Wednesday, December 29, 2004


Not too many Christmas bargains this year

Another good day: up $3000. Also, I bought 2500 shares of TRT. However, I’m still sitting on over $50,000 in cash. I just can’t find enough good stocks to invest in, and as I’ve said before, I’d much rather own cash than crap. What a difference two years make. At this time in 2002, there were literally dozens of stocks with great growth potential that were trading well under cash value, often 50 percent below cash. Now bargain stocks are few and far between, especially in the microcap universe that has traditionally been my stalking ground.

At least during the bubble years, there were still assets that remained reasonably valued: real estate, emerging market bonds, commodities, not to mention value stocks and the big “old-economy” stocks. For the value investor, there were still many bargains to be found. All that has changed. Now everything seems overvalued: Real estate prices are sky high, bond yields have fallen, commodity prices have soared, and stocks of every sort have risen, from the small cap growth stock to the big cap S&P 500 stock.

What’s responsible for these developments? Partly it’s the low interest rate policy pursued by the Fed to stimulate an economy suffering from excess capacity and anemic employment growth. But no matter how you cut it, stocks are overvalued now, and so the coming year may bring many disappointments to investors such as myself. Off the top of my head, I can think of at least 4 reasons why stocks are overvalued now by conventional measures of valuation:

• The P/E ratio on the S&P 500 is over 20 now. The historic average is 16, and if you remove the late nineties from the data, it’s even lower. The average P/E on NASDAQ stocks is even higher.

• Inflation is very low now. Contrary to popular belief, P/E ratios should be lower when inflation is low. The reason is that inflation reduces the real value of debt, which increases a firm’s net equity value. Looked at it a different way: when inflation is high, nominal interest rates will also be high, and the firm will have higher interest expenses, thus lowering its reported earnings.

• Corporate profits as a percentage of GDP are the highest since the 1920’s. This has occurred because productivity growth has been stellar while wage growth has been weak. Thus, not only are P/E ratios high, the E in the ratio is very high as well. Eventually, wages will either accelerate as unemployment continues to fall or productivity growth will taper off. In either case, this will be bad news for stocks.

• The market P/B value is still extremely high by historic standards. I can understand that price to book will tend to increase over time, as the economy becomes more technology oriented and firms accumulate more intangible assets, which GAAP often requires that firms expense instead of capitalize (such as R&D expenditures). Still, market capitalizations are very high relative to book values, and some of those book values include nebulous assets like goodwill, the value of which may be close to zero, especially if stemming from acquisitions or mergers during the bubble years.

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