Source: Http://www.ritzholtz.com

This is a historical chart of the S&P 500’s Price-to-earnings ratio (P/E). For those that don’t know, a P/E ratio tells you how many years of a company’s earnings it will take to buy it outright.

So – if you buy a company for $1,000, and it earns $100 a year, you’re said to have a P/E ratio of 10 ($1,000 / $100).

In other words, it would take you ten years to break even (As a buyer).

Today, the S&P has a P/E of 12.6. But in the early 20’s, 30’s and late 80’s, this ratio dropped to as far as 5.
This can only mean one thing: Stocks have just entered fair value… the market as a whole isn’t even cheap yet!

The reason why is because we’re in a market where both earnings and stock prices are dropping dramatically.

This also means that shorting the S&P 500 as a whole is still a generally safe bet. You can do that by issuing a short-sale on the SPDR S&P 500 ETF (NYSE: SPY).

This from Money Morning:

The consensus estimate of earnings for the Standard and Poor’s 500 Index for 2009 is currently about $83. The index itself is currently standing at about 904. That means the market is trading on only 10.6 times next year’s forecast earnings, far below the historical average multiple.

So it is a screaming buy, right?

Not so fast.

“Consensus” estimates of earnings lag reality substantially. Because they include an average of all earnings forecasts over a considerable period, forecasts made in late September would still be included in today’s consensus estimate. But in a period such as the present, when reality has changed substantially since September, the official consensus forecast may differ wildly from what most analysts currently believe. The $83 number is thus a lagging indicator, which doesn’t take account of financial sector disasters, sharply slowing output, or tight credit conditions.

Most analysts, finally made more cautious by five successive quarters of declining earnings on the S&P 500 index, currently believe that the S&P 500 will earn about $60 in 2009. What’s more, David Rosenberg of Merrill Lynch & Co. Inc. (NYSE:MER), who has been exceptionally bearish for some time with an estimate of $50, has been joined in bearishness by Goldman Sachs Group Inc. (NYSE:GS), which has brought its group estimate down to $53.

That’s much more scary. Taking the average S&P 500 multiple at around 14 times earnings, an earnings estimate of $60 would put a “median” estimate of the index at 840; an earnings estimate of $50 would put it at 700. Take a bear market low at 10 times earnings, and you could postulate an S&P 500 low of 600 or even 500.

Still, bear market earnings estimates can be taken only so far, especially those of analysts. After all, on July 7, 2008, a joint report by two top houses predicted that the S&P 500 index would have its best six months since 1982 in the latter half of 2008. That’s about as wrong as they could possibly have been!

Still, one should not be surprised by their failure; while one of the two well respected but wrong houses was Deutsche Bank AG (NYSE:DB), the other was – Lehman Brothers Holdings Inc. (OTC:LEHMQ). Truly, a lot can change in six months.

2009 Bears

Nevertheless, while it’s clear that from an earnings viewpoint 2009 should be approached with caution, it is also clear that some sectors and countries will do reasonably well, while others have futures that are truly scary.

Some of the more bearish sectors and regions include:

• Financial services: The entire industry appears to be scaling down to a fraction of its 2007 size, as many of the innovations of the last 20 years turn out to have been spurious. Investment management also is destined to be much less innovative and less lucrative in the wake of the Bernard Madoff scandal. Eventually, banks and other financial institutions will emerge from the downsizing, but 2009 is much too early to expect that.

• Real estate and construction: Housing won’t bottom out until mid-2009 at the earliest, and will recover only very slowly thereafter. Non-residential construction will also be very limited, as offices, stores and hotels will be in glut. There may be some money to be made in road construction from President-elect Obama’s infrastructure program, however.

• Emerging markets with no money: The emerging markets that rely on borrowing to fund themselves will be out of luck, as debt will be expensive and hard to come by. Eastern Europe and most of Latin America will be in for a thin time, as their balance of payments and in many cases budget deficits will take years to straighten out.

• Western European countries with high cost bases: The Western European countries with expensive labor and high taxes will find life tough in 2009, particularly if they previously enjoyed a real estate bubble or were big in finance. Germany will probably do fine because its high-skill labor is highly competitive and it had no housing boom; Britain, Spain and Italy will be in a much more difficult situation.

2009 Bulls

Conversely, there will be sectors and countries whose earnings can be expected to hold up well, and whose shares are worth looking at:

• Gold mines: Inflation is almost certain to return in 2009, because of all the fiscal and monetary stimulus. That has to be bullish for gold, other precious metals, and mining companies.

• U.S. exporters: The rest of the world will show some economic growth, and the U.S. budget and payments deficits and expansionary monetary policy will make U.S. exporters benefit, unless they are involved in businesses that depends heavily on tourism, such as aircraft.

