will say it, the stock mar­ket is fear, hope, and greed only loosely con­nected to the busi­ness cycle – man­age the risk! So where does all of this leave us? Well, I have been con­sis­tent in the belief there is going to be no double-dip reces­sion, unless we talk our­selves into one, and the strength­en­ing eco­nomic data rein­forces that view. If cor­rect, the SPX should earn some­where between $100 and $110 in 2012. At 1344.90, the SPX is trad­ing in the range of a 12.2x to 13.5x this year’s esti­mated earn­ings. The ques­tion then becomes, given the news back­drop what is the appro­pri­ate P/E level for those earn­ings? Using Bloomberg’s 16.4x median P/E mul­ti­ple seems a bit too opti­mistic to me, yet even hair­cut­ting that P/E ratio to 14.5x earn­ings still gives investors plenty of room on the upside, pro­vided they man­age the risk.

Speak­ing of man­ag­ing the risk, after being extremely bull­ish at the August 2011 “lows,” and wildly bull­ish at the Octo­ber 4, 2011 “under­cut” low (con­sis­tent with my 1978 and 1979 trad­ing pat­tern analo­gies), I stayed pos­i­tive on stocks into year-end, as well as into the new year. That said, I turned more cau­tious a few weeks ago because stocks had become very over­bought (read: too much bull­ish­ness) in the short term, and most of the market’s inter­nal energy had been used up in the upside dash from the Octo­ber “lows” into the recent mid-January “high.” The only ques­tion I posed was, “Is this going to be a side­ways cor­rec­tion, or are we going to get more of a pull­back?” What­ever the pat­tern, I con­tin­ued to sug­gest it would be a mis­take to get too bear­ish. So far, it has been pretty much a side­ways affair with the SPX only 17 points above where it was when the Buy­ing Stam­pede ended on Jan­u­ary 25th. Still, the SPX is two stan­dard devi­a­tions above its 50-day mov­ing aver­age and con­se­quently very over­bought (again). Like­wise, the McClel­lan Oscil­la­tor is back into over­bought ter­ri­tory, many of the indices I fol­low are up against their respec­tive down­trend lines, as seen by con­nect­ing their May 2011 highs with their July highs, none of my short-term indi­ca­tors are bull­ish, near-term per­for­mance fol­low­ing upside “gaps” like last Friday’s typ­i­cally has been poor, and there is the poten­tial for a double-top in the DJIA (INDU/12862.23), which would be negated with a close above 13250. On the pos­i­tive side are the fun­da­men­tals, var­i­ous Dow The­ory “buy sig­nals,” huge side­line cash (read: the under­in­vested crowd), last night’s win by the New York Giants (Super Bowl Indi­ca­tor), and the stock market’s inter­nal energy is qui­etly being rebuilt.

Given the short-term “mixed metaphors,” while I still think it is a mis­take to get too bear­ish, I also remain timid on a trad­ing basis. So what are par­tic­i­pants to do? Well, one tack to take is accu­mu­lat­ing good com­pa­nies with solid fun­da­men­tals and the poten­tial of being acquired. Names men­tioned over the past few months by our fun­da­men­tal ana­lysts that fit these cri­te­ria include: Anadarko Petro­leum (APC/$84.34/Strong Buy); Big Lots (BIG/$43.59/Strong Buy); Casella Waste (CWST/$7.00/Strong Buy); Inter­ac­tive Intel­li­gence Group (ININ/$27.78/Outperform); Kodiak Oil & Gas (KOG/$8.66/Outperform); Lumos Net­works (LMOS/$16.23/Strong Buy); National Penn Banc­shares (NPBC/$9.74/Strong Buy); and Oasis Petro­leum (OAS/$31.91/Outperform). We have “sound bites” from our ana­lysts on all of these com­pa­nies under­scor­ing the basis for our pos­i­tive rat­ing, and in many cases why the ana­lyst believes the com­pany is a poten­tial acquiree; please see our recent fun­da­men­tal research on these names.

The call for this week: Remem­ber all those Neg­a­tive Nabobs that caused you to panic and sell-out at the August lows? Or, the Bear Boos who told you the under­cut low of Octo­ber 4, 2011 was the start of a whole new leg to the down­side? Then there was the Cow­er­ing Crowd that insisted the first half of 2012 was going to be ter­ri­ble. Such rants have left the world pro­foundly under­in­vested in U.S. equi­ties. So when you are think­ing of get­ting really bear­ish, study the atten­dant chart from our friends at River­front, and sourced to Intrin­sic Research, which shows rev­enues, earn­ings, and the SPX’s share price for the past decade (through 12/8/11). Rev­enues and earn­ings are at all-time highs, yet the SPX is ~13.5% below its Octo­ber 2007 “high;” indeed, “Strange brew try­ing to get through to you…” (Cream 1967; Eric Clap­ton at his finest).

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