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Sunday, October 19, 2008

Fundamental Valuation: How Low Could We Go?

Came across this excellent article by Brett Steenbarger with the above titled here - http://seekingalpha.com/article/100533-fundamental-valuation-how-low-could-we-go?source=headline1

To me, the key chart is here:

Brett focussed on the S&P500. My own observations from Ned Davis Research chart above are:

* The estimated Book Value for S&P500 is around 615.

* S&P500 closed 940.55 last Friday.

* In the last 31 years, the S&P traded at an average of 2.4 times book value.

* In the last 31 years, the S&P traded at a low of below 1 times book value, and traded at a high of around 5 times book value.

* Based on the above chart, if one wants to buy at the lowest over the last 31 years, then, a definition of "cheap" is set at half the normal figure, i.e. 50% x 2.4 = 1.2 times book value.

* This suggests that "cheap" may be 1.2 x 615 = 738, or a further 22% downside, despite the new S&P low.

* Or if you think this is one hell of a financial crisis, and it could be worse, then, maybe even the Book Value itself could be possible (615), or 35% downside.

* At the moment, the S&P is trading at around 1.52 times Book Value. Whilst this is lower than the 31 year historical average of 2.4 times, it is still not regarded as absolutely cheap, which is around 1.2 times. There is still quite possibly, another 20% more downside to go.

* There is no rule nor law that says that the stockmarket must conform to this "31 year old pattern". Nothing is certain in stock markets.

* One thing certain is that you have been hearing pundits saying the "bottom is near". I don't know, but if we take the last 31 year old history into account, you could still suffer considerably if you just "Buy and Hold". Why buy for example at 950, only to see it fall to say 800 (or 750 or 700 or ... ) after 2 (or 3 or 4 or ...) months, and then takes say another 4 months (or 6 or 8 or ...) to rise back to 950, only to make nothing during that 6 (or 8 or 10 or ...) months? The key concept is why try to catch a falling knife, when doing so could hurt you and subject you to unnecessary anguish over a prolonged and uncertain period if you "buy and hold"?

* One thing we cannot discount is the possibility (and more like probability) that our KLCI will broadly track the US markets.

* In recent months, our KLCI has "outperformed" US markets, in that KLCI has not fallen as much as the US. However, if you believe in "reversion to the mean", this could actually be bad news, because what happens if the KLCI starts to "outperform" US markets as markets revert to the mean? Meaning, what if we start to see even faster downside for KLCI, as KLCI "catches up" with the US downside?

* Again, whilst nothing is conclusive.

* Markets are full of vested interests, there will be pundits taking positions or calling for positions at every level of the S&P from now down all the way to the lowest possible estimates. With reasons why the past will not repeat itself because certain events in the past are once-off, inflation adjustment, growth, past wealth creation, etc, etc. etc.

* If you have thought through all the issues, great for you! However, what is clear in my observation is that many pundits don't consider the possibility that somehow, the ugly (we've long past the "bad") could turn even uglier. There are no guarantees and certainties in stock markets. There is no rule that says that there is a minimum floor to the stock market. The only certainty in stock market is uncertainty will forever rule the stock market.

* But what I do believe is that success in stock markets depends on how we manage our risk in times of uncertainties. It's all about risk management.

Do give Brett's article a good read and an independent critical thinking.

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