The top row reflects periods of time when valuations are favorable and thus acceptable to engage in long-term investing. The bottom row reflects periods of unfavorable valuations in which speculative investments should be properly hedged to reflect this risk. As the chart depicts, I believe we are in a late bear market period in which valuations are starting to turn favorable. Unfortunately, market conditions are still unfavorable and better entry points are likely for most investments.
Valuations:
Current market valuations are based on the S&P 500. According to the S&P 500 website, peak earnings in 2006 were $83.11 and is estimated at $16.00 in 2008 due to Financial Sector. While I do not believe 2008 is representative of future earnings, a tightening of profit margins due to less leverage and increased consumer savings will produce lower earnings going forward compared to its peak in 2006. I will use earnings of $60 and apply an average multiple of 13x to get an intrinsic value of 780 for the S&P. After today's rally due to the latest Giethner Plan, the S&P stands at approximately 823. I consider the market appropriately valued right now with severe downside risk after the recent rally.
Sector:
During the past year, everything that wasn't a U.S. Treasury or gold-related was being sold off. While overall the selling was warranted, especially in the financials, it did open up appealing valuations in different sectors. The graph above shows where I believe certain sectors are headed. Obviously I am more bullish on oil and agriculture in the long-term than I am in the U.S. dollar. However, the U.S. dollar continues to be the safest haven for investors and nothing is changing that in the near future, despite the Fed and Treasuries best efforts. I am still bullish on China in the long-term but so far the country has not shown any indication that internal demand is increasing to correct its imbalances. I fear China still has a painful transition ahead of it. The Euro is another area of weakness, it will be interesting to see how Eastern Europe fares in the future and what costs these countries impose on Western Europe.
A good graph to track the weeks trading in the different sectors is available from the Wall Street Journal and published on www.investmentpostcards.com each week.
Market Conditions:
Despite the recent rally, it is hard to consider market conditions to be anything but unfavorable. The government has made it clear they will do whatever is necessary to combat deflation and prevent bank failures. It is hoping that leverage will be the cure to prop up asset prices long enough for the economy to recover and all to be well again. I fear these actions are prolonging a necessary correction period and any recovery will be generally weak.
What does all this mean? I believe we are in a period in which valuations are fair but market conditions are unfavorable. Certain sectors may start decoupling soon and show strength but for now I believe most investments will be down and not up in the months ahead.