• Healthcare providers: Pharmaceutical companies may have problems with President elect Barack Obama’s healthcare plans, because the returns for patented drugs will be reduced, but hospital chains and other healthcare providers will probably benefit from an overall increase in government healthcare spending.

• Asian countries: In general, Asian countries will do better than the United States and Western Europe, because their cost bases are less overblown and their competitiveness is greater. China and India may have problems, but I like the prospects for Korea, Taiwan and Japan and for companies in those countries involved primarily in their domestic markets. If the Indian election in spring goes to the pro-business BJP party, it will be a buy too; if not, India will have difficulty funding its overblown government sector.

• Brazil: Brazil has a well-balanced economy, less foreign debt than it used to have, and a monetary policy of high real interest rates. It can, therefore, afford to expand domestically through monetary means in a way no other country can.

Source: Gloomy Earnings Prospects Hold Key To Stock Buying

This from Penny Sleuth:

Here in the United States, the household savings rate has stayed below 2.5% since 1999, according to our friends over at The Economist. Instead of stashing our money in savings accounts, we spent with reckless abandon and used our homes as savings, borrowing against their ever-increasing value whenever cash was needed.

But now that the stink has hit the fan, the once unstoppable American spender is doing something quite curious: playing it safe with his money. And he’s certainly not buying stocks. One look at the crashing yield curve says it all. No-interest 90-day T-bills are flying off the shelves…

Of course, the same folks who are buying Treasuries and stuffing money under mattresses right now are the ones who were telling us house prices would never go down and subprime was nothing to worry about. Looking back even further, these were the same people frantically buying stock back in late 1999, when the global price-to-earnings was 35.

The Economist writes that when American P/E ratios are low, returns on equities over the next 10 years average 8%. And when they are high, returns average 3%. You can’t argue with those numbers. The time to consider stocks best is while everyone else’s back is turned. We’re looking at a global P/E near 10 right now…opportunity awaits.

Follow the Crowd and You’ll Miss Great Opportunities…

For every brilliant idea, there’s someone waiting to call it a blunder. Many people consider the light bulb to be one of the most important scientific innovations of the last hundred years.

But this wasn’t always the case. To some of the greatest scientific minds of the late 19th century, Thomas Edison’s light bulb was a foolish toy…

“[The light bulb is] good enough for our transatlantic friends… but unworthy of the attention of practical or scientific men,” decided the British parliamentary committee in 1878.

In 1880, Henry Morton, president of the Stevens Institute of Technology, claimed “Everyone acquainted with [the light bulb] will recognize it as a conspicuous failure.”

Looking back now, we see these critics as fools. The light bulb became the founding invention of Edison’s small business venture — a company we know as General Electric. As gratifying as Edison’s victory was personally, the financial windfall for Edison and his early investors, including J.P. Morgan and the Vanderbilt family, helped create some of the greatest fortunes in history.

Are there more brilliant inventions out there for the taking right now? You’d better believe it…

Source: Low P/E Ratios Spell Opportunity as Investors Flee to T-Bills

1. That the recession is short and shallow, and something resembling healthy growth will resume beginning in the second half of this year.

2.That company earnings will once again enter double-digit territory in the second half of this year.

If you want to get sucker-punched by these false good tidings, then all you have to do is fall for the improvement of a company’s forward P/E compared to its TTM (trailing twelve months) P/E ratio. For example, if a company shows a TTM P/E of 15 going to a forward P/E of 12), you’d be investing on the premise that the company’s earnings in the next year will go up over 25 percent. You have to ask yourself, what are the chances of that actually happening?

PEG ratios have also been sucked into Wall Street’s inflated numbers. The “G” or “Growth” part of the PEG ratio looks at growth for the next five years. That number is way higher than it should be, because (as I’ve been saying for months) this recession is neither shallow nor short.

Finally… in the face of housing starts, housing inventories, foreclosures, consumer sentiment, durable orders and a host of other indicators hitting lows not seen for either years or decades, Wall Street is beginning to catch on.

J.P. Morgan cut its second-half-growth forecast by one full percentage point to 1.25%. I have a feeling other brokerages will be following suit.

These reassessments are lagging badly behind the data. It’s almost as if by closing its eyes, Wall Street is trying to will the economy into turning around. But the real laggard is earnings expectations. They’re even trailing behind the broader economic predictions.

It’s setting up the market for a fall in the second half of the year. We all know that markets move up and down based on expectations. And when expectations aren’t met, share prices can go south quickly.

The market went up last week. That means there’s hope. And hope is the last thing the market needs. Hope floats expectations. But it does nothing to raise company performance. And that disconnect is going to kill the market as summer turns to fall.