The Simple Reason for Stocks' Hard Fall

February 2nd and Feb. 5th 2018 were market disasters. From the all-time highs set on Jan. 26, 2018, virtually every major index fell solidly into negative territory YTD. Everybody is asking, Why? The ferocity of the drop was not predictable. That blue-chip, large-cap stocks would correct sharply, though, was inevitable and long overdue. I picked four examples of these type stocks to illustrate but almost all DJIA members and the majority of the S&P 500's larger names sported similar valuations just days ago. In every part of the life there are mood swings. We all have good days, when everything goes great and bad ones, when nothing goes well. They tend to average out over time. Those same cycles play out in real estate prices and stock quotes. Asset values, just like manic/depressive individuals fluctuate between bargain prices and insane levels. Only when you understand what normal valuation is you can gauge whether any particular thing is cheap, dear or fairly priced. Stocks provide all the information needed to determine true fair values if you take the trouble to study their own past trading histories. Every equity has a normalized price to earnings ratio (P/E) and a typical dividend yield (if it makes cash payouts). Shares available at discounts to their own average levels tend to do well going forward. Traders who jump on the momentum bandwagon and pay higher than typical multiples while accepting sub-par yields don't fare as well. They are equivalent to people who buy/bought near the tops of peak real estate booms. They might see near-term price increases, but usually see things cool off, resulting in paper or realized losses. Boeing was the #1 best stock in the DJIA last year and through most of January, 2018. Here is what had taken place in its shares since 2011. From 2011 through early 2017 investors could have owned BA at reasonable price points. Its six best buying opportunities (green-starred below) offered people the chance to buy in at P/Es ranging from 9.4x to 15.8x current year's estimates. Dividends at those times all registered above Boeing's average level. Some ranged as high as 3.00% to 4.27%. All those valuation compared favorably with BA's long-term average P/E of 16.2x along with about 2.5% yields. At this year's peak price of $361.45 BA fetched a ridiculous 30.1x its forward estimate for 2018 while paying just 1.80%. The stock hadn't been nearly that expensive in many years. No wonder it has sold off since then. A regression to the mean normalized valuation for Boeing suggests it could fall to under $195 without even becoming historically cheap. As of Feb. 5, 2018, BA still commanded 27.4x this year's estimate while paying only 1.98%. If you own BA, ask yourself if the risk/reward justifies your investment Professional services firm Accenture exhibited exactly the same general pattern. Since 2011 ACN's average P/E ran 17.5x and its typical dividend was 2.14%. There were numerous chances to buy the stock cheaply (green-starred) along with better than average yield. At this year's peak Accenture fetched more than 24x earnings. It paid a historically meager dividend. From those inflated valuation metrics it was almost guaranteed to revert back towards normal, rather than becoming more extended. As of Feb. 5, 2018, Accenture was still pricey at 22.5x EPS along with a stingier than typical dividend. If ACN simply dips back to its long-term average P/E is could be $118 or so by year's end, about $33 below its current quote. Microsoft had a great multi-year run. Much of that price improvement was fueled by multiple expansion. It might surprise people that MSFT's average P/E since 2011 has only run 14.4x. A normal yield was 2.77%. ON a few occasions MSFT was available for single-digit P/Es. During parts of 2013 through 2016 it even offered better than 3% in yield. Why, then, should it have sold for almost 27x forward estimates just a few weeks ago while paying just 1.74%? While MSFT has dropped back since, it remains far from cheap, at 24.7x 2018 EPS along with just a 1.93% dividend. A full reversion to the mean target price could see MSFT back under $52, from its Feb. 5 close at $87.15. Market darling 3M is yet another example of how overpriced the blue-chip had become. Its long-term average P/E has been 18.3x. A typical payout was about 2.46%. At last month's all-time high of $259.77 it fetched 26.4x projected 2018 earnings and paid just 1.92%. By Feb. 5, 2018 it had given back around $28 per share but still commanded a 23.5 P/E while paying a less than average yield of 2.16%. 3M was available on many occasions for much more tempting valuations. There appears to be another $50 of downside risk if MMM simply regresses to a more average valuation. All four of the profile companies are posting record profits and have been raising dividends. Investor overenthusiasm had pushed their prices well above any rational level, based on their own past trading histories. The next time someone asks you why the indices plunged you can tell them it was all about over-priced stocks, not higher rates, not political matters and certainly not because the companies weren't doing well. There are plenty of good values in today's stock market. The trend toward mindless index fund investing and robotic asset allocation of money, though, conspired to send large-cap, blue chips to unsustainable heights. Avoiding clearly expensive stocks and concentrating on out-of-favor names is the key to achieving good future results.

The Simple Reason for Stocks' Hard Fall

There's really no mystery to why stocks fell so sharply.

Columnist Conversation

Exiting Some Nice Gainers -- JPM, CERN

Cutting the Puts

More of that "Non-Existent" Inflation for New Yorkers

COLUMNIST TWEETS

Please Join or Log In to manage and receive alerts.