Once Again, Valuations Matter

The stock market may continue to appreciate, but stocks are hardly cheap.
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In June, I wrote a column that advised selling stocks. I based that advice on my market-timing indicators, which include valuation, sentiment, business fundamentals and liquidity considerations. Lately, market bulls have become much more vocal in stating their case for higher stock prices. Many even address the valuation issue, but in a disingenuous manner. Don't buy their contentions, and don't be bullied into chasing this market.

The Bulls' Questionable Reasoning

One way to minimize the valuation is to dismiss it altogether, which is both foolish and dangerous. Valuation may not matter today, but it will tomorrow or the day after. Don't get caught chasing a trend that's about to reverse.

Another trick is to exaggerate a company's earnings potential. "Who knows how much XYZ can make in the next cycle?" is the refrain from those attempting to dismiss high current valuations. There are limitations as to how high they can get.

Some market cheerleaders even confront the valuation issue head on. Instead of considering high valuations a concern, these people contend that the market is cheap! They get there by citing a type of model -- some call it the "Fed model" -- that compares price-to-earnings ratios to bond yields. These market gurus contend that the 10-year government bond yield should equal the stock market's earnings yield. So, if the 10-year Treasury yields 4%, the stock market should have a price-to-earnings ratio of 25. Pricing the market at 25 times 2004 operating earnings (the most optimistic set possible) generates much higher stock prices. But, it's wrong.

Why? Well, except for during the bubble, we have never had 25 P/E ratios on the market. Also, a fair earnings discount model should use a fixed-income input with a similar duration as stocks. In today's market, that would be the 30-year bond. Heck, if you really want to make stocks cheap, why not put 1% cash rates into your model? Then stocks should trade at 100 times earnings!

Finally, most models included an equity risk premium to account for the lower safety and higher volatility of stocks vs. government bonds. Historically, this has been around 2%. My earnings discount model uses the 30-year bond at 5.25% plus 200 basis points for an equity risk premium. An earnings yield of 7.25% in stocks would result in a P/E ratio of around 15. The stock market may continue to appreciate, but stocks are hardly cheap!

Contrary Signals

Despite the bulls' growing aggressiveness, the stock market has been churning for quite some time. The

S&P 500

is not much higher than it was in June, when I penned the "sell" column. In my opinion, further churning over the next quarter would represent a good outcome for share prices. More likely is a market that corrects, or the secular bear might even resume.

Sentiment is extremely bullish today -- and viewed as a contrary indicator, generating a sell signal in my book. Insider selling is very strong into this big rally, another cautious sign. Seasonality is a major obstacle, with the worst months of the year just beginning.

The economy appears to be stabilizing, but a strong recovery, especially in capital goods and technology, appears unlikely. Operating rates are far too low to foster new investments. For consumer durables, pent-up demand just doesn't exist. Higher mortgage rates will temper the refinancing and cash-out boom of the past few years.

Corporate profitability may come in "better than expected" (what a silly concept), but the nearly peak profit margins forecasted in 2004 estimates will not occur. Nominal revenue growth rates have collapsed to midsingle digits for many sectors of the market. Lower top-line growth rates also need to be factored into stock market models, and they are not a positive.

Since my last column, I've been decreasing my equity exposure during market rallies. I'm now only about 20% net long. I still have a decent-sized long portfolio, but I have eliminated most of my tech specs and trimmed some of my controversial value names. I've kept stocks such as





(CI) - Get Report





Washington Mutual

(WM) - Get Report


Liz Claiborne


because they represent good companies at reasonable valuations. But I've also put on significant short hedges in the exchange-traded funds of the S&P 500, Nasdaq 100 and Russell 2000. I am also short


(AMZN) - Get Report

, which is very expensive and should start reporting decelerating revenue growth next quarter.

To most investors, this sell call appears dubious. Correct market calls often do at the time. I'm very comfortable protecting the well-earned gains from my

most exquisite

buy call of last October.

If you're buying stocks today because of the emerging "new bull market," remember this: The average stock, as measured by the Value Line Arithmetic Average, is up more than 50% since last fall. We have already had a major bull market! Maybe the part of the bull you're viewing today is its backside. If that's the case, can the bear be far behind?

Robert Marcin is the principal of Marcin Asset Management, a private investment firm. Formerly, Marcin was a partner at Miller, Anderson & Sherrerd and a managing director at Morgan Stanley, where he managed the MAS Value fund (currently Morgan Stanley Institutional Value). At the time of publication, Marcin was long Tyco, Cigna, Cendant, Washington Mutual and Liz Claiborne, short SPY, QQQ, IWM, and Amazon, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Marcin appreciates your feedback and invites you to send it to