Don't You Get It

"The market has turned"
"The recession is over"
"Things are getting better"
These are the phrases heard when talking to investors these days, but rarely does anybody talk about the price being paid for stocks. As if the fact that the economy is getting better justifies paying any price for a stock. In 1999 investors said "the internet is the future" and they were right, but that did not justify paying any price for internet stocks. In 2007 they said "they aren't making any more land" and that was correct but that did not justify paying any price for real estate. Back in March, when the economy was "bad" no price was too low to sell at. The most common mistake investors make is to ignore price and invest based on a catchy phrase or story.

Stocks are trading at extreme valuations given that we are at the beginning of an economic recovery and in a secular bear market. Further, it is up for debate if the economy is getting better. If injecting an injured athlete with drugs so that he can play another quarter is your idea of getting better, than the economy is getting better.

John Hussman addresses many of these issues in his weekly piece:

When we look at the current market environment today, it is clear that the enthusiasm about the market here is largely based on the idea that the recent recession is over, and that the economy will form a “V” shaped recovery similar, but much stronger quantitatively, to standard post-war recoveries. This is a very difficult argument to make, because the drivers of economic growth that existed in typical economic recoveries – particularly debt origination and consumption growth – are very compromised at present. Our perspective on the ongoing credit risk in the economy is much like that of economists Kenneth Rogoff and Carmen Reinhart, who foresaw the recent financial crisis, and are far less sanguine about the prospects for sustained recovery.

... Presently, my primary concern is that stocks are now overvalued, to about the same extent as they were in the late 1960's, and just prior to the 1987 crash, but certainly less overvalued than they were at the 2000 or 2007 peaks.


Fred said...

Stocks are perpetuities and so valuation has to take into account the stream of dividends and buybacks for the next 20 years, at a minimum, not just the next 2 quarters. It really doesn't matter if we have a near-term recovery or not. What matters is whether, in the long run, earnings and earnings growth will justify current prices. Finally, assuming that earnings and earning growth can be estimated for the next 20 years, we also need to know the appropriate discount rate and risk premium to apply. If you go through the above calculations, it isn't obvious that stocks are overvalued. If earnings eventually return to a $60 trend-line for SP500 AND if investors are willing to accept a P/E multiple of 18 going forward, then fair value is 1080, or just about today's price.

Earnings will be low for the next few years, of that I'm pretty sure, but I see little difficulty in returning to the $60 trend-line eventually (actual earnings will be higher than $60 when we get back to the trend-line, since the trend-line is an exponential curve going up). Also, an argument can be made that P/E's in the future will be higher than in the past (18 rather than 15), for various reasons.

Granted, my conviction about the above argument is not too strong (especially the part about P/E's being at a permanently higher plateau), but I'm not just arguing to be argumentative. The case for the market being at fair value is reasonable, and that is reason enough for me to sit tight rather than moving aggressively right now.

Anonymous said...

I can't think of a conceivable argument why P/E's will be higher in the future. Growth in the U.S. is slowing, and even if it picks up, we've printed so much money that inflation will become a problem. Inflation cannot be good for stocks. The discount rate will increase. Moreover, stocks are like bonds in the sense that ROEs are 12%. With inflation, the value of that ROE declines relative to newly issued fixed income instruments. Finally, inflation leads to higher cost of goods, and I'm excluding wages for the purposes of this argument.

Fred said...

You've got inflation completely confused. Other than for taxation effects, stocks are neutral with respect to inflation and nominal interest rates. What matter is the real rate, which is indicated by the 20 year TIPS rate, which is currently just over 2%. Furthermore, there is no indication that we will have high inflation looking forwards. We are deflating now and the Fed seems quite determined to stick to its 2% target for CPI. Don't underestimate the power of consensus, and the consensus among economists nowadays is that inflation above 2% or so is bad and should be vigorously fought.

There are several arguments why P/E's might be lower:

a) Investors are more comfortable with stocks than in the past, which would tend to drive risk premiums down.
b) Trading costs are lower and thus more of the earnings passes through to investors (at least those using index funds) as opposed to being taken by wall street. This will also show up as a lower risk premium.
c) Populations are again throughout the developed world, leading to a savings glut. This shows up as a low 20 year TIPS yield.

The real question is what will be the future risk premium plus slippage between earnings yield (E/P) versus what investors actually receive as dividends or buybacks. Historically, risk premiums for stocks have been about 3% and slippage perhaps 1%. Add to the current 2% 20 year TIPS yield and you get 6% earnings yield, or 16.6 PE. But if the risk premium is only 2%, then you get 5% earnings yield, or 20 PE.

Personally, I believe the saving glut will come to an end at some point, due to budget deficits as far as the eye can see in all the developing countries. This will drive 20 year TIPS yields up and PE's down. However, the TIPS market obviously disagrees with me.

Anonymous said...

I understand what you're saying, but disagree that stocks are neutral to inflation other than for taxation effects. ROE has averaged 10-12% over the past 50 years. Therefore, assuming a constant price-to-book multiple of 1.0, you will get a "dividend" of $12 for every $100 in stocks you own. If interest rates rise, then the value of that 12% dividend goes down relative to prevailing rates. The question is, what happens to the price to book ratio? Well, if we have inflation, it's more likely to hurt economic growth, discourage investment, and make replacement capex more expensive, etc. Working capital ratios are likely to remain roughly the same, competion will keep margins largely in check. I would assume that if the market P/B ratio is something like 2.0x, currently (I really don't know what it is...), there's a better chance that the P/B actually goes down, but my argument doesn't require this assumption. Stocks will go down during times of inflation, unless you can argue that profits, and profit MARGINs, increase during times of inflation.

Tsachy Mishal said...

Profit margins do go up during times of inflation. Or at least they did in the 70's, which is the only case of inflation. However, P/Es moved even more dramatically.

Fred said...

Profits in the 1970's were illusory to a great extent, due to the effects of inflation on inventory and depreciation accounting. PEs in the 1970's would not have been nearly so low if they had been computed on the basis of true sustainable after-tax-and-inflation earnings. Another way of looking at this is that, during the 1970's, owners of stocks and bonds ended up paying the deferred costs of the Vietnam war plus the costs of retrofitting American industry for higher oil prices, and they paid these costs via the inflation tax. In the 1980's, the tax burden was shifted to the workers, via the huge Social Security tax hike of 1983 together with the elimination of the inflation tax, and this is what ultimately allowed stocks and bonds to soar.

Looking forward, the question is who will pay the costs of the coming wave of boomer retirements and soaring healthcare costs plus the deferred costs of American imperial wars plus possible costs of retrofitting for peak oil? My guess is owners of stocks and bonds (and housing and gold) via high real interest rates in about 4 years. But like I noted earlier, the TIPS market disagrees with me right now.