Stocks: Expensive or Cheap?
Dr. Craig Callahan, ICON Advisers – Founder & President
May 26, 2020
There is disagreement on value regarding the overall stock market. ICON thinks stocks, in general, are underpriced relative to their intrinsic value but many analysts are stating stocks are expensive. As an example, on April 13, a guy named Tepper, who manages a $13 billion hedge fund and owns the Carolina Panthers, said stocks are overpriced, about as bad as early 2000. We presume analysts who think stocks are expensive are basing their views on the broad market P/E. In addition, Warren Buffett says he is not actively buying. Who’s right, and why the disagreement?
A few years ago ICON put out a paper that showed there is no statistical relationship between the P/E on the S&P 500 and that index’s return 12 months later. That paper is still relevant as the P/E on the S&P 500 Index has no predictive abilities. Many investors missed the 11 year bull market, because they thought the P/E on the S&P 500 was too high.
They were wrong for 11 years and were still wrong in February, but got bailed out by a virus.
I expect the P/E ratio will spike up and result in even more commentary that the market is too expensive. A P/E spike along with expensive market commentary occurred in the Fall of 2009. We subscribe to the belief that stocks lead the economy and in 2009 stocks took off in March ahead of the rebound in earnings. That market move sent the P/E on the S&P 500 from 10 in March 2009 to 22 by November 2009 and scared the P/E folks. Wouldn’t you like to own many stocks today at November 2009 prices? The same thing could happen this time if earnings are down for a quarter or two and stock prices keep moving higher.
Warren Buffett made his money by buying companies and structuring special deals, for example, a class of preferred stock unique to him with special covenants. He has not made his fortune off of short term market timing and he is not an economist. It is very possible that ICON is right, stocks are cheap, but Buffett just hasn’t found any special deals yet. I expect they will appear as the economy gets worse.
Jim Miller, noted value investor with an impressive track record, was interviewed on CNBC and got a similar question to what I was asked a week ago. “If companies are not issuing earnings guidance how can you value its stock?” In other words, if the company isn’t telling you what the “E” will be, how can you make a P/E. He gave an answer similar to mine. He said something along the lines of: we don’t need their guidance because we don’t use P/E ratios. We compute value as discounted future cash flows.
Same concept as ICON, but we use earnings not cash flow.
In Miller’s and ICON’s equations, the next one or two quarters’ earnings are not that important, as value is not a function of only one quarter’s earnings. If a company is experiencing one or two quarters of disappointing earnings and therefore has a high P/E, it might still be cheap if it has a bright future.
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Price/Earnings Ratio (P/E) is the price of a stock divided by its earnings per share.
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