Geoff Gannon February 28, 2007

On Tuesday’s Decline

After as memorable a market move as yesterday’s (made all the more memorable by the lack of such days over the past half decade), I would love to be able to write that you have nothing to be worried about. Many other bloggers have written as much and they’re right to do so. Despite the fireworks, nothing much has changed. If you were completely comfortable owning stocks on Monday you should be completely comfortable owning stocks today.

I’m comfortable with the stocks I own. I just wouldn’t be comfortable owning a representative sample of the overall market. I wouldn’t be comfortable owning the Dow or the S&P; 500, because they are trading at uncomfortable valuations.

I started this blog on Christmas Eve 2005 intending to publish a quarterly newsletter. After just two quarters, I had to close up shop for a very simple reason. During the third quarter of 2006, the trickle of good ideas slowed to the point where there was no longer something worth printing every quarter.

This blog is free. You can come and skim it as you like when you like. It’s a nice, casual arrangement that lets me write about interesting stocks without feeling like I’m holding any particular stock out as the absolute best opportunity of the moment. I’ve taken advantage of that – in fact, you may have noticed that during the second half of 2006 my posts on individual companies tended to end with more ambivalent conclusions. There’s a simple explanation: it has become much harder to find stocks I can write about with conviction.

At the end of last year, I started writing about the market in general. I presented my thoughts in a roundabout way through a series of posts on normalized P/E ratios. The most important of these posts was the one entitled “In Defense of Extraordinary Claims” which concluded with these words:

Stocks are not inherently attractive; they have often been attractive, because they have often been cheap. The great returns of the 20th century occurred under special circumstances – namely, low normalized P/E ratios. Today’s normalized P/E ratios are much, much higher. In other words, the special circumstances that allowed for great returns in equities during the 20th century no longer exist.

So, don’t use historical returns as a frame of reference when thinking about future returns – and do lower your expectations!

The long-term earnings growth rate of such a large group of big businesses simply can’t be all that fast. We can argue over whether earnings can grow 9% in any given year, but we know they won’t grow 9% in the long-run. That was the point behind my normalized P/E series. The idea that buying in at these levels will provide you with the kind of historical returns seen during the 20th century is absurd.

Stocks were a lot cheaper a lot more often than most people realize. Buying stocks at today’s prices may provide adequate returns and may be the best course of action for the long-term investor to take. However, buying stocks at today’s prices will not provide 20th century type annual returns.

The argument on the other side is that neither the Dow nor the S&P; 500 is really all that overvalued. Sure, the market may not be particularly cheap, but that doesn’t mean there’s necessarily any danger in buying here. That may be true. But, I don’t see any margin of safety here and that makes me uncomfortable.

On a related topic, here’s a post from Cheap Stocks on net/nets. I run a somewhat related screen and have also been seeing the list of results dwindle. The bigger names – and “big” is relative here (usually a market cap of $100 – $300 million or so) – have almost all disappeared.

Conspicuously cheap stocks have been disappearing. If there’s any value in today’s market it’s probably in large, growing businesses trading at reasonable prices. I’ll mention three such stocks in my next post.

Until then, don’t worry about Tuesday’s decline – but do take some time to look at current multiples and ask yourself if you would be comfortable owning this market if you couldn’t trade it and just had to live off the operating results. That’s the question to ask, not where the market will be in a day, a week, or a month – but whether these are prices you can pay.