A Look at Market Fundamentals: the rebuttal

[Eugene]

Re: http://www.pcasd.com/are_stocks_cheap_or_expensive_a_look_at_market_fundamentals

Here I will show how two people can start with the same data, apply slightly different mindsets and some massaging, and arrive at startlingly different conclusions. 🙂

In the link above, Rich argues that the stock market is relatively overpriced, on the basis of the ratio of price to trailing 10-year earnings.

This is, indeed, a good measure, but we have to consider one detail. Specifically, earnings just took a massive one-time tumble in the last few years. They usually do during recessions, but this one was unprecedented in its magnitude. And it was clearly temporary (the most recent data, from Q3 2010, already show earnings back to Q3 2007 levels, though not quite back to their Q1 2007 peak). It would be appropriate to smooth over this tumble. For a good measure, let’s take out some of the 2001-2003 dip. To compensate, take out 2000 and 2007 peaks as well.

Massaged earnings might look like this (same units as Shiller):

And I’d think that I’m being conservative, seeing how unemployment is still 9%, but earnings are already above the ‘smoothed’ level.

Next, consider that, since about the mid-60’s, stock market P/E has had a tendency to correlate quite well with the yield on a 10-year. This makes perfect sense, economically, since, assuming that stock investors have roughly a 10-year scope of interest, the return on investment from the stock market and the return on investment from a 10-year should differ only by the risk measure. And, since the risk of the entire market simultaneously going bankrupt is low, the risk measure should be low too. (Why didn’t it work like that before the 60’s? Maybe there just weren’t any arbitrageurs around.) Here’s the chart, showing the inverse 10 year vs. the adjusted S&P trailing P/E:

(everything current through yesterday, except earnings)

The correlation is clear, except for some kind of steady divergence in 1987-1995, the huge internet bubble starting in mid 90’s that didn’t fully deflate till 2002, a minibubble around 2005, and the ongoing period of unnaturally low stock market prices starting in 2008.

Going forward, the market will remain undervalued until either the S&P gains another 30% (that would put the fair value around 1700), the 10-year yield gains another 30% (to 4.7%), or there’s an unexpected big drop in earnings.

An even better picture could be seen if we could subtract financials from the S&P…

[patb]

here’s my take, the market is rigged.

[patb]

here’s my take, the market is rigged.

[patb]

here’s my take, the market is rigged.

[patb]

here’s my take, the market is rigged.

[patb]

here’s my take, the market is rigged.

[socrattt]

Here’s my take, I agree with patb.

Eugene, you are very bright and generally make very good points and arguments. Unfortunately it’s hard to be convinced by charts and numbers. Our economy is completely inflated by bogus numbers all over the board and there’s plenty of proof of that. Charts are laughable in this market, although I love the optimism!

And if you were to ask me my opinion of where the market is heading I’d say either we hit some sort of hyper inflationary period that shoots equities through the roof or we have another big crash. I’m sort of leaning on the crash side right now, but still a firm believer that inflationary footprints are all over the place.

[socrattt]

Here’s my take, I agree with patb.

Eugene, you are very bright and generally make very good points and arguments. Unfortunately it’s hard to be convinced by charts and numbers. Our economy is completely inflated by bogus numbers all over the board and there’s plenty of proof of that. Charts are laughable in this market, although I love the optimism!

And if you were to ask me my opinion of where the market is heading I’d say either we hit some sort of hyper inflationary period that shoots equities through the roof or we have another big crash. I’m sort of leaning on the crash side right now, but still a firm believer that inflationary footprints are all over the place.

[socrattt]

Here’s my take, I agree with patb.

Eugene, you are very bright and generally make very good points and arguments. Unfortunately it’s hard to be convinced by charts and numbers. Our economy is completely inflated by bogus numbers all over the board and there’s plenty of proof of that. Charts are laughable in this market, although I love the optimism!

And if you were to ask me my opinion of where the market is heading I’d say either we hit some sort of hyper inflationary period that shoots equities through the roof or we have another big crash. I’m sort of leaning on the crash side right now, but still a firm believer that inflationary footprints are all over the place.

[socrattt]

Here’s my take, I agree with patb.

Eugene, you are very bright and generally make very good points and arguments. Unfortunately it’s hard to be convinced by charts and numbers. Our economy is completely inflated by bogus numbers all over the board and there’s plenty of proof of that. Charts are laughable in this market, although I love the optimism!

And if you were to ask me my opinion of where the market is heading I’d say either we hit some sort of hyper inflationary period that shoots equities through the roof or we have another big crash. I’m sort of leaning on the crash side right now, but still a firm believer that inflationary footprints are all over the place.

[socrattt]

Here’s my take, I agree with patb.

