Not all the news is bad
Martin Wolf (whom we’ve most recently cited as a pessimist) today reminds us in the FT that not all the news is bad, and that some is actually good. He says “The good news is that, after an extended period of overvaluation, stock markets are, at last, attractively priced.” Here’s an excerpt from his reasoning:
How does one measure fundamental value? The chart shows two such measures – “Q” and the “cyclically adjusted price earnings ratio” (Cape). The first of these measures derives from the work of the late James Tobin, a Nobel laureate economist. Q is the ratio of the value of an individual stock (or of the stock market as a whole) to net assets, at replacement cost. Tobin initially proposed this ratio as a way of explaining investment. Andrew Smithers of London-based Smithers & Co, from whom I have obtained the data, realised that Q could be turned round, to value the stock market, instead: high Q then forecasts not so much an investment surge as a stock market fall, and vice versa. If the stock market values the net worth of a company at far more than it costs to re-create its assets, either assets should expand or the market valuation should fall. In practice, argues Mr Smithers, it is more likely that the market is wrong than the investment decisions of companies.
The second of these measures has been used, in particular, by Robert Shiller of Yale University. The denominator is a 10-year moving average of earnings, in real terms. The purpose of this adjustment is to eliminate the cyclical effects on earnings that make price/earnings ratios look low at cyclical peaks, when earnings exceed sustainable levels. At times of rapidly increasing leverage, such as the 2000s, cyclically unadjusted earnings are likely to prove particularly meaningless because they are intensely vulnerable to changes in economic conditions…
the market has seen three peaks since 1920: 1929, 1965 and, biggest of all, 1999 (on the Cape). Prolonged bear markets followed in all cases. Peaks were, in other words, bad times to “buy and hold” -– the recommended strategy in the 1990s…the market has also seen two bear market troughs since 1920: 1932 and 1981. These were excellent times to buy stocks. It helps if purchasers are patient: the period from trough to subsequent peak was 33 years and 18 years, respectively.
We’re certainly prepared to continue to see crazy fluctuations in the market, but we must also admit that some things are looking up a bit. The most important thing would appear to be that the incoming regulators of the new administration (viewed by skepticism by some on the left) seem to have learned from the mistakes of the last two months, and don’t want to repeat them. Making a definitive statement about Citigroup was crucial as a first step. Now volatility is down a bit, and the Fed is attacking mortgage market illiquidity directly. We’ll just have to see where we go from here.