A Look at Market Fundamentals: the rebuttal

[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.

[davelj]

I defer to Jeremy Grantham on issues of macro-market valuation issues because his logic is always impeccable on these matters. If you normalize profit margins (“if profits don’t mean-revert then capitalism is broken”) and mean-revert valuations (along with interest rates), the S&P’s fair value is about 900 right now. A certain group of folks will always try to come up with justifications for higher valuations during a bull market but these justifications will prove faulty… eventually. Doug Short does a lot of Grantham-like mean reversion work on his website: dshort.com.

[davelj]

I defer to Jeremy Grantham on issues of macro-market valuation issues because his logic is always impeccable on these matters. If you normalize profit margins (“if profits don’t mean-revert then capitalism is broken”) and mean-revert valuations (along with interest rates), the S&P’s fair value is about 900 right now. A certain group of folks will always try to come up with justifications for higher valuations during a bull market but these justifications will prove faulty… eventually. Doug Short does a lot of Grantham-like mean reversion work on his website: dshort.com.

[davelj]

I defer to Jeremy Grantham on issues of macro-market valuation issues because his logic is always impeccable on these matters. If you normalize profit margins (“if profits don’t mean-revert then capitalism is broken”) and mean-revert valuations (along with interest rates), the S&P’s fair value is about 900 right now. A certain group of folks will always try to come up with justifications for higher valuations during a bull market but these justifications will prove faulty… eventually. Doug Short does a lot of Grantham-like mean reversion work on his website: dshort.com.

[davelj]

I defer to Jeremy Grantham on issues of macro-market valuation issues because his logic is always impeccable on these matters. If you normalize profit margins (“if profits don’t mean-revert then capitalism is broken”) and mean-revert valuations (along with interest rates), the S&P’s fair value is about 900 right now. A certain group of folks will always try to come up with justifications for higher valuations during a bull market but these justifications will prove faulty… eventually. Doug Short does a lot of Grantham-like mean reversion work on his website: dshort.com.

[davelj]

I defer to Jeremy Grantham on issues of macro-market valuation issues because his logic is always impeccable on these matters. If you normalize profit margins (“if profits don’t mean-revert then capitalism is broken”) and mean-revert valuations (along with interest rates), the S&P’s fair value is about 900 right now. A certain group of folks will always try to come up with justifications for higher valuations during a bull market but these justifications will prove faulty… eventually. Doug Short does a lot of Grantham-like mean reversion work on his website: dshort.com.

[Anonymous]

Here’s an article describing some of the possible issues with the CAPE ratio:

http://money.cnn.com/2011/02/09/pf/shiller_cape_ratio.fortune/?section=magazines_fortune

Some of the items mentioned in the article are similar to Eugene’s points.

It is difficult to know how to treat the recent swings in the market (the big peaks and valleys in the past 10 years.) Since they are somewhat unusual, it might be reasonable to treat the extremes as some sort of outliers. But the extremes are real data, and don’t really fit the definition of statistical outlier.

So I’m not sure the smoothing is the right thing to do.

CAPE is not a perfect model – no model is. Perhaps it could be improved by tweaking, but the tweaking would need to be applied consistently (e.g. weighting results by age instead of weighting all ten years the same.)

It would definitely be folly to dismiss the CAPE numbers completely.

[Anonymous]

Here’s an article describing some of the possible issues with the CAPE ratio:

http://money.cnn.com/2011/02/09/pf/shiller_cape_ratio.fortune/?section=magazines_fortune

Some of the items mentioned in the article are similar to Eugene’s points.

It is difficult to know how to treat the recent swings in the market (the big peaks and valleys in the past 10 years.) Since they are somewhat unusual, it might be reasonable to treat the extremes as some sort of outliers. But the extremes are real data, and don’t really fit the definition of statistical outlier.

So I’m not sure the smoothing is the right thing to do.

CAPE is not a perfect model – no model is. Perhaps it could be improved by tweaking, but the tweaking would need to be applied consistently (e.g. weighting results by age instead of weighting all ten years the same.)

It would definitely be folly to dismiss the CAPE numbers completely.

[Anonymous]

Here’s an article describing some of the possible issues with the CAPE ratio:

http://money.cnn.com/2011/02/09/pf/shiller_cape_ratio.fortune/?section=magazines_fortune

Some of the items mentioned in the article are similar to Eugene’s points.

It is difficult to know how to treat the recent swings in the market (the big peaks and valleys in the past 10 years.) Since they are somewhat unusual, it might be reasonable to treat the extremes as some sort of outliers. But the extremes are real data, and don’t really fit the definition of statistical outlier.

So I’m not sure the smoothing is the right thing to do.

CAPE is not a perfect model – no model is. Perhaps it could be improved by tweaking, but the tweaking would need to be applied consistently (e.g. weighting results by age instead of weighting all ten years the same.)

It would definitely be folly to dismiss the CAPE numbers completely.

[Anonymous]

Here’s an article describing some of the possible issues with the CAPE ratio:

http://money.cnn.com/2011/02/09/pf/shiller_cape_ratio.fortune/?section=magazines_fortune

Some of the items mentioned in the article are similar to Eugene’s points.

It is difficult to know how to treat the recent swings in the market (the big peaks and valleys in the past 10 years.) Since they are somewhat unusual, it might be reasonable to treat the extremes as some sort of outliers. But the extremes are real data, and don’t really fit the definition of statistical outlier.

So I’m not sure the smoothing is the right thing to do.

CAPE is not a perfect model – no model is. Perhaps it could be improved by tweaking, but the tweaking would need to be applied consistently (e.g. weighting results by age instead of weighting all ten years the same.)

It would definitely be folly to dismiss the CAPE numbers completely.

[Anonymous]

Here’s an article describing some of the possible issues with the CAPE ratio:

http://money.cnn.com/2011/02/09/pf/shiller_cape_ratio.fortune/?section=magazines_fortune

Some of the items mentioned in the article are similar to Eugene’s points.

It is difficult to know how to treat the recent swings in the market (the big peaks and valleys in the past 10 years.) Since they are somewhat unusual, it might be reasonable to treat the extremes as some sort of outliers. But the extremes are real data, and don’t really fit the definition of statistical outlier.

So I’m not sure the smoothing is the right thing to do.

CAPE is not a perfect model – no model is. Perhaps it could be improved by tweaking, but the tweaking would need to be applied consistently (e.g. weighting results by age instead of weighting all ten years the same.)

It would definitely be folly to dismiss the CAPE numbers completely.

[Author]

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