Tuesday, October 6, 2009

Market Valuation, Revulsion, and a Few Things on the Horizon

There are many big picture items in the market that are important, but not all of them are knowable. If one was buying an index fund or investing in the market in a broad fashion, having the information at hand to tell him or her whether the market was in bubble territory, bargain territory, or somewhere in between would be important and, at the extremes, somewhat knowable. The Graham/Shiller PE is one way to estimate the overall level of market valuation – and even though value investors focus on buying individual bargains, there may be reasons to keep an eye on this type of information to help manage risk in one’s portfolio.

The Graham/Shiller PE is a tool used to estimate the fair value of the market (S&P 500). It is like a PE ratio on a stock, except that it comprises all stocks in the S&P 500 and is based on a 10-year moving average of earnings instead of just using earnings over the past year. This is done to smooth out the results that occur as a result of the business cycle and other year to year fluctuations. The average Graham/Shiller PE over time is just north of 15 although, as you can see from the graph, the index spends little time fixed on that value. As you can also see from the graph, this tool has been very good at identifying stock market bubbles, such as the 1929 bubble and the Internet bubble that peaked in 2000.

As of mid-September, with the S&P 500 priced at 1049 (close to today’s price), the Graham/Shiller PE was at 18.77. A month earlier, Frank Martin – a well-respected investor whom I admire – made the following observation: “With one exception, no bubble market in the last 130 years—defined as one in which the Graham/Shiller PE rose above 20 times earnings—escaped the ignominy of sinking to single-digit PEs in the bust that followed. The exception, at least thus far, is the current bear market (or is this a new bull market?).” At the March 2009 low, the Graham/Shiller PE bottomed just north of 13. So that brings up the question: Are we destined for another major fall?

Before I answer that question, let’s briefly explore the final stage of an asset bubble: revulsion. According to the late economist Hyman P. Minsky, the revulsion stage develops along these lines: Sometimes, panic of the insiders infects the outsiders. Other times, it is the end of cheap credit or some unanticipated piece of news. But whatever may be, euphoria is replaced with revulsion. The building is on fire and everyone starts to run for the door. Outsiders start to sell, but there are no buyers. Panic sets in; prices start to tumble downwards, credit dries up, and losses start to accumulate. Have we already seen the revulsion stage in this market or are we currently in a bull market rally on the way to reaching a lower level? Has the accessibility of information made us more or less prone to overshooting on the downside? Has the increased role of institutions in the market made us more or less prone to overshooting on the downside?

The answer to these questions may only be known in hindsight. However, it may be useful to keep in mind one of the rules of investing from Bob Farrell, a retired Wall Street “guru”: Excesses in one direction will lead to an excess in the opposite direction: Think of the market baseline as attached to a rubber string. Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction.

In what many are calling the worst recession since the Great Depression, maybe a Graham/Shiller PE of 13 will be as low as we see. After all, Mr. Farrell didn’t say the overshoot on the downside would equal the overshoot on the upside, and I certainly don’t think Newton’s Third Law applies to market psychology. However, one may acknowledge that the risk is there. In 1982, a recession said to be less bad than our current time, the Graham/Shiller PE dipped below 7, the dividend yield on the S&P 500 was about 6.5%, and the market traded below book value – all a good bit below where we reached at the lows and a country mile below where we are now. Or to consider other times of euphoria that ended in bust, consider the early 1920’s and early 1930’s – when interest rates were more comparable to today – in which the Graham/Shiller PE also found bottom in the mid single digits.

To repeat a question above: Are we destined for another major fall? My answer is one that I can say with absolute conviction…..I don’t know. The focus of a value investor should be on finding business that are significantly undervalued even under the most stressful of economic assumptions. So why should we even pay attention to such information?

As 2008 and early 2009 showed, in an abnormally distressed market, the good gets thrown out with the bad and there are opportunities for profit that one may only see once every couple of decades…..but to profit, you must have the liquidity available to take advantage of those opportunities. As such, it may be a good idea to set the bar a little higher for putting money to work and use some of the recent market strength to build a larger cash position. There are some big news items on the horizon – most notably the continued trend in mortgage delinquencies and foreclosures, the Alt-A and Option ARM resets that really just began and will continue for the next couple of years, more bank write offs, bank closures, and the resumption of the deleveraging process by the U.S. consumer, among other things – and although we can’t know if they’ll lead to the revulsion we’ve seen in the past, it is probably wise to focus on maintaining a portfolio that you think can weather all storms and one that will allow you to take advantage of opportunities should they present themselves.

I am analyst for Chanticleer Holdings, Inc. and Chanticleer Advisors, LLC and am based out of Charlotte, NC. This article should not be taken as investment advice. Please do your own research before making investment decisions.

Other sources for the article: