Best of the Week
Most Popular
1. Investing in a Bubble Mania Stock Market Trending Towards Financial Crisis 2.0 CRASH! - 9th Sep 21
2.Tech Stocks Bubble Valuations 2000 vs 2021 - 25th Sep 21
3.Stock Market FOMO Going into Crash Season - 8th Oct 21
4.Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
7.AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
8.Why Silver Price Could Crash by 20%! - 5th Oct 21
9.Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
10.Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Last 7 days
Quantum AI Stocks Investing Priority - 26th Jan 22
Is Everyone Going To Be Right About This Stocks Bear Market?- 26th Jan 22
Stock Market Glass Half Empty or Half Full? - 26th Jan 22
Stock Market Quoted As Saying 'The Reports Of My Demise Are Greatly Exaggerated' - 26th Jan 22
The Synthetic Dividend Option To Generate Profits - 26th Jan 22
The Beginner's Guide to Credit Repair - 26th Jan 22
AI Tech Stocks State Going into the CRASH and Capitalising on the Metaverse - 25th Jan 22
Stock Market Relief Rally, Maybe? - 25th Jan 22
Why Gold’s Latest Rally Is Nothing to Get Excited About - 25th Jan 22
Gold Slides and Rebounds in 2022 - 25th Jan 22
Gold; a stellar picture - 25th Jan 22
CATHY WOOD ARK GARBAGE ARK Funds Heading for 90% STOCK CRASH! - 22nd Jan 22
Gold Is the Belle of the Ball. Will Its Dance Turn Bearish? - 22nd Jan 22
Best Neighborhoods to Buy Real Estate in San Diego - 22nd Jan 22
Stock Market January PANIC AI Tech Stocks Buying Opp - Trend Forecast 2022 - 21st Jan 21
How to Get Rich in the MetaVerse - 20th Jan 21
Should you Buy Payment Disruptor Stocks in 2022? - 20th Jan 21
2022 the Year of Smart devices, Electric Vehicles, and AI Startups - 20th Jan 21
Oil Markets More Animated by Geopolitics, Supply, and Demand - 20th Jan 21
WARNING - AI STOCK MARKET CRASH / BEAR SWITCH TRIGGERED! - 19th Jan 22
Fake It Till You Make It: Will Silver’s Motto Work on Gold? - 19th Jan 22
Crude Oil Smashing Stocks - 19th Jan 22
US Stagflation: The Global Risk of 2022 - 19th Jan 22
Stock Market Trend Forecast Early 2022 - Tech Growth Value Stocks Rotation - 18th Jan 22
Stock Market Sentiment Speaks: Are We Setting Up For A 'Mini-Crash'? - 18th Jan 22
Mobile Sports Betting is on a rise: Here’s why - 18th Jan 22
Exponential AI Stocks Mega-trend - 17th Jan 22
THE NEXT BITCOIN - 17th Jan 22
Gold Price Predictions for 2022 - 17th Jan 22
How Do Debt Relief Services Work To Reduce The Amount You Owe? - 17th Jan 22
RIVIAN IPO Illustrates We are in the Mother of all Stock Market Bubbles - 16th Jan 22
All Market Eyes on Copper - 16th Jan 22
The US Dollar Had a Slip-Up, but Gold Turned a Blind Eye to It - 16th Jan 22
A Stock Market Top for the Ages - 16th Jan 22
FREETRADE - Stock Investing Platform, the Good, Bad and Ugly Review, Free Shares, Cancelled Orders - 15th Jan 22
WD 14tb My Book External Drive Unboxing, Testing and Benchmark Performance Amazon Buy Review - 15th Jan 22
Toyland Ferris Wheel Birthday Fun at Gulliver's Rother Valley UK Theme Park 2022 - 15th Jan 22
What You Should Know About a TailoredPay High Risk Merchant Account - 15th Jan 22

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

How to Pick Stocks in the ‘New Normal’ Economy

Stock-Markets / Investing 2010 Jul 29, 2010 - 05:23 AM GMT

By: Money_Morning

Stock-Markets

Best Financial Markets Analysis ArticleShah Gilani writes: In today's potentially ultra-slow-growth "New Normal" economy, old stock market multiples do not apply.

In fact, investors who rely on long-held rules about Price/Earnings (P/E) ratios when they buy and sell stocks are risking a pretty big "haircut:" They may be overvaluing some of their stocks - and the stock market in general - by 17% to 20%.


Let's take a closer look...

The "New Normal" Spawns New Rules
The recently popularized term "New Normal" economy refers to expectations that U.S. growth will be sub-par for several quarters - and quite likely for years - to come. At the same time, key emerging markets elsewhere in the world will continue to post rapid growth.

These divergent outlooks - upbeat for those emerging markets, downbeat for the U.S. economy - spells opportunity for companies with a global reach. And that divergence promises lackluster performance for "New Normal" economy companies - those whose products and services are tied solely to the domestic U.S. economy.

The companies experiencing the fastest profit growth will be "non-New Normal" firms - those that derive more than 50% of their revenue from surging emerging-market economies. Those stocks will warrant the more "normal" earnings multiples, as we shall see.

Investors need to understand the difference in order to evaluate Wall Street's earnings forecasts, and to determine whether a given New Normal stock is over, under, or fairly valued at a given price and P/E-ratio level.

Here's why.

Research shows that long-held beliefs about what constitutes "fair" or "warranted" P/E ratios are leading to substandard returns - for two very clear reasons.

First, keep in mind that - as a ratio - a P/E is basically a calculated relationship between two pieces of information: The price of a company's share of stock, and the per-share earnings (EPS) that company is expected (or projected) to earn.

