"Here I go again! Gosh it was only six years ago that I cemented my place in stock market history by predicting that the Dow would fall from 8,500 to 5,000, instead of going up to 14,000 where it peaked in October of 2007. Well, I could use the standard set of excuses: 1) No one else saw it coming, 2) I was misinterpreted, and taken out of context, 3) I was tired, overworked, and had family problems, or 4) I had just come out of rehab. But these days what really works is a full confession. I mean, like, uh, it was totally my fault and I take full responsibility. The fact is I was only off by 9,000 points. That’s my story, and I’m stickin’ to it."
See, I'm a Bond guy, and Stocks aren't really my game. So, although I screwed up royally before in predicting where stocks are going, it's still worth listening to what I have to say, because, even though I'm not a stock guy, I'm a very good bond guy. Needless to say, buyer be very aware.
"Well, fools rush in. This time though I’m definitely older and maybe a little bit wiser. No magic number, nor a specific target date from the Swami of the Dow. This one will be more conceptual, but still present a “take” that you can criticize or damn with faint praise. And no, despite the title, it doesn’t imply that the stock market is headed to 5,000 and that I was always right or just a little bit early. It only suggests that I’m readdressing the critical topic of equity valuation – that mysterious fragile flower where price is part perception, part valuation, and part hope or lack thereof. Press on, Swami.'
I'm certainly wiser, since I'm not going to give specific numbers, which are, unfortunately, specific, this time. I'm going more heuristic this time, adding a kind of Nostradamus tinge to my predictions. Oh, and by the way, equity evaluation is a messy business, involving problems such as Skepticism, the Uncertainty Principle, and Weakness Of The Will. So cut me some slack.
"Let me first announce a fundamental premise with which I think all rational investors would agree: I believe in stocks for the long run – but only if purchased at the right price. That statement packs a real punch. It says that capitalism is and will remain a going concern, that risk-taking – over the long run – will be rewarded, but only from a starting price that correctly anticipates the economy’s growth and its share of after-tax corporate profits within it. Acknowledging the above, let’s look at a few basic standards of valuation that historically have stood the test of time, to see if at least the price is right. "
Since it's a premise, if you don't agree to it, there's no point in going on. Here's the premise:
You buy a stock at a specific price. When you go to sell it, what matters is your profit, into which you need to take into account things like inflation, taxes on the sale, taxes on dividends perhaps, etc. Sometimes, holding a stock for a long time works very well, and sometimes it doesn't. If you buy an index, the same rules apply. You bought at one index level, and when you later sell at another level you will have to factor other things in besides the rise in it's price.
So, where are we now? Is this a good place to buy stocks?
"One of them is what is known as the “Q” ratio, or the value of the stock market relative to the replacement cost of net assets. The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, “Q” should mean revert to 1.0. If so, then oh, oh what a “Q”! Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation, as seen in Chart 1."
First off, what's a ratio:
"A ratio is an expression which compares quantities relative to each other. The most common examples involve two quantities, but in theory any number of quantities can be compared. Mathematically they are represented by separating each quantity with a colon, for example the ratio 2:3, which is read as the ratio "two to three".
So, our ratio compares:
1) Price of stock
2) Price to replace net assets
"The ratio of stock prices to the current replacement values of the firms' underlying assets. Some analysts believe a relatively high Q ratio (higher than 1.0, although the level is subjective) indicates an overbought market. Also called Tobin's Q."
The level is subjective, eh. Fine. Take it with a grain of salt. Since we're talking money, add a handful of salt.
"Tobin's q is a ratio comparing the value of the stocks of a company listed in a financial markets with the value of a company's equity book value. The ratio was developed by James Tobin (Tobin 1969). It is calculated by dividing the market value of a company by the replacement value of the book equity:
- Tobin's q =
Another use for q is to determine the valuation of the market as a whole. The formula for this is: 
Here's a criticism:
"Doug Henwood, in his book Wall Street, argues that the q ratio fails to accurately predict investment, as Tobin claims. "The data for Tobin and Brainard’s 1977 paper covers 1960 to 1974, a period for which q seemed to explain investment pretty well," he writes. "But as the chart [see right] shows, things started going away even before the paper was published. While q and investment seemed to move together for the first half of the chart, they part ways almost at the middle; q collapsed during the bearish stock markets of the 1970s, yet investment rose." (p. 145)"
Why did I include this? You don't need to analyze it. I don't. It's just to show that the graph and methodology Gross is using, although mapped out, is controversial, and you need to consider that when weighing his analysis.
One other reason. I'm a big fan of Willem Buiter, and this is his doctoral committee:
"Ph.D. in Economics with Distinction. Dissertation: Temporary Equilibrium and Long-Run Equilibrium. Dissertation Committee: James Tobin, Gary Smith, Katsuhito Iwai. Published by Garland Publishing, Inc., New York, 1979."
