When the Dow has come down thousands of points in a matter of months, listening to some guy chatter on the TV screen telling you that this stock or this equity is cheap… that is going to get killed… what the heck is cheap anyway… do we want to own stocks that look cheap, or stocks that can go higher… when the market is taking a beating… I mean when stocks are getting thrashed left and right… lots of stocks can appear cheap using what I call traditional metrics… but that does not make them good buys… do you know what happens to stocks that look cheap in a really ugly market… well, let me let you in on this one… they tend to get even cheaper.

The worst reason to buy a stock during a big downturn is valuation… the analysts love to throw this one around… we think this stock is a buy based on its valuation… we like it because its price to earnings multiple is historically very low… you know what… in a market where stocks get indiscriminately crushed, you need a better reason than that to own something… don’t be, it is sophomoric and sophistic… going back to the multiple because this is a really important point… usually a stocks price to earnings multiple, the way to compare stocks, apples to apples… remember E, earnings per share times M, the multiple equals P, the price… not even real math, just arithmetic, is what you want to look at to determine a stocks relative cheapness.

But in a bear market… coupled with a recessionary economy, that logic goes out the window for a lot of stocks… for many, many companies the multiple becomes the least reliable way to measure value… the least… why… it all goes back to that equation… for the multiple to mean anything you have to know what the earnings are going to be… and when the economy stinks… but the analysts have yet to cut their earnings estimates… we have no idea about the earnings… that makes the multiple pretty useless frankly… instead of E X M = P… it is X, as in unknown X M = P, and you cannot do anything with that equation other than scratch your head… good for an algebra lesson… no good for picking stocks.

This is especially true for cyclical stocks… companies that need a strong economy to make money… and maybe only break even when the economy is bad or worse… or maybe swing to a loss… I say this as a grizzled veteran of more than one recession… you will see cyclical stocks trading at 1 or 2 times earnings… and you will think, that is cheap, as cheap as cheap can be… but in fact, that is when these stocks are actually most expensive… the multiple only looks small because the earnings estimates are going to be way too high and are about to get sliced… and when those estimates come down, who knows how far they will fall… you know how wrong you were to think that you had found something cheap… and I have seen this happen over, and over, and over again.

Back in the 80’s Bethlehem Steel went from trading at 1 times earnings, looked really cheap… to huge losses in less than a year… and it was a sell all the way down, until it destroyed you… if you think estimate cuts are coming, you simply cannot rely on the price to earnings multiple… and even if you are looking at a more secular growth stock, one that is less to the slings and arrows of an outrageous economy downturn… don’t think that a low multiple will be enough to save the stock… when everyone is selling everything… that low valuation won’t stop the stock from going even lower.

This is one of the reasons the high yielders and the accidental high yielders make such great safe havens in a lousy market… unlike a price to earnings multiple, a dividend yield is something tangible that you can hang your hat on… when you can’t use the earnings to value a stock, you can use the dividend… a stock with a safe 5% yield has a reason not to go lower… and if it does lower, you can just buy more at a still higher yield… you know that dividend is solid, you have done the work ahead of time… in a way you really can’t know about the earnings… so if you are going to access cheapness when the market is incredibly negative and the wheels are falling off the economy/bus… use a stocks yield… not its multiple.

Here is the bottom line…