The problem with those earnings projections is that most analyst forecasts are far too rosy.

Wall Street Overshoots on Profit Projection
In the July issue of its quarterly business journal, consulting firm McKinsey & Co. studied the last 25 years of stock-market-analyst forecasts, concluding that "on average, analysts' forecasts have been almost 100% too high." During that quarter-century stretch from 1985 to 2009, equity analysts projected earnings growth of 10% to 12%.

Actual earnings growth during that period was 6% - or half of what the Wall Street set had forecast, the McKinsey Quarterly article concluded.

Unfortunately, lousy earnings forecasts are just one problem. There's another issue that is just as bad: Forecasters failed to understand how deeply market volatility undercuts valuations.

New Normal Volatility Demands New Market Multiples
For the "New Normal" stocks, earnings multiples need to be re-evaluated because they don't have the same potential high growth trajectory that companies exposed to global markets have. The historic market multiple (P/E) of 15.7 that investors apply to domestic-only companies is way too high.

Not surprisingly, it's increased market volatility that undercuts the old multiple.

In an empirical study titled "The P/E Multiple and Market Volatility," two professors and a quantitative analyst wrote in the respected Financial Analysts Journal that that market volatility deserves to have a significant impact on "warranted" market multiples.

The authors concluded that their study suggested that "a permanent one-percentage-point increase in market volatility can, over time, reduce the market multiple by 1.8."

Market volatility is typically a measure - in percentage terms - of the expected annualized movement of the Standard & Poor's 500 Index. If volatility is said to be 10, it means that over the next 12 months the S&P 500 could swing 10% - in either direction.

Average volatility during the postwar period up to 1995 was 17. From 1990-2008 - after a switch to our modern-day volatility measure (the Chicago Board Options Exchange Volatility Index (VIX), an implied-volatility calculation derived from index options) - the average volatility jumped to 19.49.

From 2005 to the middle part of this year, the VIX averaged 22.86. (For some perspective, at the height of the credit crisis on November 24, 2008, the VIX reached its all time high of 80.86.)

If we average the three overlapping periods that I mentioned, the volatility would be 19.78. But, in what might be considered a precursor to the New Normal, the average of 22.86 for the past five years is a full three percentage points higher than the rolling average of all the post-World War II years right up to the present day.

Stocks and the market have been considered fairly priced when they trade at a historically normalized 15.7 times "forward" earnings.

But if we use the three authors' research on volatility influences - which says that every one-percentage-point increase in market volatility reduces the "warranted" market multiple by 1.8 - the "New Normal" economy market multiple might be as low as 10.3.

The exact middle ground between the old standard market multiple of 15.7, and the 10.3 multiple the New Normal implies, is exactly 13. So, let's use the middle ground to see how the market looks now.

What Are Stocks "Really" Worth?
Standard & Poor's estimates that the S&P 500 will earn $81.72 this year. At a P/E of 13, the S&P would be trading at 1,062. If we use the "Old Normal" benchmark multiple of 15.7, the S&P index would be fairly priced at 1,283. Since the S&P 500 has been trading a lot closer to 1,062 than to 1,283, maybe the New Normal is already old news.

The Standard & Poor's 500 closed yesterday (Wednesday) at 1,106.13.

When it comes to individual stocks, investors need to know which camp the companies they hold or are interested in fall into. We've already established that some of the most promising stock-market profit opportunities will be those "non-New Normal" companies that derive at least 50% of their top-line revenue from emerging-market economies.

"New Normal" economy companies, by contrast, are the firms whose fortunes are fully tied to the slow-growth U.S. market. In other words, New Normal stocks are really the shares of U.S. firms that do not sell their products and services to high-growth markets outside U.S. borders.

It's important to point out that not all U.S. firms are New Normal economy companies. It's all about the markets they sell to.

An excellent example of a U.S. company with a terrific international footprint is E.I. du Pont de Nemours & Co. (NYSE: DD). On Tuesday, DuPont posted blowout second-quarter earnings. But it wasn't that net profits were up almost 300% that impressed analysts: It was the fact that DuPont's revenue advanced 26%, with 60% of the top-line sales emanating from overseas markets.

Emerging-market sales advanced 32%.

An important takeaway from this earning's season is this: While not all companies that reported improved earnings saw their share prices increase, those that did rise didn't sustain their positive advances.

Meanwhile, companies that reported significant revenue gains in emerging-economy markets have held onto their recent gains. Indeed, in the two weeks since I recommended DuPont to subscribers of my Capital Wave Forecast private-advisory service, the stock has already advanced 8.5% .

If there's one final lesson to be learned here, it's this: For your global players, use the old standard P/E multiple of 15 times earnings as your comparative valuation benchmark. But, for the New Normal companies, you'll need to use the new standard multiplier of between 10.3 and 13 or less.

Actions to Take: In the slow-growth "New Normal" economy, it no longer makes sense to use a single P/E multiple to evaluate all stocks. Companies that derive at least half of their revenue from faster-growing, emerging-market countries likely deserve this richer multiple. And while there's nothing inherently wrong with most of the companies that cater exclusively to U.S. economy customers, they don't merit the same high multiples as companies that sell into a faster-growing market. So apply your P/E multiples wisely: Use an earnings multiple of 15 for global players, and a P/E of between 10.3 and 13 for companies catering to the (domestic) New Normal economy.

Source : http://moneymorning.com/2010/07/29/new-normal-economy/

Money Morning/The Money Map Report

©2010 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in