The stock market took heavy losses last week as the S&P 500 dropped nearly 10% in one week. Times like these frighten even the most even-keeled and patient investors. It seems that everyone has an opinion about where we are headed and most of them are pessimistic. No one can accurately see into the future but we can learn from the past. Financial markets are cyclical and we know from experience that this misery shall pass. At Ockham, we are contrarians at heart and thus, when circumstances look their most dismal—and it currently feels pretty dismal—we see opportunity. For example, our valuation methodology, which covers 5400 U.S. equities and ADRs, currently rates its highest number of stocks as “Undervalued” ever. We simply do not get a more bullish reading on the market than we are currently. We expect that we will get a number of comments taking issue with this post. However, we have a methodology that has worked in the past and we must have the discipline to stick with it in good times and bad, despite our level of trepidation.

So, we have already admitted that most of our coverage universe is rated Undervalued or Greatly Undervalued. Allow me to explain why. We know that the stock market is down and that equity valuations are as low as they have been in many years. One key valuation metric that we track is the price-to-peak earnings multiple that is advocated by financial guru and mutual fund manager John Hussman. Similar to the simple P/E multiple the price-to-peak earnings just takes a bit of the volatility out of the measurement. Many people do not understand that corporate earnings are quite volatile and having one volatile measure divided by yet another volatile measure is likely to generate results which will be wildly inconsistent and very misleading from time to time. By using peak earnings we can smooth the results and make the reading more informative. Also, although earnings are comparatively low right now and perhaps headed much lower, it is a fair assumption that they will again be back to their previous highs, and in time will exceed them. This is the inarguable truth of the capitalist model. Despite some predictions that this model is broken and no longer reliable, we believe that well run companies will benefit from the creative destruction going on around us and future S&P 500 earnings charts will continue to move up and to the right.

We have followed the price-to-peak ratio weekly since January 1989 and we find it a very reliable way to track relative valuation. Coming into this week, the S&P 500 was trading at only 12.3x peak earnings and it has certainly dropped lower in today’s trading. Since we began tracking this metric nearly 20 years ago, there have been exactly two instances where this number has gone below 12—once in March 1989 and again in September 1990. One of our favorite Ben Graham quotes is, “In the short run the market acts as a voting machine, in the long run it is a weighing machine.” Sentiment right now is clearly bearish, but there are opportunities in certain stocks in this market.

Obviously, many investors have lost money in this market and are not eager to experience further losses; however, if you have parked some of your money on the sidelines now is a very defendable time to re-enter selectively. Ockham Research is not advocating blindly buying everything that you can because there are certainly some stocks that are better buys than others. The Healthcare, Basic Materials and Conglomerates sectors are particularly appealing at present. We are in agreement with Warren Buffett’s recent quote on CNBC, “When we look back at this in ten years we will remember this as a great opportunity to make money.”