Market Forecasting Tutorial Part 3: Market Valuation
Here is the third and final piece of Mike Stathis’s series on market forecasting. His previous two articles on this subject can be found by clicking here for part 1 and clicking here for part 2.
PE Ratio
As you can see from the table, the PE ratio for the Dow hit 14 in June. After the sell-off in July 2008, it most likely fell by another point or so. Now I want you to look at the projected PE. This is the PE based on consensus earnings forecasts. It’s the one we should always focus on, whether we are looking at an individual stock or the entire market. However, trailing PE ratios do tell us what the market will bear, so they factor into sentiment.
Projected PE ratios are what investors partially base their buy and sell decisions on. And if earnings estimates are wrong, prices get crushed. So now we ask whether analysts have discounted the effects of the economy adequately or even aggressively. If you can answer that, you will know where the market is headed over the next few quarters.
I want to emphasize that this PE ratio data is critical because there is little doubt that July market lows moved the future PE ratio very close the single digit territory. This is critical because every bubble washout I have studied has only shown a recovery once the PE has either hit the low teens or single digits. Ever since the dotcom meltdown, the PE ratio has not fallen to the low teens until now. I cannot overemphasize the importance of this because it has significant implications for a trend reversal. I discuss this in more detail and its implications in my book America’s Financial Apocalypse.
So for those of you who seem to think I am a permanent bear, this is just one example that proves I am not such a beast, since the DJIA PE ratio has very bullish implications. In contrast, while the market PE is very impressive, I feel there is much more carnage down the road, as I have previously mentioned. The effects of the real estate and banking meltdown will spill over into the entire economy. We will soon see the broader effects of the banking collapse which has been cushioned by the endless printing of the dollar, record oil prices, and what I expect to be a global recession.
No one knows whether this worst case scenario will play out but if you are on the look out, you will spot further problems in advance and this will give you an edge over other investors.
So what am I saying? The message is that you cannot use market valuation techniques for market timing. But you can use valuation to help with other indicators when trying to determine the timing. Timing is better estimated by understanding the full risks to the economy and stock market. And when news is first reported, those who have factored in these risks will more readily understand the full impact in advance, while others cling onto hope and misguided optimism.
It is very possible DJIA earnings will not reach consensus estimates. If so, that alone will lower the PE. and combined with a further drop in the Dow, it would clearly send it into the single-digit territory. This would provide significant evidence of a bottom. But we must also accept the fact that there is much house to clean in the economy, and this will take quite a bit of time. Still, this single-digit PE ratio, if reached is something we need to keep an eye on because it will have signaled the beginning of a washout phase. Now, this bottom, once reached, could linger for quite a long time. For estimates on timing of a trend reversal, I would focus on sentiment – responses from the market upon news events, put-call ratios, money flow, and VIX.
q Ratio
We have another way to estimate market valuation. We can use something known as the q ratio, developed by James Tobin, a Nobel Laureate in economics. According to q, as of the close on July 18, 2008, the S&P 500 is about 2% overvalued excluding the financials. Adding the financials, the S&P is still significantly overvalued. This is further evidence that the financials may soon top out and reverse course over the short-term. In contrast, as pointed out earlier, the 14-month chart of the Dow (and the S&P 500) shows a downward trend beginning in October, followed by a downward zigzag pattern of lower lows and lower highs. A continued rally is likely to be led by the financials. But a sell-off is also likely to be led by the financials.
Background on q
q is a measure of the ratio of the value of companies, as measured by their market capitalization, and their net worth, measured by replacement cost. When corporate debt is included, the ratio as referred to as Tobin’s q. When debt has been excluded (as in the case I have mentioned here), it is known as the equity q. The qratio is calculated from the data published quarterly by the Federal Reserve’s “Flow of Funds Accounts of the United States Z1.”
When q is greater that 1, the stock (or stock market) is considered overvalued since the market capitalization is more than the costs to replace assets. Greater than 1 implies that a firm’s stock is more expensive than the replacement cost of its assets. In contrast, the stock (or stock market) is considered to be undervalued when q is between 0 and 1 since the cost to replace the assets is more than the value of, as measured by market capitalization.
One problem with q is that it seems to oversimplify valuation since intellectual property accounts for a very significant portion of value for even basic industries. Obviously, it is much higher for high-tech firms. However, investors seem to understand this. How do I know? Because it is known that the majority of valuation (and thus share price) for the stocks included in the S&P 500 is attributed to intellectual property. The same may be said of the Dow components, although most likely a smaller amount.
Whether or not you chose to use the q ratio or PE ratio as measures of market valuation, the fact is that valuation rarely coincides with timing. For timing we should look to events, charting trends, and technical indicators. In using these tools, we must weigh all of the evidence together and continue to watch for key indicators, such as reporting and guidance by companies, market volume, trend analysis, geopolitical events, oil prices, and further announcements by the Fed and economic reporting agencies.
A Final Note on Valuation Methods
One should never rely solely on valuation methods like PE and q ratios to predict for market timing. The market can remain under-or overvalued for a good deal of time since investors often disagree as to what will happen to earnings. And if earnings change, the PE will change and that will change the valuation of the market.
A Final Note on Market Forecasting
The key thing to remember about market forecasting is that it is dynamic and must be revised as things change. But if we keep the bigger picture in mind, it can help us make better short-term forecasts when using indicators such as RSI, MACD, put/call ratios, money flow and others. While the volatility indexes like the VIX and others can certainly help determine big moves and reversals, I think it’s much more important to look at events, such as the Fed’s bailout plan and recent bank earnings, all while keeping in mind the fact that the market is in a downward trend.
While everyone is different, I really only look at volatility indexes, put/call ratios and other indicators when I am lost and there is nothing more compelling to consider. Whatever you find works for you consistently is what you should use. As with anything so difficult to perfect, consistently accurate market forecasting requires a lot of trial and error.
If you want to read more detail of the techniques I use for investment management, risk analysis, forecasting and trading, I will be releasing a 2-volume series of investment books soon. Volume 1 is scheduled for release in a few months, while volume 2 will be released sometime in 2009. Until then, I advise you to read America’s financial Apocalypse and Cashing in on the Real Estate Bubble. if you want to know what caused this mess, how bad things will get and how to profit while others face the harsh consequences of denial.
Mike Stathis is the Managing Principal of Apex Venture Advisors, a business and investment intelligence firm serving the needs of venture firms, corporations and hedge funds on a variety of projects, including valuation analysis, deal structuring, investment strategy, market forecasting, and business strategy. Mike is the author of several publications including “America’s Financial Apocalypse: How to Profit from the Next Great”