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Monday, December 28, 2009

Is the Market Fairly Valued? Did the Market Achieve Any Meaningful Bottom Back in March?

This is a follow-up post to my last large Fundamental Analysis post The Long View. I explored many topics including valuations in that post. I would like to talk about valuations in a little more detail here.

I can just here it now: "binv, would you just shut up about this! Ever since the 1990s there is just a new valuation paradigm and you should be comparing valuations in this context. As such the market is not overvalued, or is closer to fairly valued in this context"

There have been many arguments made in response to my posts that are materially similar to the statement above.


No sir, not one bit. Because once you strip away the fancy words, the statement above says "This time its different. We are much smarter / cleverer / more sophisticated (pick your adjective) than people were back 50-100 years ago and therefore all the rules have changed".

And I disagree.

Why? ... Because the same emotions that drives overvaluation (greed) and undervaluation (fear) exist exactly the same today just as it has ever since the invention of money.

Exuberance can last a long time, decades in fact. So much so that investors buy their own hubris. Monetary policy can distort signals and show nominal growth in asset classes such as equities and suppress signals in the bond market further distorting the "fairly valued" signals. But this is ultimately a transient event. The "transient" may be so long that investors not looking at the big picture will call it the "new normal". Government manipulation of market forces is a delay tactic. Because the government has no wealth of its own, it only moves around wealth (very inefficiently) within the economy, consuming a large portion of it. And market forces, at the end of the day, will decide the amount of debt the Treasury can sell and what interest rates are. (The caveat being that there is no limit to the amount of debt that the Fed can monetize - including Treasury debt. Which, as long as there is a Fed, is ultimately why the outcome will be inflationary, not deflationary. Deflationary impulses against the backdrop of massive inflation. Most assets you own fall in value and most assets you need to buy/consume rise in value). But the market emotionally high overshoots are met with emotionally low overcorrections. Everything runs in cycles.

And I think this down cycle is far from complete.

I do not expect agreement on this post, nor am I looking for it. Whether you agree with it or not is immaterial. I have an opinion and I am sharing it. Hopefully you find this useful in trying to understand the big picture. If it does (even if you come to the completely opposite conclusion that I do) then this post did its job.

Required Reading / Sources for this Discussion

-- The Long View
-- Sentiment: P/E, BPSPX, VIX and CPC
- Thoughts on the Dow/Gold Ratio
-- http://www.zealllc.com/2007/longwave3.htm
-- http://www.econ.yale.edu/~shiller/data.htm
-- Regarding Economic Debates and Opinions: The Fallacy of "Purely Objective" Analysis

Main Analysis Point

I will assume you read the links above. These discuss the fundamental case that I make for the current overvaluation of stocks (as a general asset class) relative to the current economic conditions, and how valuations did not, at any point in the crisis since 2000, reach anything approaching a valuation bottom when compared against the historical record.

I discussed valuations using both GAAP and Operating Earnings back in October (Sentiment: P/E, BPSPX, VIX and CPC), and I will take a slightly different approach in this post: I want to examine P/E and Dividend Yields for nominal and real rates using Professor Shiller's data.

But first, to go along with the prologue above, let me reiterate that valuations, especially when viewed in a long term context, are as much a sentiment tool as they are an objective analysis tool.

Let's think about what P/E means. It is the the "payback period" for a stock's current earnings to justify/cover the current share price. Another way to look at it is the *premium* that you place on the stock's ability to generate future earnings. Earnings theoretically grow for growing companies, or they are stable and consistent for well-run companies. But shouldn't a P/E for a particular company or even a sector be a well-known and consistent metric? Why would anybody pay a premium on P/E beyond the historical average P/E?

Because investors are emotional. They fall prey to greed and fear, optimism and pessimism.

Moreover, large scale herd-behavior for optimism and pessimism actually runs in cycles. Read this article, it is a fantastic description of this valuation cycle: http://www.zealllc.com/2007/longwave3.htm. The main upshot of the article is that these long valuation waves take about 32-36 years to run, the last bottom was in 1981, and valuation bottoms do not occur until the broad market (as measured by P/E's on the Dow or the S&P 500, which have very similar P/Es most the time) P/E is between 6-10. Long Term (100 year) average P/E is ~14.

People right now are buying the hype. They buy the upgrades from Wall St. analysts. They buy the "turned the corner" rhetoric from economists. Nobody seems to remember this from the 2007 top or the 2000 top. SENTIMENT and RHETORIC is always extremely optimistic at the top! So they go back to the default "this time its different" mentality, buy the hype and pay the premium on the market with respect to valuation.

On to the data.

