See The Forest And The Trees

4/25/2011


Making stock-market predictions and making money in the stock market are two very different things. With predictions, you don’t get much credit if you’re right for the wrong reasons. With moneymaking, it doesn’t matter why your stocks go up — and even accurate forecasts can end up costing you if you let them dominate your thinking.

Consider the wise prognosticators who predicted in March 2000 that the U.S. stock market was headed for a fall because it was overvalued. The S&P 500 Index was trading at an astronomical 31 times trailing earnings, and it lost 49% of its value from March 2000 to October 2002.

As predictions go, that’s tough to beat. Still, it’s not clear that exiting the stock market in March 2000 was a good move for value investors, as there was no shortage of cheap stocks at that time. Even within the large-company S&P 500 Index, the median stock traded at 16 times trailing earnings, meaning one-half of S&P 500 stocks had a P/E below 16 — the lowest since 1995 and lower than nearly 80% of the monthly observations since January 1990.

Apart from two short-lived rallies, the S&P 500 Index slumped fairly steadily from March 2000 to the second half of 2002, reflecting huge declines in richly valued technology and other growth stocks. But the median S&P 500 stock — a decent proxy for the return of a mediocre stock-picker — gained 7% in the 12 months following March 2000, then another 11% in the next 12 months. The S&P 500 Index P/E did not move below 20 until August 2004, nearly two years after the index bottomed.

While this example demonstrates the pitfalls of focusing too much on capitalization-weighted indexes and of valuing stocks based on a volatile number like trailing 12-month earnings, it also shows the danger of investing based on predictions — especially predictions related to such indeterminable items as the fair value of U.S. stocks.

Even when your forecast is correct, you risk missing opportunities if you limit your worldview to the framework on which your prediction is based. In other words, the most important question to ask in March 2000 was whether attractively valued stocks were available — not whether the total value of the S&P 500 Index was high relative to the index’s total earnings.

Big stocks at a discount

Looking ahead, investors risk making the opposite mistake as the bears made in March 2000. Reflecting the massive outperformance since 2000 of the broad market relative to the giant stocks that dominate capitalization-weighted indexes, the S&P 500 Index appears cheap relative to the typical U.S. stock.

At 13 times expected year-ahead earnings, the S&P 500 Index trades at discount to its 55-year norm of 16 since 1956, according to Bloomberg. But the median company in the S&P 1500 Index of large, midcap, and small stocks trades at 16 times expected earnings — roughly in line with the norm since 2004.

Based on trailing P/E ratios, the median S&P 1500 stock is 14% more expensive than the median of the largest 50 companies in the S&P 500. Over the past 16 years, the largest stocks have typically traded at a premium.

Conclusion

Because giant stocks are unusually cheap, the S&P 500 Index is painting a somewhat misleading picture of the market’s valuation. Don’t assume the typical U.S. stock has ample upside potential simply because the S&P 500 Index has traded at much higher valuations in the past. At this point, much of the bullish case for stocks depends on expectations of continued robust earnings growth.

Still, as shown in the charts below, the number of reasonably valued stocks in the S&P 500 is still slightly above long-term norms. For value investors, the chronic underperformance of giant stocks has created some attractive buys. Focus on finding opportunities one stock at a time, and consider boosting your exposure to such high-quality giants as Exxon Mobil ($84; XOM), IBM ($165; IBM), and Oracle ($34; ORCL).


CHEAP STOCKS AVAILABLE, NOT ESPECIALLY PLENTIFUL

As shown above, the number of S&P 500 stocks with very high P/Es is below 21-year norms, while the number with relatively low P/Es is slightly above historical norms. For example, 32 S&P 500 stocks have P/Es of 8 to 10 — above the 21-year norm of 24.

As shown above, 44 profitable companies in the S&P 500 Index currently have trailing price/earnings ratios below 10 — in line with the 21-year average of 43. The number of stocks with P/Es between 10 and 14 is 96, versus a 21-year average of 83.


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