Part 1 found here
Recently, in an interview on CNBC, the world's greatest value investor, Warren Buffett, said he was ready to buy stocks and the valuations are compelling. Last week Buffett took a US$10B stake in IBM[Here is a good explanation why he did it]. IBM has been around for more than 100 years and has been a blue chip company for the at least the last 40 years so Buffett would have tracked the valuation of the stock over a long period of several decades and only now he decides to buy the stock. You can actually do better than him because IBM stock has fallen a few % since his purchase. Buffett rarely buy tech companies - he owns a small stake in Microsoft. So why is he doing it now? Remember a few years ago when the tech bubble took the Nasdaq index upwards of 6000 in year 2000? The Nasdaq index today, 11 years later is 2440. If you look at the tech bellwethers like Intel, Cisco, Dell they went from P/E ratios in the range of 30-60 to 7-10. Dell today is a $14.22 stock that earns $1.94 per share. The market values the company at US$20B. It has net cash of $8B and annual free cash flow of $3.5B[Link to Dell financial statistics].
If you take the current financial statistics of many companies, you find that they are at their cheapest or close to their levels in history. All the speculative fluff in the dot.com era has completely disappeared and if companies like Dell simply maintain their current performance and do no worse, the stock price can double in 10 years because it would have so much cash in its bank account, it would be able to buy back every share at double the price.
Stock valuations are more striking if you look at what risk free (these days not so risk free) US treasuries are yielding and the current interest rate which is at their lowest in decades. Remember the main cause for the US tech bubble was the aggressive rate cuts by the Federal Reserve after the Asian crisis that drove money towards higher yielding assets such as stocks. So why hasn't the same happened?
An interesting study by Robert Shiller - the guy who coined the term "irrational exuberance", warned us about the tech bubble and housing bubble - shows why stocks may not be as cheap as what investors think. Looking at average earnings in the last 10 years, finds that stocks are actually expensive:
The reason why the average 10 year earnings for stocks are poor is because they include the year when we had the financial crisis. So basically you value stocks with the assumption that there will be an economic crisis within the next 10 years just like the last 10 years stocks, stocks are actually not cheap. If the next 10 years is as unstable as the last 10 years, stocks are not cheap.
However to make money investing, investors shouldn't be asking whether stocks are cheap or expensive but whether they will be going up or down.
So how useful is Shiller's work for making money in the next 5 years? If you look a Shillers' P/E ratio for stocks (see above), you will notice when it shows that stocks are really cheap and get to the bottom valuation of ShillerPE of 10, the stcok market is followed by rallies or stop falling. If valuations go above 30, stocks can go higher but a sharp correction or bear market tends to follow. One thing to note is the financial crisis did not the ShillerPE to below 10 - it stopped at around 13 in the bottom of 2009. That left many investors who were waiting for the market to go lower out of the subsequent rally. Also if you look carefully at the chart, there is a period in the 60s when the market exceed today's ShillerPE of 20 and continued going up for a few years.
I believe the ShillerPE overstate the "expensiveness" of stocks for 2 reasons.
Stocks are not priced in isolation or in absolute terms. When you have money, you can keep it in the bank, but a piece of property for investment, buy some US treasuries or commodities or gold or just keep it in the bank. Because stocks are an investment option and it has to be valued relative to other investments.
This is the first time stock dividend yields pay more than US govt bonds in our lifetime. The reason being investors are extremely fearful of holding any assets with risk so they prefer US treasuries even though the yield is so low. In that sense stocks are cheap because it is unloved by investors...and not for unjustifiable reasons given we are in the midst of a very crisis.
In my opinion, stocks are not as expensive as suggested by Shiller. However, they have not fully priced in the crisis in the worse case scenario. The outcome of the crisis is a complete unknown and much of the outcome depends on the actions leaders caught in the turmoil. Stocks are probably cheap enough to rally once there is some kind of stabilisation of the global economy. Where stocks will be in the coming months hinges on on whether the EU leaders would perfer a quick "kick the can down the road" approach or a more painful but more permanent fix or something in between. In the longer term, if stocks fall sharply from current levels, they are probably good bargains even if we go into a recession as long as the economic system is not too broken to recover in a few years. In the previous posting on stock valution[oart 1] I showed a valuation approach using book value - stocks become irrationally cheap when investors start selling below their book value....each time that happens stocks prices move up. Such below book value valuations tend to occur during a recessions and a rough estimate puts the STI at 2000 if our blue chips trade at book value.