All the charts shown in the post are generated from Professor Shiller's data. Here is the relevant excerpt for interpolated and composited data:

This data set consists of monthly stock price, dividends, and earnings data and the consumer price index (to allow conversion to real values), all starting January 1871. The price, dividend, and earnings series are from the same sources as described in Chapter 26 of my earlier book (Market Volatility [Cambridge, MA: MIT Press, 1989]), although now I use monthly data, rather than annual data. Monthly dividend and earnings data are computed from the S&P four-quarter tools for the quarter since 1926, with linear interpolation to monthly figures. Dividend and earnings data before 1926 are from Cowles and associates (Common Stock Indexes, 2nd ed. [Bloomington, Ind.: Principia Press, 1939]), interpolated from annual data. Stock price data are monthly averages of daily closing prices through January 2000, the last month available as this book goes to press. The CPI-U (Consumer Price Index-All Urban Consumers) published by the U.S. Bureau of Labor Statistics begins in 1913; for years before 1913 1 spliced to the CPI Warren and Pearson's price index, by multiplying it by the ratio of the indexes in January 1913. December 1999 and January 2000 values for the CPI-Uare extrapolated. See George F. Warren and Frank A. Pearson, Gold and Prices (New York: John Wiley and Sons, 1935). Data are from their Table 1, pp. 11–14. For the Plots, I have multiplied the inflation-corrected series by a constant so that their value in January 2000 equals their nominal value, i.e., so that all prices are effectively in January 2000 dollars.

Notice the pattern? Stocks become a tremendous value when the P/E ratio approaches the Dividend Yield. Fear of equity performance drives valuations to very favorable ratios. Each time this happens, the market puts on a subsequent tremendous bull run. The market becomes eventually becomes overvalued and then needs to pullback and consolidate while the ratios bottom before the next major bull run can commence

Let's think about why. When times are perceived as good, when investors are (as a herd) optimistic, prices rise and a premium gets placed on growth (P/E goes up and Dividend Yields go down). When times are perceived as bad, investors are pessimistic, prices consolidate or fall and a premium gets placed on safety (P/E goes down and Dividend Yields go up).

And like I am observing above, emotions overshoot in both directions: we get irrational exuberance at the top and abject fear at the bottom.

But why the equality of P/E and Dividend Yield at the bottom (why is this value of about 6-10 P/E and 6-10% dividend yield).

Because this is the ultimate spot for value investors. When the market goes down to a P/E of 6-10, you will have a 100% appreciation on your investment (in terms of earnings) in 6-10 years assuming no earnings growth. That is exceptionally compelling no matter what the investment is. Additionally, a dividend yield of 6-10% means that you will receive cash return on your investment costs that completely pay you back in 10-17 years. Again, this is a ridiculously compelling scenario.

That is what we find at bottoms: absolutely ridiculously compelling investments because the herds emotional state is terrified.

And is that what we found on March 9, 2009? .... NOT EVEN CLOSE.

Earnings were in the toilet but fear was at a peak. So we got a bounced based on oversold technicals and a bearish sentiment extreme. That's all.

The rebuttal (I can just hear it being voiced now): "That is a completely incorrect assessment. The stock market is now based on growth, not dividend yields. This is a result of inflation / monetary policy." (which is the correct assessment on the upward side of the valuation cycle). Or perhaps the rebuttal will be even less well analyzed: "We reached a bottom, the economy is recovering and 666 on the S&P 500 was truly a good value for long term investors".

..... and this explanation is BULLS**T (in this case it is quite literally BS)

Because it assumes "This time it is different". Nothing goes up or down in a straight line. There are secular markets and there are always cyclical countermoves within the secular market. There was a cyclical countermove up (bear market rally) from the bursting of the Tulip Bubble, South Sea Bubble, early stages of the 1929 crash during the Great Depression. The is always some reason to justify why the asset rises despite unfavorable long term valuations while on the way down from a peak. In this case (March 2009 to now) we had massive liquidity injections from the government coupled with favorable currency exchange rates for an inrush of money to place this bounce at the macro level. But both aspects are now changing.

The next chart is using Professor Shiller's Long Term Interest Rate and CPI adjusted P/E and Dividend Yields. Read this for an explanation of what these curves mean.

Why am I showing you this? For the same reason I showed valuations in this post (Sentiment: P/E, BPSPX, VIX and CPC) using both operating and GAAP earnings. Some people argue that GAAP earnings are not representative, so I showed that even in *operating earnings* terms we did not reach any meaningful bottom.

Same deal here. Some smart aleck might argue that the nominal picture is distorted by inflation, even though I have already shown that inflation arguments for P/E are also invalid, because P/E is "inflation neutral" (Prices are inflated and Earnings are inflated, so P divided by E removes inflation effects). But how Dividend Yield, P/E, and the CPI interact is a bit more complicated. So it is worth showing the slightly more nuanced picture.

But the point is, even in Real terms, there was no meaningful Valuation bottom in March when compared against the historical record

So What's that Upshot?

From the point of view of the long term value investor there was no meaningful bottom reached in March 2009 with respect to P/E ratios and Dividend Yields when compared to the bottoms of the last 100 years.

Moreover, if you look at the patterns on the charts above, the correction periods of declining valuations were always short in comparison to the previous bull market. This showed that for the last 67 years (1933-2000) we were in a secular bull market and the bearish moves were all countertrend.

This is yet another reason why I reiterate that we are in a secular bear market. This current valuation and price cycle is on the decline and is already 9 years old, and we did not reach the bottom yet. There will be many more years of this bear market to go until we get utter bullish capitulation and absolutely insane "end of the world" valuations (which I firmly believe WILL **NOT** HAPPEN: Thoughts on the Dow/Gold Ratio)

.... But then again, maybe this time it's "different"
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