The Economic Recovery: Have Stock Values Gone From Green To Yellow To Red?

Human psychology is a strange thing. Two months ago, I was fielding hostile questions from readers wanting me to defend my position that we were in neither another Great Depression nor a “lost decade” like Japan experienced in the 1990s.

Today I’m fielding questions from readers who are shoveling money back into the market - since they were earning next to nothing in cash anyway - and want to know what to buy to take advantage of the coming economic recovery.

What has actually changed over the past two months? Very little, really…

• The economy is still weak and losing 600,000+ jobs a month.
• Consumer confidence and spending is anemic.
• Housing remains mired in the quicksand.
• Banks are reluctant to lend; credit is tight.

The biggest change is simply investor perceptions about when an economic recovery will occur. And, of course, the recent surge in stocks.

Unfortunately, the uncertainty today is just as bad - if not worse - than it was two months ago. Here’s why there’s more cause for concern, not less, and what you should be doing about it.

Will We See An Economic Recovery In 6 or 9 Months?

As the old Wall Street saw goes, “Markets make opinions.”

Two months ago investors believed - and the market appeared to confirm - that the economy was in a freefall. Today investors argue about whether the economic recovery will kick in six months or nine.

• These new optimistic perceptions may be right - or even understated - in which case the market will keep spiraling higher.
• Or those perceptions could be wrong, in which case the market may go back into a funk.

I’m not going to opine about who is right at this juncture. We were pounding the table that stocks were dirt-cheap two months ago - and a 35% rally has vindicated that view.

But it has also erased a lot of bargains.

• Based on the last 12 months of operating earnings, for example, the S&P 500 (^GSPC) is currently at a forward P/E of 14.5 compared with a 25-year average of 15. That indicates that the market as a whole is fairly valued, not undervalued. However, it’s tough to put too much weight on a forward P/E ratio when the earnings outlook for many companies is so uncertain.
• So why don’t we look at the trailing P/E? In the fourth quarter of 2008 - for the first time in modern history - there were no collective earnings for the S&P 500. A P/E doesn’t mean much without the E.
• Yale economist Robert Shiller combats this by comparing stock prices to a 10-year trend in earnings adjusted for inflation. In March, his normalized P/E ratio dropped to 13, its lowest since 1986. (A superb buy signal, subsequently confirmed.)
• Now, however, the measure is close to its historic average with a reading of 16. Again, that suggests stock market returns will return to historical averages for the next 10 years.

We’ll see. But if you want superior returns, it’s probably too late for the shotgun approach. Better to get choosy.

Don’t be a buyer of highly leveraged companies or ones that are losing market share, experiencing flat sales or declining profit margins.

There are plenty of great companies, like Coinstar (CSTR), that are screaming buys right now. (We’ll highlight several of them in the days ahead.) But, if history is any guide, the Dow (^DJI) itself is not.

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