*****Warren Buffett's commonsense approach to valuing the stock market

Warren Buffett does not possess a magic formula for determining when the stock market is grossly overvalued or undervalued. By all accounts, his decisions to plunge into or escape from the market are based on several commonsense factors.

1. The relationship between stock yields and bond yields.
2. The rate of climb in the world.
3. Earnings multiples.
4. The state of the economy.
5. The big picture.

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1. The relationship between stock yields and bond yields.

EY = 1/PE
Bond yields = Coupon rate

• Buffett covets stocks that offer earnings yields that can surpass bond yields over time. (EY of stock > Bond yields)
• When bond yields are rising and threaten to overtake stock yields, the market is generally overvalued. (Bond yields > EY of stock)
• When stocks fall to the point where their earnings yields are above bond yields, they are most attractive.  (EY of stock > Bond yields)

2. The rate of climb in the market.

History tells us that the stock market cannot outperform the economy for very long. That is, you shouldn't expect corporate sales, earnings, or share prices to rise at rates in excess of economic output.

• If stock prices are rising at, say, four times the rate the economy is expanding, the market is primed for a fall at some point.
• Conversely, if stock prices are falling while the economy is surging, an undervalued condition may be opening up.

3. Earnings multiples.

In 1982, the PE ratio for the S&P 500 index was just 7 (Americans were willing to pay just $7 for every $1 corporations earned on their behalf).

By mid-1999, Americans were willing to pay $34 for every $1 of earnings generated by these same companies.

What explained the disparity?

• Falling interest rates accounted for some of the increase in PE ratios. Declining rates make every $1 of earnings worth more to an investor.
• Improved profitability also accounted for some of the increase in PE. By the late 1990s, corporate returns on equity and assets had reached 70-year highs. It stood to reason that $1 of earnings carried more value because corporations could reinvest earnings at high rates.
• Yet the majority of the climb in stock prices can be attributed to emotion - the sheer willingness of investors to pay higher and higher prices without regard to value.

When PE ratios are expanding faster than what could be expected, given changes in interest rates and corporate profitability, investors must be on the alert for a correction.

4. The state of the economy.

When the economy is running full throttle and there seems to be little chance of it sustaining present growth rates, investors should ponder whether to decrease their exposure to the stock market and find alternatives.

Likewise, during tough economic times, stocks usually fall to bargain levels and offer high rate-of-return potential. Using Buffett's 15% rule, you can quickly gauge whether stocks are worthy of holding.

The general rule is to buy during a recession (when PE ratios are at their lowest) and to sell when the economy can't get any stronger (and PE ratios are their highest).


5. The big picture

Because Buffett endeavors to hold a stock for several years or more, he must take a more holistic view of companies, industries, and the entire market before buying.

Buffett won't buy or sell a stock in response to near-term changes in a company's profitability, nor will he pin his hopes on a sector "catching fire" on Wall Street to sell at a higher price.

Instead, he assesses longer-term fundamentals in the economy and the market and examines whether those fundamentals can support higher stock prices. If a stock doesn't offer the potential rate of return he seeks, he is likely to sell the security or avoid buying.

http://spreadsheets.google.com/pub?key=t7u4BYlpDKstozulNims5Hw&output=html

From the above spreadsheet, Buffett prefers to play an economic cycle to the fullest, whenever possible.

• During a recession, when nearly all US industries are experiencing a downturn, Buffett is apt to load up on numerous stocks, knowing that several consecutive years of improved profitability lie ahead.
• When the economy peaks and odds favour an eventual slowdown, selling is the prudent course.
• When stocks fall to the point where their earnings yields (1/PE) are above bond yields, they are most attractive. (EY of stock > Bond yield)