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Back to Armageddon
By: Dr. Charles Lieberman
Date: 6/1/2010
Investors fear that problems in Europe will undermine our economy and stocks are perceived to be vulnerable because the stock market has risen sharply off its March 2009 lows. However, stocks are now only slightly more expensive now than they were at the absolute low, because corporate profits have increased almost as much as the stock market indices. Thus, the recent stock market decline in response to the turmoil in Europe has recreated another extraordinary buying opportunity for longer-term investors who can cope with the interim market volatility.
At the low in March 2009, the S&P 500 hit 677. But earnings for the S&P 500 were expected to be less than $65, so the S&P 500 was trading at slightly more than 10 times expected earnings. That was cheap and it reflected the fear of a catastrophic meltdown of the financial system and the economy in the face of a credit crisis that rendered markets inoperative. Firms could not borrow either from banks or from the bond market to meet routine needs. Therefore, stock prices had to discount the possibility of a disaster and assign some probability to a total meltdown.
Today, the S&P 500 is 1089, while analysts project earnings of $78.23 for 2010 and $89.30 next year. So, stocks are now trading at a 2011 earnings multiple of just 12.2. Historically, such multiples have varied inversely with interest rates. Market multiples were lowest during the 1970s when inflation and market interest rates were at post-war highs and market multiples were close to 20 when inflation and interest rates were quite low during the 1950s and early 1960s. So with inflation and interest rates are back to those earlier levels, a very strong case can be made for equilibrium price earnings multiples to be closer to 20. So, why arent stocks 64% higher?
Investors appear to be fearful that another meltdown, as occurred in 2008, might reoccur. Indeed, the purveyors of gloom and doom have been repeating their dire forecasts. This can not be dismissed as a possibility. But market conditions are vastly improved today. First, corporations have refinanced record amounts of debt over the past 17 months and are now much less exposed to the vagaries of the credit market. Second, corporate profits have surged and so has cash on the balance sheet. Companies are now sitting on $1 trillion in cash, a record. Companies are so liquid that bank loans outstanding keep falling, even though banks are very liquid and need to make loans to avoid more shrinkage of their balance sheets. Third, our banks have written off losses, have recapitalized by issuing stock and are also sitting on plenty of cash, but cant find borrowers. Therefore, stocks are close to discounting Armageddon once again, even though a total meltdown is now much less likely. This makes stocks very, very cheap. Once fear dissipates, expect another wild surge in stock prices.
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