That's right, James Tobin. So, I put the Tobin reference in just for fun.
Okay, by this graph, stocks are undervalued. They generally are. Does that make sense. To me, not really.
"Another long-term standard of valuation comes from the good ol‘ P/E ratio, where earnings per share, or E, is compared as a function of P, or price. Chart 2, going all the way back to 1871, shows the same relatively massive undervaluation, not only in the U.S. but elsewhere. This has been a global bear market. Yet here one should be careful. The sage of rationality, Yale’s Robert Shiller, cautions us to look at earnings on an historical 10-year moving average to remove adverse or fortuitous cyclicality. When measured on this basis, P/E’s are cheap but less so, slightly below their mean average for the past century."
"Professor Shiller may be on to something, although even his 10-year approach may not be enough to adjust for our future economy and its functioning within the context of a delevering as opposed to a levering financial system. "
The economy and stocks are going down as we unwind from the build up. Ten years might not be a good guide, because, well, we don't know how long this unwinding will last.
"Recent Investment Outlooks and indeed, discussions in PIMCO’s Investment Committee and Secular Forums for the past several years have pointed to the necessity to view current changes as not only non-cyclical, but non-secular. They are, in fact, likely to be transgenerational. We will not go back to what we have known and gotten used to. It’s like comparing Newton and Einstein: both were right but their rules governed entirely different domains. "
First of all , were Newton and Einstein both right? I don't think so. However, we can use Newtonian Mechanics, suitably modeled, to solve real world problems, even today. But was he right? If equations are useful, are they automatically right? I don't find this very useful. Will we still be able to use the old models of analyzing stocks or not? What are the domains of stocks? Einstein's rules apply, only in very tiny ways, that allow Newtonian type equations to still be useful. Something like that.
"We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money. Welcome to a new universe stock market investors! In this rather “sheepish” as opposed to “brave” new world, here are some considerations that may affect Q ratios, P/E’s, and ultimately stock prices for years to come:"
This seems true. We shouldn't expect prices of stocks to look like they have in the 1990's and since. Returns will probably go down.
I've no idea, but this seems right, or, at least, prudent.
"Animal spirits, and with them the entrepreneurial dynamism of risk-taking has likely experienced a body blow. Not only have dancers on the financed-based dance floor been shown the exit à la Chuck Prince, but those that remain have been publicly chastened and handcuffed. Golden parachutes, options, executive compensation and bonuses themselves are now at risk. Care to climb to the throne of this new world? Well, yes, egos will always dominate, but the rules will be changed and hormone levels lowered."
This sounds like Shiller. I'm most at home here. These kinds of dampening moods seem to change very quickly. A lot depends upon wars, etc.
"The benevolent fist of government is imperative and inevitable, but it will come at a cost. The champion of free enterprise, Ronald Reagan, knew that growth of the private sector was in no small way dependent on deregulation and the lowering of tax rates. Now that those trends have necessarily come to an end, no rational investors should expect innovation and productivity to be unaffected. Profit and earnings per share growth will suffer."
In the short term, yes, but we certainly did grow after WW II. That was a different world. Yes, but so is this.
"My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner. "
Let's think about that. Will young people, raised under those conditions, automatically reject them because of this crisis? Are we unwinding the whole system as well under this crisis?
"Dow 5,000? We don’t have to go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well. One only has to recognize that roughly 20% of bank capital is now owned by the U.S. government and that a near proportionate share of profits will flow in that direction as well. Better to own corporate bonds than corporate stocks, but that’s a story for another Investment Outlook."
See, I'm a bond guy. Good points. He's a bit more pessimistic than me, but he's quite a bit wealthier. I'm a conservative financial person by nature. So, investing wise, to the extent that I do such a thing, this analysis didn't change anything I'll be doing in the near future.
As to the economy and current trends, he does clearly map out some of the problems or changes ahead, generally flowing from more government involvement in the economy. But these are only trends and challenges, and I'd say that they're pretty clearly in view, for us to deal with as we will.
Are stocks worth buying? If I could tell you I'd let you know.
Finally, let's look at Yves points:
"Gross does not mention that this last upturn saw an unprecedented portion of GDP growth going to corporate profits, as opposed to labor. Labor has had no bargaining power, and companies have been running as lean as possible in a nominally good economy. There will likely be some reversal of rules that worked against unions, but it is not clear whether this will help average workers much."
I tend to believe that higher wages are good for the economy, but that's just me.
"We noted before that in 1980, financial shares were a mere 8% of S&P 500 earnings versus over 40% at the stock market peak. The financial services industry will shrink as the economy delevers. Some of those earnings are not coming back."
I'm actually wondering if these financial guys will end up more powerful before this whole thing unwinds.
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