Making money.

Years ago, my friend Bob Meier told me that bears start every bull market. Sounded strange. But it’s true.

Bulls push rallies farther and higher on big hopes, but they’re not the ones to start them. But bulls are like adolescents. They don’t handle adversity well. And just about the time the bulls are upset because they aren’t going to make 40% a year, the bears are smelling honey in those trees. They are seeing stocks that should go up 15% to 20% and priced at half to two-thirds of their fair value.

But how does a bear know what the fair value is?

Because the market has standards and traditions. Bears are the ones who know them.

For instance, you have heard that the normal historical P/E for the stock market in the United States is 15. Good research shows that it is actually around 16 (Jeremy Siegel) to 17 (Ned Davis). It swings around those numbers, not often much lower, but in recent years a lot higher.

And today the P/E ratio for the S&P based on the last four quarters’ earnings (the trailing 12 months or ttm) is only 10. It hasn’t been this low since the early1980s. Right before the last great bull market.

Things are just as deeply discounted on other valuation scales. The price to sales ratios for the NYSE and Nasdaq average 0.85 today. That implies almost everything is a great bargain because a ratio of 1.0 is considered a strong value. Most of the time, this ratio is closer to 1.2 to 1.5 and it sometimes goes much higher.

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Price to book value? It is actually 1.0 for Nasdaq and 1.5 for the S&P 500. The implies that most companies are now selling for the replacement cost of their assets or exactly what shareholders have invested in the company. The S&P’s price to book ratio is usually over 2.0, and a ratio of 4.0 is not uncommon because a business is much more than a package of assets. 

Finally, there’s price to cash flow. I like to see a ratio of 10.0 or lower, and it can be a challenge to find strong companies going for less that 15 in many years. Today the market average is 8.5 and the S&P is 9.9.

Now why would that make a bear happy? Because if he buys a stock that’s at a P/E of 10 today, and it usually goes for a P/E of 18, he’s already got one paw in the honey jar. The stock should appreciate by 80% simply if it can get back to its normal valuation. Then add any growth on top of that and you are seeing triple digit gains.

But don’t expect that these bargains mean the market “must” turn around immediately and sharply. The real bears are cool value hunters, typically cautious and experienced investors. They are likely to average in carefully.

Still, if you want a reason for the stock market to take off—turn on the Bernanke-Greenspan show and simply look at the stock market. The reasons for the next bull market are already in place.

This entry was posted on Wednesday, November 5th, 2008 at 4:40 pm and is filed under Resources. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.