Are Stocks Cheap Enough to Start Buying, Yet?

As an investor, if you feel Johnson & Johnson (JNJ) is going to be around for the foreseeable future, you should evaluate the stock as if you were going to buy the whole business by discounting anticipated cash flows. Stockholders basically own a partial claim to future cash flows. Using this rationale, value investors have the guts to step in and buy good businesses during a bear market (when they are cheap).

As bad as things are now, we all know numerous companies will still be producing free cash flow (real profits) for many years to come. Not all public companies are going the way of Bear Stearns. I think it is reasonable to assume that businesses like Coca-Cola, McDonald’s, Microsoft, Proctor & Gamble, and Wal-Mart will be viable in five years.

How Much is Cash Flow Worth?

Since stocks were trading at inflated valuations for many years, investors still need to evaluate what a claim to the future cash flows [of a particular company] is worth. A good stock has relatively stable long-term cash flows at a fair price. Price-earnings ratios (PEs) are used to track the valuations of stocks or stock indexes.

A PE ratio tells us how much investors are willing to pay for $1 worth of earnings. Relatively high PE ratios indicate investors are willing to pay more for the earnings/cash flows of businesses. Conversely, when PEs are low, investors are willing to pay much less for future cash flows/earnings.

Technical Analysis

The odds of success for investors are highest when we have both favorable fundamentals [Price, PE ratios, Dividends, etc.] and favorable technicals [chart patterns based on Price].

From a technical perspective, support is an area or price level on a chart where buyers have previously stepped in to buy and halted a decline in price. Support shows where investors in the past have seen relative value in the price of a security (business) or index (a group of businesses).

Fundamental Analysis

Just as in the dry cleaning example above, investors should not evaluate a stock solely on peak (expansion) or trough (recession) earnings since the value of the business is determined by the anticipated long-term future cash flows, which will include both good and bad times.

Protect Principal

A large cash position is still warranted. Having some one, two, and three month CDs continually rolling over will force you to be patient with some capital while remaining flexible should the market find its footing.

No Safe Haven Except Cash

We are watching almost every investment option available to individual investors. With the exception of U.S. Treasury bonds, the U.S. Dollar, and Japanese Yen, everything is and has been losing money. The list of money losers includes oil and gas trusts, preferred stocks, dividend-paying stocks, gold, and TIPS. With the rush to “safety” and the unwinding of carry trades, gains in Treasuries, the Dollar, and Yen may be subject to rapid reversals even on a minor improvement in market conditions.

Principal Protection May Still be Important

Based on S&P 500 at 852.3
(11/12/08 Level)

Do Not Chase Yield on Anything (Yet):

This includes locking yourself into long-term CDs or a fixed annuity with an attractive teaser rate. Inflation will be an issue in the future. It could be a very serious issue.

Over the next three to five years, interest rates may move higher at a surprisingly rapid rate. A 5.0% CD may be very unattractive sooner than most think.

In general, higher-yield comes with higher risk. Banks with weak balance sheets gather capital by offering above market CD rates. Insurance companies in need of funds may offer teaser fixed annuity rates above what their more stable and better managed competitors offer.

Yes, CDs are FDIC insured. But, in this environment things can deteriorate and change rapidly. It is not worth the extra yield for the added risk and uncertainty that comes along with it. There will be a time to look for better yields. It is still too early in the cycle. Seeing higher highs and lower lows on some income-producing securities would be a nice start.

Understand The Inflation Implications Of The Seemingly Endless Government Bailouts, Equity Stakes, and Loans:

Inflation is primarily triggered by an excessive expansion in government liabilities relative to economic output. When the government sells bonds to finance the deficit, the proceeds flow back into the economy via government spending, increasing the money supply in the real economy.

If I exchange "dead money" in a shoebox for a government bond, we end up with more "active money" in the economy and a piece of paper (a bond) in my shoebox. While I was sitting on "dead money" in my shoebox, you can rest assured our politicians will spend the proceeds from the sale of the bond (or they already have spent it).

A rapid expansion in the "active" money supply adds to pricing pressures. This is not a big issue in the current state of economic disarray. However, when some stability returns to the financial system and global growth finds its footing, you can bet the ranch inflation will become a major concern for people around the globe.

When the economic clouds begin to clear, the government cannot “undo” the rapid expansion in deficit spending. If you have not noticed, the government has “slightly” increased spending in recent months. The seeds of future inflation have been planted – a lot of seeds.

When to Shift from Principal Protection Back to Purchasing Power Preservation

Cash, CDs, and fixed annuities do not help investors protect their purchasing power during periods of high inflation. Mentally, you should be preparing yourself to reenter asset markets that can help protect your purchasing power. When gold, oil, and the CRB index (commodities) begin to make higher highs and higher lows, it will be time to begin a migration from principal preservation to purchasing power protection. For older Americans, this transition may be the most important financial undertaking in their lives. Managing this transition will be difficult for the most seasoned investors, much less the part-time do-it-yourselfer.

Don’t Shift Back To Purchasing Power Protection Assets Too Soon

Those of us who are close to the markets are appropriately concerned about the rapid expansion in government liabilities. It is tempting to buy gold, oil, and short the U.S. dollar. Gold and oil continue to make lower highs and lower lows which is the definition of a downtrend. Trying to catch a falling knife may destroy hard-earned principal. Some frustration inevitably lies ahead in all asset classes as we can expect to get rallies and sharp retracements.

Review Any Liability With A Variable Interest Rate

Mortgage rates went as high as 18.45% during a period of high inflation in the early 1980s. Enough said.

Keep An Open Mind

The bursting of the credit bubble across all asset classes is a serious and unique problem that should be respected. However, the S&P 500 has lost 46% of its value since the October 2007 peak.

These staggering declines (especially if you did not follow a disciplined strategy to cut losses) have already discounted some of the bad news that lies ahead. Market participants are well aware that earnings and economic news will be quite bleak for an extended period and at least some of that future news is already built into stock prices.

Only time will tell whether all the bad news has been discounted. We have very serious problems, but 46% is a very serious decline. We are currently in a battle of a primary downtrend in stocks which eventually will be counteracted by attractive valuations. Currently, the primary downtrend firmly retains the upper hand.

Patiently Watch The Dollar

Being concerned about inflation and future dollar weakness go hand in hand. Long-term fundamental concerns about the dollar are warranted, but it is too early to bet against the greenback. Gold and oil look somewhat like a mirror image of the dollar’s chart, which means the path of least resistance for both remains lower (for now – subject to change).

Let the Market Come to You

Sports fans are familiar with the expression "let the game come to you." Just like a good athlete, we should not try to force our beliefs on the market. If we pay attention and remain patient, the market will help us make decisions when better risk-reward ratios exist. This is not the time to be throwing up indiscriminate "three-pointers".