Best of the Week
Most Popular
1. Stock Markets and the History Chart of the End of the World (With Presidential Cycles) - 28th Aug 20
2.Google, Apple, Amazon, Facebook... AI Tech Stocks Buying Levels and Valuations Q3 2020 - 31st Aug 20
3.The Inflation Mega-trend is Going Hyper! - 11th Sep 20
4.Is this the End of Capitalism? - 13th Sep 20
5.What's Driving Gold, Silver and What's Next? - 3rd Sep 20
6.QE4EVER! - 9th Sep 20
7.Gold Price Trend Forecast Analysis - Part1 - 7th Sep 20
8.The Fed May “Cause” The Next Stock Market Crash - 3rd Sep 20
9.Bitcoin Price Crash - You Will be Suprised What Happens Next - 7th Sep 20
10.NVIDIA Stock Price Soars on RTX 3000 Cornering the GPU Market for next 2 years! - 3rd Sep 20
Last 7 days
The Copper/Gold Ratio Would Change the Macro - 21st Oct 20
Are We Entering Stagflation That Will Boost Gold Price - 21st Oct 20
Crude Oil Price Stalls In Resistance Zone - 21st Oct 20
High-Profile Billionaire Gives Urgent Message to Stock Investors - 21st Oct 20
What's it Like to be a Budgie - Unique in a Cage 4K VR 360 - 21st Oct 20
Auto Trading: A Beginner Guide to Automation in Forex - 21st Oct 20
Gold Price Trend Forecast into 2021, Is Intel Dying?, Can Trump Win 2020? - 20th Oct 20
Gold Asks Where Is The Inflation - 20th Oct 20
Last Chance for this FREE Online Trading Course Worth $129 value - 20th Oct 20
More Short-term Stock Market Weakness Ahead - 20th Oct 20
Dell S3220DGF 32 Inch Curved Gaming Monitor Unboxing and Stand Assembly and Range of Movement - 20th Oct 20
Best Retail POS Software In Australia - 20th Oct 20
From Recession to an Ever-Deeper One - 19th Oct 20
Wales Closes Border With England, Stranded Motorists on Severn Bridge? Covid-19 Police Road Blocks - 19th Oct 20
Commodity Bull Market Cycle Starts with Euro and Dollar Trend Changes - 19th Oct 20
Stock Market Melt-Up Triggered a Short Squeeze In The NASDAQ and a Utilities Breakout - 19th Oct 20
Silver is Like Gold on Steroids - 19th Oct 20
Countdown to Election Mediocrity: Why Gold and Silver Can Protect Your Wealth - 19th Oct 20
“Hypergrowth” Is Spilling Into the Stock Market Like Never Before - 19th Oct 20
Is Oculus Quest 2 Good Upgrade for Samsung Gear VR Users? - 19th Oct 20
Low US Dollar Risky for Gold - 17th Oct 20
US 2020 Election: Are American's ready for Trump 2nd Term Twilight Zone Presidency? - 17th Oct 20
Custom Ryzen 5950x, 5900x, 5800x , RTX 3080, 3070 64gb DDR4 Gaming PC System Build Specs - 17th Oct 20
Gold Jumps above $1,900 Again - 16th Oct 20
US Economic Recovery Is in Need of Some Rescue - 16th Oct 20
Why You Should Focus on Growth Stocks Today - 16th Oct 20
Why Now is BEST Time to Upgrade Your PC System for Years - Ryzen 5000 CPUs, Nvidia RTX 3000 GPU's - 16th Oct 20
Beware of Trump’s October (November?) Election Surprise - 15th Oct 20
Stock Market SPY Retesting Critical Resistance From Fibonacci Price Amplitude Arc - 15th Oct 20
Fed Chairman Begs Congress to Stimulate Beleaguered US Economy - 15th Oct 20
Is Gold Market Going Back Into the 1970s? - 15th Oct 20
Things you Should know before Trade Cryptos - 15th Oct 20
Gold and Silver Price Ready For Another Rally Attempt - 14th Oct 20
Do Low Interest Rates Mean Higher Stocks? Not so Fast… - 14th Oct 20
US Debt Is Going Up but Leaving GDP Behind - 14th Oct 20
Dell S3220DGF 31.5 Inch VA Gaming Monitor Amazon Prime Day Bargain Price! But WIll it Get Delivered? - 14th Oct 20
Karcher K7 Pressure Washer Amazon Prime Day Bargain 51% Discount! - 14th Oct 20
Top Strategies Day Traders Adopt - 14th Oct 20
AMD is KILLING Intel as Ryzen Zen 3 Takes Gaming Crown, AMD Set to Achieve CPU Market Dominance - 13th Oct 20
Amazon Prime Day Real or Fake Sales to Get Rid of Dead Stock? - 13th Oct 20
Stock Market Short-term Top Expected - 13th Oct 20
Fun Stuff to Do with a Budgie or Parakeet, a Child's Best Pet Bird Friend - 13th Oct 20
Who Will Win the Race to Open a Casino in Japan? - 13th Oct 20
Fear Grips Stock Market Short-Sellers -- What to Make of It - 12th Oct 20
For Some Remote Workers, It Pays to Stay Home… If Home Stays Local - 12th Oct 20
A Big Move In Silver: Watch The Currency Markets - 12th Oct 20
Precious Metals and Commodities Comprehensive - 11th Oct 20
The Election Does Not Matter, Stick With Stock Winners Like Clean Energy - 11th Oct 20
Gold Stocks Are Cheap, But Not for Long - 11th Oct 20
Gold Miners Ready to Fall Further - 10th Oct 29
What Happens When the Stumble-Through Economy Stalls - 10th Oct 29
This Is What The Stock Market Is Saying About Trump’s Re-Election - 10th Oct 29
Here Is Everything You Must Know About Insolvency - 10th Oct 29
Sheffield Coronavirus Warning - UK Heading for Higher Covid-19 Infections than April Peak! - 10th Oct 29
Q2 Was Disastrous. But What’s Next for the US Economy – and Gold? - 9th Oct 20
Q4 Market Forecast: How to Invest in a World Awash in Debt - 9th Oct 20
A complete paradigm shift will make gold the generational trade - 9th Oct 20
Why You Should Look for Stocks Climbing Out of a “Big Base” - 9th Oct 20
UK Coronavirus Pandemic Wave 2 - Daily Covid-19 Positive Test Cases Forecast - 9th Oct 20
Ryzen ZEN 3: The Final Nail in Intel's Coffin! Cinebench Scores 5300x, 5600x, 5800x, 5900x 5950x - 9th Oct 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

