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Yes, They Do: Low Interest Rates Do Make Stocks Cheap

 April 27, 2012 11:18 AM

(By Chuck Carnevale) Introduction: Pessimism Is For Losers

I'm inspired to write this article because I am so frustrated by the plethora of all the so-called expert market prognosticators that continuously bombard the public with negative forecasts. I consider this to be both erroneous and irrational.  When the markets are doing well, we are immediately inundated with articles talking about how the market has surely topped and a big drop is imminent.   When markets are doing poorly, we are flooded with numerous forecasts of just how bad it's going to be. The real truth of the matter is that nobody really knows.  Not the Federal Reserve, nor any of the so-called experts who are more than willing to provide us with their forecasts of doom and gloom. Pessimism is pervasive, but optimism is, in fact, more accurate and rational in my opinion.

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The best investing minds that I've come across, which are also the ones with the best long-term track records, universally agree that timing markets, or forecasting the economy or interest rates, etc., are exercises in futility. The great investor Bernard Baruch put it quite succinctly when he said:

"Don't try to buy at the bottom and sell at the top. It can't be done except by liars." Bernard Baruch

Or you could look to the sage advice from Peter Lynch that he offered in Chapter 2 of Beating The Street his best-selling book, which I highly recommend to anyone with money invested. Chapter 2 is titled: The Weekend Worrier. In this chapter Peter talks about the same issues that I'm complaining about in this article. The Weekend Worrier, as Peter calls them, always have many draconian reasons why they believe it's not a good time to invest in stocks or why the economy is bad and getting worse.  But Peter makes a very strong point with the first two sentences of Chapter 2:

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"The key to making money in stocks is not to get scared out of them.  This cannot be over emphasized."

And later in the book Peter provides us with Peter Principle number 19 where he says:

"unless you are a short seller or a poet looking for a wealthy spouse, it never pays to be pessimistic."

And finally, I would like to share two of his 25 Golden Rules of Investing (he actually gives us 26), numbers 18 and 19:

"Golden rule number 18- there is always something to worry about.  Avoid weekend thinking and ignore the latest dire predictions of the newscasters.  Sell a stock because the company's fundamentals deteriorate, not because the sky is falling."

"Golden rule number 19-nobody can predict interest rates, the future direction of the economy, or the stock market.  Dismiss all such forecasts and concentrate on what's actually happening to the companies in which you've invested."

My goal with this introduction was to establish a foundation that supports optimism over pessimism. Secondarily, my objective was to point out that forecasting the economy, markets, interest rates or any other macro event is both impossible and an exercise in futility. However, it never ceases to amaze me how so many people continue to incessantly promogulate headline after headline and article after article positing their negative forecasts about the economy, the stock market, interest rates, etc. No matter how often they are proven wrong, and they usually are, they remain a persistent and shameless group.

Recently there has been a spate of articles debating whether or not stocks are cheap relative to things like interest rates or forward PE ratios. These articles really get my blood boiling because they tend to be full of forecasts about the very things which I have suggested cannot be forecast. Therefore, I find that their cases are full of opinion, but usually very light on facts. But perhaps most of all, they state their cases with an arrogance and conviction that I find too incredulous to tolerate. Therefore, my goal is to counter these articles based more on fact than opinion,and most importantly of all, on real numbers rather than statistical inferences.

Stocks Are Cheap Relative to Earnings (Past Present and Future)

Before I go on, I want to be clear, and consistent with what I've already written, by stating that I do not believe in predicting economies or stock markets in general. Instead, I believe in analyzing and investing in specific (individual) well-run companies at sensible or attractive valuations. However, if I feel compelled to talk about the markets in general, it is usually because I was incited by the types of articles I've been referring to throughout this piece. Moreover, I try to focus on the actual facts as they currently exist. Consequently, if there is any forecasting involved, it needs to be based on a short time period and upon a reasonable range of probabilities given what we do already know.

The following F.A.S.T. Graphs™ reviews the S&P 500 Index since the beginning of calendar year 1994. The orange line on this graph plots earnings-per-share at a PE ratio (earnings multiple) of 15. To be clear, as you look at this graph recognize that if the stock price (black line) is above the orange line, then the PE ratio is over 15, if the stock price is below the orange line, then the PE is less than 15, and of course if the price is touching the orange line, then the PE ratio of the S&P 500 is precisely 15. The same can be said about the historically normal price earnings ratio (blue line), however, this line is a calculated PE ratio of 19.3.

With the exception of the last earnings plot, the orange line is based on actual reported earnings (what we do already know) , and therefore, is a factual portrayal of how  "Mr. Market" has been valuing the S&P 500 Index since 1994. To repeat, when the price is above the orange line the S&P 500 is overvalued, when the price is touching the orange line the S&P 500 is fairly valued, and when the price (black line) is below the orange line, as it is now, the S&P 500 is undervalued. Statistically speaking, which is a language I hate to speak in, a PE ratio of 15 is the long-term historical average PE ratio for the S&P 500. Once again, statistically speaking, a PE ratio of 20 is the historical norm over the past 20 years (note that the blue line on the graph is drawn using a calculated PE of 19.3 over the past 19 years, which is obviously very close to the 20-year average of 20).

However, even though these ratios are statistically (mathematically) portrayed, a closer scrutiny of the graph can show how statistics can be misleading. Instead of relying on a mere numerical statistical calculation, the reviewer can clearly see how the market has actually valued the S&P 500 since 1994.

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