Eugene, you are very bright and generally make very good points and arguments. Unfortunately it’s hard to be convinced by charts and numbers. Our economy is completely inflated by bogus numbers all over the board and there’s plenty of proof of that. Charts are laughable in this market, although I love the optimism!

And if you were to ask me my opinion of where the market is heading I’d say either we hit some sort of hyper inflationary period that shoots equities through the roof or we have another big crash. I’m sort of leaning on the crash side right now, but still a firm believer that inflationary footprints are all over the place.

[patientrenter]

I am impressed with your ability to include graphs with your posts, Eugene.

Rich hit the nail on the head. Ultimately, when you buy US stocks you are buying a share in the aggregate future earnings of US companies, which itself is a slice of the US GDP. When price/GDP ratios are high, you are paying a lot, and when price/GDP ratios are low you are paying a little.

Rich’s method is sound. Divide that historical (Stock price)/GDP analysis up into two pieces:

(Stock prices) / GDP = A x B, where

A = (Stock prices) / (Smoothed earnings), and

B = (Smoothed earnings) / GDP.

Sure, A and B move over time, but the further they get from historical values, viewed over several generations, the less likely they are to stick. When both ratios are high compared to historical values, the warning lights start to flash twice as fast.

Smoothing earnings is best done using an approach like Shiller’s (that Rich also uses), employing a long term moving average. Over the long run, this kind of smoothed result is guaranteed to converge to the actual results, making it an unbiased estimate. Your approach to smoothing is interesting, but it is far too subjective to be an unbiased or otherwise reliable estimate of underlying earnings.

[patientrenter]

I am impressed with your ability to include graphs with your posts, Eugene.

Rich hit the nail on the head. Ultimately, when you buy US stocks you are buying a share in the aggregate future earnings of US companies, which itself is a slice of the US GDP. When price/GDP ratios are high, you are paying a lot, and when price/GDP ratios are low you are paying a little.

Rich’s method is sound. Divide that historical (Stock price)/GDP analysis up into two pieces:

(Stock prices) / GDP = A x B, where

A = (Stock prices) / (Smoothed earnings), and

B = (Smoothed earnings) / GDP.

Sure, A and B move over time, but the further they get from historical values, viewed over several generations, the less likely they are to stick. When both ratios are high compared to historical values, the warning lights start to flash twice as fast.

Smoothing earnings is best done using an approach like Shiller’s (that Rich also uses), employing a long term moving average. Over the long run, this kind of smoothed result is guaranteed to converge to the actual results, making it an unbiased estimate. Your approach to smoothing is interesting, but it is far too subjective to be an unbiased or otherwise reliable estimate of underlying earnings.

[patientrenter]

I am impressed with your ability to include graphs with your posts, Eugene.

Rich hit the nail on the head. Ultimately, when you buy US stocks you are buying a share in the aggregate future earnings of US companies, which itself is a slice of the US GDP. When price/GDP ratios are high, you are paying a lot, and when price/GDP ratios are low you are paying a little.

Rich’s method is sound. Divide that historical (Stock price)/GDP analysis up into two pieces:

(Stock prices) / GDP = A x B, where

A = (Stock prices) / (Smoothed earnings), and

B = (Smoothed earnings) / GDP.

Sure, A and B move over time, but the further they get from historical values, viewed over several generations, the less likely they are to stick. When both ratios are high compared to historical values, the warning lights start to flash twice as fast.

Smoothing earnings is best done using an approach like Shiller’s (that Rich also uses), employing a long term moving average. Over the long run, this kind of smoothed result is guaranteed to converge to the actual results, making it an unbiased estimate. Your approach to smoothing is interesting, but it is far too subjective to be an unbiased or otherwise reliable estimate of underlying earnings.

[patientrenter]

I am impressed with your ability to include graphs with your posts, Eugene.

Rich hit the nail on the head. Ultimately, when you buy US stocks you are buying a share in the aggregate future earnings of US companies, which itself is a slice of the US GDP. When price/GDP ratios are high, you are paying a lot, and when price/GDP ratios are low you are paying a little.

Rich’s method is sound. Divide that historical (Stock price)/GDP analysis up into two pieces:

(Stock prices) / GDP = A x B, where

A = (Stock prices) / (Smoothed earnings), and

B = (Smoothed earnings) / GDP.

Sure, A and B move over time, but the further they get from historical values, viewed over several generations, the less likely they are to stick. When both ratios are high compared to historical values, the warning lights start to flash twice as fast.

Smoothing earnings is best done using an approach like Shiller’s (that Rich also uses), employing a long term moving average. Over the long run, this kind of smoothed result is guaranteed to converge to the actual results, making it an unbiased estimate. Your approach to smoothing is interesting, but it is far too subjective to be an unbiased or otherwise reliable estimate of underlying earnings.

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