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Stock Market is Getting Cheaper and Cheaper

by bogbit

Uncertainty and anxiety are not quite the same but they have similar effects on investors. Respected economists currently differ whether the U.S. economy faces inflation, deflation or maybe a little of both. The plunge three years ago from the heady highs of the stock market of 2007 remains a vivid memory keeping fear the dominant force in the stock market.

The result is that stocks have been marked down to quite tempting valuations. These apparent bargains look even better when compared to the alternatives in a record low interest rate environment. Just because prices are cheap does not mean they cannot become even cheaper. The trick is to assess their valuations with realistic earnings assessments in an effort to invest with a reasonable margin of safety.

Current analyst earnings estimates for the 500 companies in the S&P 500 for 2011 range from $80 to $95, down from $85-$97 a few weeks ago. At $80, that’s a price-to-earnings ratio (“P/E”) of 13 today. That’s about average for the last century but a bit low for the last twenty years.

The P/E ratio for this market average got down to around 8 in 1949, 1974 and 1980. In those days, the economy was smaller and much more cyclical with big swings from the auto and steel industries. Since then, it has not only grown but become much more profitable with increases in productivity from advances in computer and communications technology. Globalization has brought more competition but also opened new markets.

At the height of the dot.com bubble in 2000, the S&P’s P/E had risen to 32. Today’s valuation is around the low for the last twenty years. Should the economy reverse into the dreaded “double-dip” recession, the “E” for earnings denominator would decline. This seems unlikely and the pace of the economic recovery seems highly likely to continue at a middling 2%-3% pace. The P/E ratio thus might actually get a bit smaller but the prevailing anxieties have already substantially reduced downside price risk though it may take a few weeks or even months for stocks to regain their vigor.

P/E ratios are normally used to value (or promote) individual stocks. Used in connection with an eye toward overall market conditions, they can show interesting contrasts. For example, Concho Resources (CXO-$59), a Midland, Texas-based developer of established oil and gas fields has a current P/E of 24. This drops to 15 if it hits the current forecasts for next year. Given oil prices no less then than today’s levels, it probably can and the stock is a buy for more aggressive investors.

In contrast, Total (TOT-$46), the big French international energy company with sales over 200 times that of Concho has a P/E of only 7. Analysts forecast modest growth that would drop this ratio toward 6 for next year. Concho offers faster growth and Total a 6% dividend yield. Total is also a buy and more suitable for the income investor.

Amazon.com (AMZN-$124) has a current P/E of 51, dropping to 35 on forecast earnings. Apple (AAPL-$243) has lower ratios of 18 and 14. Both are burning up the consumer market but Apple is not only bigger but also growing twice as fast. Amazon had has become the world’s most successful retailer but the contrast leads me to recommend selling Amazon and buying Apple.

In this shaky market, I continue to advocate closed end bond funds in the higher yield category like Western Corporate High Income (GDO-$19-8%yield) to build up reserves. The more venturesome will like Balchem (BCPC-$24), a smallish specialty chemical growth stock with a current P/E of 22. It’s growing both sales and earnings at rates over 20% and even pays a small dividend.

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