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Are Stocks Really Cheap?: SPY, TLT, POT, SDS

Whenever the stock market comes under some pressure, the rallying cry from bulls is almost inevitably that “stocks are cheap!” Over the past week or so, we have heard more and more pundits and analysts come on TV and tell us that the market is a bargain after this ferocious sell-off (sarcasm intended). With all the panic and commotion, one would think the market is down 20% over the past month. But, the SPDR S&P 500 ETF (NYSE: SPY) is only down 7% from the 2012 highs. The fairly moderate drop has not created a compelling reason to buy stocks, at least from a valuation standpoint.

One can make a compelling argument that, relative to treasuries, stocks are a much more attractive investment, and that yields can’t possibly go lower. The yield on the 10-year is currently sitting at about 1.66%, not far from historic lows. Also, the iShares Barclays 20+ Treasury Bond ETF (NYSE: TLT) has rocketed higher over the past year, and is near all-time high levels. So, yields can’t possibly go lower, and the TLT can’t possibly keep going higher, right? I’m not so sure. From a valuation standpoint, and given all the economic headwinds/diminishing impact of easing, I am not head-over-heels about stocks in general.

Forget all the noise with the headlines, and let’s just look at some valuation numbers and facts. At the moment, the P/E of the S&P 500 stands at ~15.1x. This is above the historical median of 14.5x, and about inline with the historic mean of 15.5x. In other words, the current P/E doesn’t scream “buy.” For history buffs, the lowest the P/E ever got was 5.3x in 1917, or eight years after the Cubs won their first and only World Series.  The max was 123.7x in 2009.

The news gets worse if we were to use the Case Shiller P/E ratio, which is based on the average inflation-adjusted earnings from the prior ten years. Using that model, the S&P 500 is saddled with a P/E of 21.1, compared to a median of 15.8x and mean of 16.4x. So, if anything, the market looks fairly valued or perhaps slightly expensive, using these models.

We haven’t yet discussed the inaccuracy of future earnings predictions from analysts, which are oftentimes, far too rosy, and are slow to ratchet estimates down. This, of course, is especially important now, as the economic data continues to weaken. Here are some stats to consider, courtesy of McKinsey Research. Over the past 25 years, analysts have estimated S&P 500 earnings growth of 10-12%, compared to actual growth of 6%. Also, over this period, actual earnings growth surpassed forecasts on only two occasions, and in both instances, this was during the earnings recovery following a recession. Therefore, it is possible, if not probable, that current estimates – or the “E” in the P/E – is too high at this point, making the valuation look more attractive than it really is.

With that said, there are some good stocks that are trading with attractive multiples. For instance, Potash (NYSE: POT), the producer of fertilizer and feed products, is trading with a 1-year forward P/E under 10x, as its stock is trading at levels not seen since the summer of 2010. The stock has recently been hit by a USDA report that showed that corn planting and corn supply is far above last year’s pace, limiting the need for farmers to use more fertilizer this year. However, the sell-off may have created the opportunity to pick up shares at a discount as the food/ag “super cycle” plays out over the coming years. In short, the world’s population is increasing, while farming acreage is shrinking, creating a favorable dynamic for food prices. This increases farming income, allowing POT and other companies to raise prices.

Overall, however, I believe that investors and traders need to be more proactive than ever, and should be in a defensive posture. The global economy is incredibly fragile, as recent data has shown, but there is another economic model flashing clear warning signs to investors. That model is the Investment Rate, which was developed by Tom Kee, Jr, the Founder and President of Stock Traders Daily. Mr. Kee says that it is the most accurate leading longer term economic and stock market indicator ever developed, and yet, it is only now beginning to gain recognition. It predicted the Great Depression in advance, the Stagflation period of the 1970s in advance, the up-trends in between, and is now telling us that the economy has already entered the 3rd major downturn in U.S. history. The Investment Rate is a measurement of demand levels for all investments, using demographic and economic trends. It is vital that investors familiarize themselves with this model, and you can do so by signing up for a free trial here.

In conclusion, knowing what we now know about stock valuations and analysts’ estimates, and combining that with the macro environment we are in, and with what the Investment Rate tells us, we need to be proactive. Protecting your portfolio through instruments like the ProShares UltraShort S&P 500 ETF (NYSE: SDS) is a highly recommended strategy and is one that I have implemented for insurance purposes.

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