Implicit with the Thanksgiving Holiday is a spirit oriented towards counting our blessings.  Being thankful associates more closely with optimism than it does pessimism. However, the euro zone debt crisis is occurring after what has been a seemingly endless string of macro-economic headwinds driving extreme investor pessimism. The psychological impact of all these negative events has taken its toll against the average investor’s appetite for risk and their attitudes about owning common stocks.

However, there is an irony associated with all these macro-economic disasters that can best be understood by turning away from the macro and focusing instead on the micro. With this shift in perspective we believe you can find some more optimistic outlooks about the stock market to be thankful for. On November 14, 2011, Liz Ann Sonders, Senior Vice President and Chief Investment Strategist for Charles Schwab & Co. prepared a report that focuses on the stock markets’ micro opportunity.

The following excerpts from Ms. Sonders’ report highlights several reasons supporting a rational shift in investors’ attitudes towards optimism. We will intersperse our own commentary among these excerpts in order to emphasize some of our key points.  However, a link to the full report can be found at the end of these excerpts.

Our objective in sharing this information, in addition to the fact that we have a great deal of respect for Ms. Sonders and her market acumen, is to support our thesis that common stocks are on sale today and, therefore, all the current pessimism is more than likely already priced in.  This doesn’t mean it’s impossible for stocks to go lower, because we all know that anything is possible with Mr. Market, at least in the short run. Furthermore, it is also our contention that prudent investing is not about finding perfect market bottoms; instead it’s about making sound and rational long-term valuation decisions.

The So-called Flight to Quality Could Backfire

This next chart in Ms. Sonders’ report offers a vivid expression of why stock prices have recently fallen as much as they have.  This actually frightens us because we believe that investors don’t realize how volatile bonds can be in a rising interest rate environment.  People are fleeing stocks because they are afraid the prices of stocks could fall.  Yet with today’s interest rates so low, it is a mathematical probability that if interest rates returned to more normal levels (for example, 6% to 8% on the 30-year Treasury bond), that bond prices could easily fall by 50% or more.

Yes, it’s true, that eventually the bonds would return to par.  However, it might take as much as 25 to 30 years for that to occur, and the demographic makeup of today’s average investor probably doesn’t have the luxury of that much time. On the other hand, there is also a high mathematical probability that stock prices and dividends on stocks that pay dividends could also move higher off of today’s low base.  Therefore, there is at least a distinct possibility that investors are fleeing stocks at precisely the time they should be embracing them.

Current Earnings are Strong

In spite of all this negative investor sentiment, corporations continue to achieve solid earnings results.  As Ms. Sonders’ following chart depicts, most companies in most sectors have been beating consensus analyst estimates with Telecom being the only exception.

Valuation is a Key Driver of Future Returns

When stock valuations are high, the markets face a virtually insurmountable headwind against achieving attractive returns.  Moreover, investors simultaneously are absorbing excessive risk in order to achieve mediocre returns at best.  Conversely, when valuations are low, future returns can be expected to be higher and the risk taken to achieve them lower.  On a micro-basis, stocks look cheap, or as Ms. Sonders so eloquently puts it, the “Forward P/E is dirt cheap.”


Follow this link to the complete report presented by Ms. Sonders at Charles Schwab & Co.’s website

Conclusion: The S&P 500 is Undervalued Based on Current and Near-Term Earnings Forecasts

The following F.A.S.T. Graphs™ on the S&P 500 depicts that on an earnings justified basis (the orange line with white triangles) that the S&P 500 is trading at the lowest valuation it has in two decades.  To clarify, the black stock price line of the S&P 500 has fallen below the orange earnings justified valuation line representing a calculated and historical normal PE of 15. Moreover, this is happening at precisely a time when earnings are actually advancing at rates that are exceeding consensus analyst estimates.  (Note that due to space constraints on graphs longer than 15 years, only every other year’s dates are typed in up to 2010, however, every year’s data points are plotted).

The following estimated earnings and return calculator shows that a 2011 year-end fair value for the S&P 500 would be 1462 (see flag on the graph).  Furthermore, based on next year’s estimate for S&P 500 earnings of $107.90 would indicate a 2012 fair value of approximately 1618. Both of these calculations are based on the S&P 500 achieving the earnings estimates derived directly from Standard & Poor’s website, and the market capitalizing those earnings at its 100-year historical normal PE ratio of 15.  Both of these calculations appear reasonable and achievable, notwithstanding current macro-economic headwinds.

Many people will disagree with the above thesis arguing that world economies are in horrible shape. Nevertheless, and as Ms. Sonders’ report also corroborates, it is during times when pessimism is the highest that the best long-term investment opportunities often exist.  Investors should at least be open to the possibility and perhaps even thankful for the opportunities that crises normally bring.  For additional perspectives on the case for optimism follow this linkto our previous article.

Disclosure:  No positions at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.