Last Bastion of Higher Stock Prices Turning Negative

The only time-proven market indicator that said stocks were undervalued for most of 2010 and 2011 is turning negative.

The Price/Earnings (P/E) ratio takes the current market price of a stock or index and divides it by the earnings of that stock or index.

Historically, P/E ratios between five and 10 are considered undervalued and indicate a good time to invest in stocks, with the thesis being that corporate earnings have bottomed. When the range is 10 to17, the companies/indices are considered at fair value by most stock market analysts; 18-25 is overvalued; with anything above 25 being considered a bubble (the S&P 500 was well above 25 during the tech bubble of 1997 to 1999).

Personally, given the low-interest-rate environment of today, I see stocks as a bargain if the P/E ratio is between 10 and 12 and corporate earnings are not nose-diving.

It is said that the stock market is the most efficient valuation tool in the world for valuing companies. In 2010, the stock market knew 2011 would be a great year for corporate earnings, hence stock prices moved higher in anticipation of higher corporate earnings.

Even with the latest rise in the stock market, the S&P 500’s current P/E ratio stands at 15.13, while the Dow Jones Industrials’ P/E comes in at 13.77. This would be considered fairly valued.

Some would make the case that any upside surprise in the U.S. economy would result in strong corporate earnings, which would move such a fairly valued market much higher.

The problem with this rationale is the “E” in the P/E—corporate earnings per share. I noted just yesterday how blue-chip companies in the S&P 500 and abroad are struggling in this environment. Over the past month, I’ve been talking about how the recession in the eurozone is causing growth to slow sharply in both Asia and the U.S. (See: Half of the Eurozone Downgraded: Time to Start Worrying.)

In the U.S., this slow growth environment (which I believe could become a recession) means corporate earnings are going to come under extreme pressure. Already, companies are blaming the difficult global economic environment for their lowered 2012 corporate earnings forecasts.

I have a feeling that P/E ratios for both the S&P 500 and the Dow may challenge the undervalued levels closer to 12 or even 11 in 2012, as disappointing quarterly corporate earnings begin to pour in. The market may be undervalued at that point, but I don’t believe the market will perform well in such an environment.

Dear reader, at these fairly valued P/E levels, the S&P 500 and the Dow Jones Industrial Average do not look attractive. If you want to jump into stocks with the hope that corporate earnings will turn higher in 2012, it’s your choice.

Just keep in mind that that roar you hear in the background is the bear lurking in the shadows. I know I’m not buying into this market (except for gold-related investments); I’m just sitting back waiting for one final blow-off to the top for the bear market rally that started in the spring of 2009. (Also see: Official Numbers in: 2012 Not Looking Good.)

Michael’s Personal Notes:

The king of the hill no longer…and a good lesson:

It was not surprising to hear that the co-CEOs of Research In Motion Limited (NASDAQ/RIMM) had stepped down earlier this week amid a falling stock price, poor investor sentiment, falling corporate earnings growth, and increased shareholder pressure to find a way to compete with Apple Inc. (NASDAQ/AAPL) and Google Inc. (NASDAQ/GOOG), which have both been steadily eating away at smartphone market share.

It was not surprising either to hear that, amid the economic turmoil, International Business Machines Corporation (NYSE/IBM), or IBM, the world’s largest computer-services provider, not only beat fourth-quarter 2011 estimates with its corporate earnings, but also painted a strong picture for 2012, boosting investor sentiment.

The “BlackBerry” set the standard for the smartphone industry and provided Research In Motion with an enviable brand name that stood for quality and ease-of-use (sometimes referred to as “CrackBerry” by those so addicted to it), which propelled their corporate earnings and their stock price, amid positive investor sentiment. However, Apple and Google redefined the smartphone industry, turning the almost untouchable BlackBerry into an inferior smartphone; the king of the hill no longer.

In 2004, when IBM decided to sell its personal computer business to Lenovo Group Ltd. (Pink Sheets/LNVGY), some people were very surprised. IBM’s management team understood that the personal computer business had become a commodity business. Future corporate earnings growth would have to come from focusing on the services side of the business, leveraging the solid brand name that IBM had garnered.

Contrast IBM’s decision to Research In Motion’s. IBM’s management team was proactive and responded to the changing dynamics of its industry, as was eventually evidenced by the company’s spectacular corporate earnings. Research In Motion was late in responding to what competitors were doing, instead of taking the lead that it had, introducing new products or entering new market segments, leveraging its brand name.

For Research In Motion to succeed at this point, it needs to redefine the smartphone or improve its product line.

This is easier said than done, because now, Research In Motion’s once stellar brand has been tarnished. Had IBM remained simply a personal computer manufacturer, its brand name would have easily been reduced to “little blue,” reflecting stagnant corporate earnings, instead of the respect and positive investor sentiment it garners today with the brand name of “Big Blue.”

Other hardware makers followed IBM after realizing that business services were where the growth and margins would now come from. IBM was able to not only maintain its market share, but also grow it. Today, IBM is once again redefining itself. The company is focused on generating half of its corporate earnings from business software programs that will help businesses analyze and project trends.

There is a big lesson to be learned here from an investor’s point of view.

IBM’s management team is proactive, responsive to their market’s needs, and is constantly searching for the next opportunity to redefine their industry and increase corporate earnings. Research In Motion’s management’s team failed to take advantage of their lead and brand name in order to expand their market share and/or define other market segments they could have aggressively pursued for future growth.

Research In Motion is now in a reactive mode to what the market is already doing. The stock is a very risky proposition here, in my opinion, because the next stage is going to be a critical one. Investor sentiment is understandably at a “prove it” stage. If the company doesn’t execute, its once-elite brand will be reduced to the dustbin and, along with its stock price, corporate earnings growth will disappear.

When it comes to investing, yes, corporate earnings, dividends, and valuations are very, very important. But you cannot underestimate leadership. Steve Jobs put Apple in a position whereby it led the industry with new and exciting products. Thomas Watson, the “father” of IBM who was with the company for 42 years, was famous for simply focusing executives on THINKING.

I cannot stress how important leadership and ingenuity are for a company’s success. It’s something most investors fail to look at when buying the stocks of public companies.

Where the Market Stands; Where it’s Headed:

If today was the last trading day of January, the Dow Jones Industrial Average would be up 4.3% for the month. Let’s not celebrate just yet. We have two trading days left. I bring this year’s performance up to remind my readers that last January we also had a great start to the year for stocks—but the year in total ended up being almost flat for the stock market.

We are in a bear market rally in stocks that started in March of 2009. This rally is getting old and tired, but still has life left.

What He Said:

“A Stock Market’s Obituary: It is with great sadness that we announce the passing of the Dow Jones Industrial Average. After a strong and courageous battle, the Dow Jones fell victim to a credit crisis and finally succumbed on Friday, October 3, 2008, when it fell decisively below the mid-point between its 2002 low and its 2007 high.” Michael Lombardi in PROFIT CONFIDENTIAL, October 6, 2008. From October 6, 2008, to November 27, 2008, the Dow Jones Industrial Average experienced one of its biggest two-month losses in history.