Will the Stock Market S&P Index Fall to 450, P/E 7 or Not?

Stock-Markets / Stock Market Valuations May 20, 2009 - 04:04 AM GMT

By: Andrew_Butter

Stock-Markets

Diamond Rated - Best Financial Markets Analysis ArticleProfessor Shiller's numbers are persuasive; since anyone can remember, whenever the stock markets and/or the economy got into a train wreak, the bottom in the stock market that followed coincided when P/E ratios went down to about 7. 

By that logic, plus the awful economic news (a little bit better is still awful), the S&P 500 is going down to 450, and the issue is not IF it's WHEN?


So here we are at S&P flirting with 900 and the doomsayers have been becoming increasingly agitated. First it was a "Dead-Cat-Bounce-Sucker-Rally" then a "Sucker Rally" then a "Bear Rally" and now, well it's a "Conspiracy"...(obviously).

Meanwhile some wag in the basement is playing that old Dr. Hook song "I Got Stoned And I Missed It". 

Could 98% of Market Oracle contributors AND Professor Nouriel Roubini, be wrong?

Here's why they might be:

(1): It's earnings in the future that count:

What matters is earnings in the future not the in past. The price of the market reflects market participant's opinions about what these will be - long term, not next week; sure earnings in the past are sometimes a guide to the future, and sometimes they are not. Likewise for earnings projections.

(2): Measurement Errors

There are different ways to work out earnings. A good example is the controversy over mark-to-market; depending on how you value your assets there can be huge differences (earnings are the change in assets net of liabilities over time, you generally know what your liabilities are; but if there are uncertainties over the value of the assets, well by definition there are uncertainties over earnings). 

Case in point the controversy over the Stress Tests, there was a difference of opinion about how much extra capital would be required, between what the Treasury team said and what the banks said of $50 billion or so. At a TCE of 4% that means a difference in opinion about the valuation of assets of $1.25 Trillion. So who was right? Well, we will find out soon enough.

