Ramblings of a Portfolio Manager 11-23-2009

Ramblings of a Portfolio Manager or News Flash: Picking Stocks Long Term Can Impair Memory

Yet another portfolio manager appeared on CNBC arguing that the market, as expressed by the price-to-earnings multiple on the S&P500, is way overvalued. His argument was, “if you use the unrealistically optimistic $60 in earnings per share for the S&P for 2009, the market is trading at a P/E in excess of 18x.” We can do that math too but what gave us pause is that this particularly money manager seemed to have quite a bit of experience in investing. If that is true, then perhaps his long-term memory is impaired (or he slept though Finance 101 in Business School) so we offer for him a little primer on how markets tend to work:

1. Price-to-earnings ratios (P/E) always peak at economic troughs and trough at economic peaks. This is simply because markets are discounting mechanisms and when economies, and thus earnings, are at their lowest point (small E), markets are already looking ahead for the recovery (larger than expected P). Conversely, at economic peaks, the E becomes very large while the P tends to remain flat, as investors look ahead to the next downturn (can’t get any better than this!) resulting in a “peak” P/E that is lower than one would see at a trough.
2. As “unrealistic” as he views 2009’s earnings expectations, they are already running at or ahead of his gloomy forecast of $60/shre. Next year’s expected EPS (2010), which the market is already discounting, are $71, an 18% growth rate over his “optimistic” number and rising fast. If we place the “normal” P/E of 15x, which he espouses, on that number, we are right about at fair value on the S&P now. However, we point out that the forecast for next year is rising and might likely come in much higher by year end 2010. So an 18% return may be conservative and if we get any kind of multiple expansion (investors willing to pay a higher P/E) as the market looks out to 2011, the return could be even higher.
3. Stock prices tend to obey the dividend discount theory that the current value of a stock is merely the present value of all the future expected cash flows (e.g. dividends) from holding that stock. Mathematically discounting those cash flows requires an interest rate assumption in the denominator so with rates effectively at zero we could, in theory, have an infinite stock market multiple. That the multiple on forward earnings is back to its recent historical average of 15x, says to us that a ratchet up in rates is already baked into market forecasts.
4. Our friend believes the “extreme overvaluation” can be corrected with a 5% pullback in the markets. Again, our math may not rival his but we calculate that a 5% drop in P, holding E constant, results in a 5% drop in the P/E. If that makes stocks more attractive to him, then we have issue with his use of the adjective “extreme.” We are inviting him in to watch us trade our portfolio, where 5% is a modest spread between the bid and ask market quotes on a good number of our holdings!

Reviewing our retort, we can acknowledge arguments for fair value and, thus, a period of consolidation in the markets. But we just can’t undo our years of finance theory education and practical experience to declare the market “overvalued” at the present time. And we note that the valuation pendulum almost always swings too far to either side (as it did to the upside in 1999 and to the downside last November). So, hating to sound like momentum investors (which we are not) we are holding onto the pendulum (albeit with a loosing grip) while it’s still on the upswing.