Cheap Is a Relative Term

• ByChris Versace, RealMoney Contributor
• On 2:59 pm EST, Tuesday December 9, 2008

Over the last week or so, I have read a number of analyst reports touting some of the stocks they cover as cheap and encouraging investors to snap up shares. Well, I could be partially wrong here, but usually stocks are cheap for a reason and a good strategy looks for a thematic reason or two as well as a catalyst to support building a position in a stock.

There is the absolute version of cheap -- a company's own valuation metric (as in "It's trading at __ times") -- and then there is relative cheap, which compares a company to its peer group or to the overall market multiple. Either it's trading at a premium or a discount for what the market should view as a fair reason -- most of the time.

The market multiple has been on my mind the last two weeks, particularly as we have a rash of preannouncements, recent earnings results and outlook adjustments as part of November sales data.

Despite the bad economic data points late last week -- the jobs report and so on -- the market managed to shrug off worse-than-expected bad news to rally late Friday. Still, the S&P 500 finished down 2.3% for the week and remains down 40.3% year to date.

Currently, Street expectations per First Call are calling for $86.25 in operating earnings for the S&P 500 in 2008, which is up modestly compared to the $85.12 posted in 2007. Most of the weakness in 2007 came in the fourth quarter, with earnings of $16.14, which one would think makes fourth-quarter 2008 an easy comparison.

However, the current consensus of $19.76 for fourth-quarter 2008 earnings is essentially flat compared to the previous quarter. Consensus expectation is for the S&P 500 to deliver operating EPS of $92.49 in 2009, up 7.2% year on year.

This is where it starts to get interesting -- or scary, depending on your perspective. Over the last few days, we have heard the following:

• Nokia cut its forecast for the global handset market for fourth-quarter 2008 and full-year 2009 for the second time in three weeks. This effects not only Nokia but the entire ecosystem: from its competitors, such as Motorola , Samsung and the like, to semiconductor suppliers like Texas Instruments and STMicroelectronics , display companies and other suppliers.

• RF Micro Devices lowered its fiscal third-quarter revenue outlook because of weak demand.

• Merck warned that next year's earnings would fall well below Wall Street estimates. The company claimed its 2009 profit before special items would be $3.15-$3.30 a share, compared to the $3.52 the Street was expecting.

• Sonoco lowered fourth-quarter 2008 EPS guidance to $0.48-$0.52 from $0.60-$0.64.

• Gentex announced lowered guidance from approximately 15% below fourth-quarter 2007 revenues to more than 25%.

• II-VI Inc. , which produces laser parts for aerospace and military customers, lowered its profit and revenue outlook for the fiscal second quarter and full year, due to slumping demand fostered by a weak economy.

• General Electric now expects to earn $0.50-$0.52 per share in fourth-quarter 2008, the bottom of its previous guidance of $0.50-$0.65 per share.

• Sears missed earnings expectations for its most recent quarter, with an EPS of $0.90.

• Nearly half (45%) of respondents participating in ChangeWave's November IT survey indicated spending will decrease in first-quarter 2009, which is 16 percentage points worse than ChangeWave's previous survey in August.

This is but a sampling and does not include what has been announced in the last several weeks. Keep in mind also that the majority of analysts that publish earnings estimates for the S&P 500 have yet to break out their third- and fourth-quarter 2008 expectations.

I would not be surprised to see more negative revisions in the next couple of weeks. The lower end of the range is $62-$68 for 2008 and $66-$74 for 2009, according to Atlantic Equity and JMP Securities. If those are even close to being true, it means the current market multiple of 10.2 times 2008 and 9.5 times 2009 consensus earnings for the S&P 500 could look more like 12.7-14.1 times and 11.8-13.3 times respectively. The midpoint of those ranges equate to a 29%-31% premium over current market multiples for 2008 and 2009.

Viewed from a slightly different perspective, if current multiples are applied to the higher end of those low ranges (the 9.5 multiple applied to $74 in earnings in 2009), it suggests the S&P will drop near 700 compared to the recent close of 876. It seems there is more than some risk to the current Street expectations for the S&P in both 2008 and 2009. How low could the operating earnings go? A number of factors involved could benefit consumer spending and corporate cost structures, including falling commodity prices as well as any traction from the announced stimulus.

I am not that big of a bear, but it's not too hard to see that as S&P earnings revisions come a-calling, what everyone was saying was so cheap may not be as cheap as they thought, at least on a relative basis.

Buzz up!