What actually gets reported as earnings is a compromise between what the SEC, the regulator and the tax-man says, how close that is to reality can vary. But here is the rub, over time, if earnings are negative (regardless of what you report), you go bust, and that's not something you can argue about. So regardless of how they are measured, the idea is that in the end everything balances out.

That may sound pedantic, but look at it another way:

All the big banks reported stellar earnings up to the end of 2007. Well either they lost all that money during Q1 and Q2 2008, or they hadn't noticed they had lost it (certainly their auditors who all signed them off a "going concerns" at the end of 2007 hadn't noticed).

Say you lend $100 to a deadbeat who has no intention of paying you back, three years later the penny finally drops. So when did you lose the $100, (a) when you handed it over or (b) when you figured out you weren't going to get it back?

Say the tax-man, decides you can write off a new piece of equipment over ten years, but in fact it can run perfectly well and productively for twenty years (I've seen twenty-five year old bottling machines running just fine, they put stuff in bottles, it's not complicated they are just a rackety combination of pumps, mixers, conveyors and limit switches - why buy a new one when the old one ain't broke?).

But as far as the tax-man is concerned your earnings were less in the first ten years (when you depreciated the machine) and much more in the next ten years (when the machine was basically free). But is that reality?

(3): Yield

The value of all those potential earnings in the future is equal to the anticipated forward earnings, discounted by a yield to get today's Present Value where the yield is theoretically some sort of function of interest rates.

That's called income capitalization, which is one way you work out the "other than market value"1 of anything. (The other way is depreciated replacement cost which is related to book value, (but that's basically impossible to calculate for stocks mainly because you can't value brands or intellectual capital easily outside of mark-to market)).

So for the P/E "Rule of Thumb" to work it should account for yield, but it doesn't. That's like saying your plane flies so long as it stays on the ground; it's a denial of known reality.

What yield you use is of course anyone's guess, a good start is perhaps the 30 Year Treasury; although I guess the alternatives (short term rates) might also have an effect (mental note to look at that one day I can't think of anything better to do); plus how much more you want depends on the market, and that "risk premium" can vary depending on the business and perceptions of risk.

What just happened was that risk was absurdly mispriced; so perhaps the participants in the stock market also mispriced risk?  Perhaps now they are overpricing risk?

If you are serious about doing valuation, you don't agonize very hard about "what should be", you just find out what the answer is.

The way you do that is that by definition when the price today is equal to the other-than-market-value, that means the market is not mispriced; so that's how you can check your input variables - long term each approach should on average give the same answer.

So what would happen if a yield was considered?

Well lets say (a) that the "correct" yield on a stock market earnings was long-term-interest-rates plus "X" where (b) "X" was a constant over the past 100 years and (c) the "normalized" earnings the way Professor Shiller works them out was a reasonable predictor of the future.

Working that out for the peaks and the troughs that gives the following chart for over pricing or under pricing of the S&P 500:

Well "rough numbers" (I just put in the peaks and the troughs), it looks as if perhaps either "X" went down over time or the way that earnings were reported went down, because the "best fit" regression of those points goes up over time.

How could that happen, well it could be a "fundamental paradigm shift" which is what Allan Greenspan thought (I think he was wrong), it could be that governments in USA have got a lot more aggressive about putting their hands in peoples pockets (and smarter at it too), so the incentive to "hide" earnings got more (that's of course unless they are linked to your bonus scheme). Or it could perhaps be a progressive genetic imbalance in the Black Swan population caused by an "alien" recessive gene? Who knows, or more important, who cares?

Playing with that idea, how about re-adjusting the line so that on average over the past 100 years the market was correctly priced. To do that you just work out the degree of separation from the best-fit regression line:

So by that logic the market now is 55% under-priced, and historically it looks like it's about time for a bottom.

Comparing to market-long-wave analysis.

This is an approach that I have used to look at property prices for years; basically what I do is an "other-than-market" valuation of the market as a whole, then look at how the price deviates from the valuation. The "calibration" of that approach is simply that you "know" that over 100 years the market was in equilibrium on average, by definition (http://www.marketoracle.co.uk/Article6250.html).

Last January I tried that out on the stock market I started off looking at earnings, but I rejected that for two reasons (a) it didn't produce a result that fit with known reality (when you do valuations for a while you always check against reference points that are known reality, the more the better), and (b) I knew very well the problems of measuring earnings; I've spent half my life trying to persuade bankers and accountants that earnings are much bigger than what they think they are, and I don't think I'm the only one. It's like that tired old accountants joke "Profit Guv', what would you like it to be?"

