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With bear market raging, are stocks priced right?

February 23, 2009

Looking past all the bad news, a forward-thinking investor should be asking: Just how cheap are U.S. stocks?

After a 37-percent decline in the Standard & Poor's 500 index in 2008, followed by another 12-percent decline so far in 2009, are stocks at bargain levels?

To answer that, it is useful to look at some comparison valuation measures. The simplest of these is dividend yield. For example, the S&P 500 dividend yield is 3.1 percent, according to Barron's, and that compares favorably with the 10-year Treasury yield of 2.9 percent.

Another measure comparing the value of stocks relative to bonds is the "earnings yield." This calculation divides the aggregate annual S&P 500 earnings by the index value. Barron's computes the current S&P 500 earnings yield as 5.6 percent.

In essence, this says that if you owned all the businesses in the S&P 500 index, the earnings from the companies would provide you with a 5.6-percent return—once again a favorable comparison versus the 2.9-percent yield of risk-free bonds. In fact, the 2.7-percent difference between these two yields is the highest difference between stocks and bonds for the last five recessions, according to the value investment shop of Longleaf Partners.

Another phenomenon we have mentioned before is the reappearance of "Net Current Asset Value" stocks. This calculation takes the liquid, current assets of a business listed on its balance sheet, and subtracts from that figure the entire liabilities of the business. The investor gets the fixed assets for free in this bottom-of-the-barrel computation.

A company selling below net current asset value is, in effect, priced below the company's liquidation value. These stocks tend to show up only in depressed stock markets and, at present, over 200 companies are trading below their net current assets.

A relationship that compares the value of the total stock market to the U.S. gross national product also suggests that stocks are attractive.

In late 2001, Fortune ran an article in which Warren Buffett suggested the stock market, at a level of 133 percent of GNP, was not a good buy. Buffett posited that when the ratio reaches 70 percent to 80 percent of GNP, stocks would provide investors attractive returns.

Today, the calculation shows a total stock market value of 75 percent of GNP.

Another died-in-the-wool value investor, who has been cautious on stocks for the past several years, is Jeremy Grantham at global investment management firm GMO LLC. His quarterly newsletter says stocks are more attractive than they have been for years.

However, Grantham recognizes that, just as the market often overshoots when going up, stocks can sink below their rational values in a bear market. Therefore, he doesn't dismiss the possibility of the S&P 500's falling another 25 percent. Grantham's strategy is to begin buying more stocks now. If the market continues to move lower, he would step up the pace of purchases.

And here is some unconventional thinking—Grantham almost comes off as hoping for the market to drop further, in that the future returns on stocks purchased at even lower prices will be that much higher. Now that is how a real investment pro thinks.
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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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