How to Pick Stocks in the 'New Normal' Economy

[Editor's Note: Capital Wave Forecast Editor Shah Gilani brought the two news anchors on Fox Business up out of their chairs with his "gutsy call" during a morning appearance on their show this week. Watch this video clip to see what prompted this response from the TV commentators and find out what stocks Gilani is recommending now.]

In today's potentially ultra-slow-growth "New Normal" economy, old stock market multiples do not apply.

In fact, investors who rely on long-held rules about Price/Earnings (P/E) ratios when they buy and sell stocks are risking a pretty big "haircut:" They may be overvaluing some of their stocks - and the stock market in general - by 17% to 20%.

Let's take a closer look...

The "New Normal" Spawns New Rules

The recently popularized term "New Normal" economy refers to expectations that U.S. growth will be sub-par for several quarters - and quite likely for years - to come. At the same time, key emerging markets elsewhere in the world will continue to post rapid growth.

These divergent outlooks - upbeat for those emerging markets, downbeat for the U.S. economy - spells opportunity for companies with a global reach. And that divergence promises lackluster performance for "New Normal" economy companies - those whose products and services are tied solely to the domestic U.S. economy.

The companies experiencing the fastest profit growth will be "non-New Normal" firms - those that derive more than 50% of their revenue from surging emerging-market economies. Those stocks will warrant the more "normal" earnings multiples, as we shall see.

Investors need to understand the difference in order to evaluate Wall Street's earnings forecasts, and to determine whether a given New Normal stock is over, under, or fairly valued at a given price and P/E-ratio level.

Here's why.

Research shows that long-held beliefs about what constitutes "fair" or "warranted" P/E ratios are leading to substandard returns - for two very clear reasons.

First, keep in mind that - as a ratio - a P/E is basically a calculated relationship between two pieces of information: The price of a company's share of stock, and the per-share earnings (EPS) that company is expected (or projected) to earn.

The problem with those earnings projections is that most analyst forecasts are far too rosy.

Wall Street Overshoots on Profit Projection

In the July issue of its quarterly business journal, consulting firm McKinsey & Co. studied the last 25 years of stock-market-analyst forecasts, concluding that "on average, analysts' forecasts have been almost 100% too high." During that quarter-century stretch from 1985 to 2009, equity analysts projected earnings growth of 10% to 12%.

Actual earnings growth during that period was 6% - or half of what the Wall Street set had forecast, the McKinsey Quarterly article concluded.

Unfortunately, lousy earnings forecasts are just one problem. There's another issue that is just as bad: Forecasters failed to understand how deeply market volatility undercuts valuations.

New Normal Volatility Demands New Market Multiples

For the "New Normal" stocks, earnings multiples need to be re-evaluated because they don't have the same potential high growth trajectory that companies exposed to global markets have. The historic market multiple (P/E) of 15.7 that investors apply to domestic-only companies is way too high.

Not surprisingly, it's increased market volatility that undercuts the old multiple.

In an empirical study titled "The P/E Multiple and Market Volatility," two professors and a quantitative analyst wrote in the respected Financial Analysts Journal that that market volatility deserves to have a significant impact on "warranted" market multiples.

The authors concluded that their study suggested that "a permanent one-percentage-point increase in market volatility can, over time, reduce the market multiple by 1.8."

Market volatility is typically a measure - in percentage terms - of the expected annualized movement of the Standard & Poor's 500 Index. If volatility is said to be 10, it means that over the next 12 months the S&P 500 could swing 10% - in either direction.

Average volatility during the postwar period up to 1995 was 17. From 1990-2008 - after a switch to our modern-day volatility measure (the Chicago Board Options Exchange Volatility Index (VIX), an implied-volatility calculation derived from index options) - the average volatility jumped to 19.49.

From 2005 to the middle part of this year, the VIX averaged 22.86. (For some perspective, at the height of the credit crisis on November 24, 2008, the VIX reached its all time high of 80.86.)

If we average the three overlapping periods that I mentioned, the volatility would be 19.78. But, in what might be considered a precursor to the New Normal, the average of 22.86 for the past five years is a full three percentage points higher than the rolling average of all the post-World War II years right up to the present day.

Stocks and the market have been considered fairly priced when they trade at a historically normalized 15.7 times "forward" earnings.

But if we use the three authors' research on volatility influences - which says that every one-percentage-point increase in market volatility reduces the "warranted" market multiple by 1.8 - the "New Normal" economy market multiple might be as low as 10.3.

The exact middle ground between the old standard market multiple of 15.7, and the 10.3 multiple the New Normal implies, is exactly 13. So, let's use the middle ground to see how the market looks now.

What Are Stocks "Really" Worth?

Standard & Poor's estimates that the S&P 500 will earn $81.72 this year. At a P/E of 13, the S&P would be trading at 1,062. If we use the "Old Normal" benchmark multiple of 15.7, the S&P index would be fairly priced at 1,283. Since the S&P 500 has been trading a lot closer to 1,062 than to 1,283, maybe the New Normal is already old news.

The Standard & Poor's 500 closed yesterday (Wednesday) at 1,106.13.

When it comes to individual stocks, investors need to know which camp the companies they hold or are interested in fall into. We've already established that some of the most promising stock-market profit opportunities will be those "non-New Normal" companies that derive at least 50% of their top-line revenue from emerging-market economies.

"New Normal" economy companies, by contrast, are the firms whose fortunes are fully tied to the slow-growth U.S. market. In other words, New Normal stocks are really the shares of U.S. firms that do not sell their products and services to high-growth markets outside U.S. borders.

It's important to point out that not all U.S. firms are New Normal economy companies. It's all about the markets they sell to.

An excellent example of a U.S. company with a terrific international footprint is E.I. du Pont de Nemours & Co. (NYSE: DD). On Tuesday, DuPont posted blowout second-quarter earnings. But it wasn't that net profits were up almost 300% that impressed analysts: It was the fact that DuPont's revenue advanced 26%, with 60% of the top-line sales emanating from overseas markets.

Emerging-market sales advanced 32%.

An important takeaway from this earning's season is this: While not all companies that reported improved earnings saw their share prices increase, those that did rise didn't sustain their positive advances.

Meanwhile, companies that reported significant revenue gains in emerging-economy markets have held onto their recent gains. Indeed, in the two weeks since I recommended DuPont to subscribers of my Capital Wave Forecast private-advisory service, the stock has already advanced 8.5% .

If there's one final lesson to be learned here, it's this: For your global players, use the old standard P/E multiple of 15 times earnings as your comparative valuation benchmark. But, for the New Normal companies, you'll need to use the new standard multiplier of between 10.3 and 13 or less.

Actions to Take: In the slow-growth "New Normal" economy, it no longer makes sense to use a single P/E multiple to evaluate all stocks. Companies that derive at least half of their revenue from faster-growing, emerging-market countries likely deserve this richer multiple. And while there's nothing inherently wrong with most of the companies that cater exclusively to U.S. economy customers, they don't merit the same high multiples as companies that sell into a faster-growing market. So apply your P/E multiples wisely: Use an earnings multiple of 15 for global players, and a P/E of between 10.3 and 13 for companies catering to the (domestic) New Normal economy.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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