In valuation you don't really care why things work, but you care very much about how clean the input data is, so I had a look at the cleanest data that exists which is nominal GDP. That number is relatively easy to measure, and it has the advantage that (a) the way it's measured hasn't changed much over time and (b) it is routinely measured three ways (consumption, expenditure, capital formation), so it's got internal independent checks on the methodology.

It's the cleanest number there is (doesn't mean it's always right, particularly in economies where tax is not paid - I'm always amazed that the basic "assumption" that all economists seem to make (or delusion depending how you look at it), is that people don't cheat).

So here is a notion, forget about what earnings are reported, how about if the reality is that over the long term the "real" earnings are a constant proportion of GDP, (after properly accounting for the $100 you gave to the deadbeat who you thought would pay you back but didn't, and the real profit from running a twenty-five year old bottling plant). In other words, the notion is that money churns around and on average people figure a way to transform a pretty constant proportion of that into earnings.

A notion...so how about dividing nominal GDP (a measure of real earnings) by LTIR (a measure of yield), and compare that to the Dow or the S&P 500?

Well do that and there is a good correlation, much better than anything you can cook up using P/E ratios or P/E rations divided by LTIR.

There are two other things (a) the deviations from the "best-fit" coincide with known bubbles and busts, and (b) this is the really magic part, the amplitude of the under-pricing almost uncannily equal to the amplitude of the preceding "wave" (after you adjust for the arithmetic that if you have a 50% increase from "X", you don't get back to "X" by a 50% decrease). That's called "efficient market hypothesis, regression to the mean or Farrell's Law #2, take your pick.

Plot that against the "adjusted" chart of P/E after accounting for a yield and you get:

So the two approaches (completely independent) give approximately the same answer, which they should, given that they are both a methodology to compare an estimate of other-than-market-value compared to price using some sort of rough & ready income capitalization approach to valuation.

The Market-Long-Wave analysis says (a) stock markets are about 45% under priced (b) they will not get any more under-priced.

Could it be that easy?

A criticism of this approach is I "back-adjusted". Well yes and no, dividing nominal GDP by LTIR and comparing that to the stock-market was just testing a notion, one string of clean data divided by another string of clean data is not monkey business.

The only "back adjustment" that was done was to say, that on average, regardless of how it happens, long-term in the past and likely in the future, markets will on average be correctly priced.

That may not be good economics, but from a valuation perspective (for example if you use International Valuation Standards), it's not just acceptable, it's mandatory; you are supposed to compare your valuation model with actual real-life market-derived data from the past, and only if you can show it works in the past, can you use it for the future.

Why that happens, I have no better opinion than anyone else. It's like you know that if you prod a bear with a stick, he will bite you, why he does that, well pick a theory; that's not the point, you know with a high degree of certainty; that if you prod you will be bitten. And that's all you need to know, that's what's called "the answer".

I've worked with a lot of economists, the joke we have is that they will tell you everything you could possibly imagine about a problem, except the answer.

The answer right now is that stock markets are not going any lower than the 9th March bottom, and if the economy picks up eventually, and interest rates don't go through the roof as they scratch around to raise all those trillions (and if they want to avoid that they have to STOP throwing money at the banks NOW), then there could be a sustained bull run as that 45% under-pricing is slowly eroded.

And then in about 2012 there will be a choice, the market will be correctly priced, and the choice will be...either (a) Do It To Me One More Time Baby, or (b) set up some sensible regulations so that idiot bankers don't borrow everyone's savings and go down and gamble them away in the casino using a formula that they get 20% if they win and you pay the whole lot if they lose; and then they get the lobbyists to persuade their cronies in the government to put their hands in everyone's pockets to pay off the debts.

In Saudi Arabia they cut off people's hands for doing stuff like that, now there's an idea, perhaps that might explain why they didn't have a credit crunch!

1Other-than-market-value is a concept used by International Valuation Standards; it is an estimate of what the market-value would be if the market was not in disequilibrium. It is not a concept used by eitherUS GAAP, FASB or IFRS (which is why if an accountant says your business is a going concern in USA or UK, take that as an "assumption", (and a wild one at that)).

POSITIONS: Long Oil (effectively).

By Andrew Butter

Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

Andrew Butter Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules