Wednesday, January 4, 2012

Smithers & Co. Market Valuation Measures Update

The indicators in this post are designed to coincide with or better yet, forecast what Charlie Dow thought of as the "tides of the market":
“Nothing is more certain than that the market has three well-defined movements which fit into each other. The first is the variation due to local causes and the balance of buying and selling at that particular time. The secondary movement covers a period ranging from 10 days to 60 days, averaging probably between 30 and 40 days. The third movement is the great swing covering from four to six years.”
-Charles Dow
Wall Street Journal editorial
January 4, 1902
They aren't much help in ascertaining the shorter term waves or the hour-to-hour ripples.
They do assist short term positioning in that they guide you toward a less aggressive stance than would be called for by the rightward bias in the historic aggregate of U.S. stock return distributions. See chart after the jump.

From The Daily Capitalist:
Updating Smithers: Continued Caution for Stock Bulls
I have frequently referred to a chart produced by a British analyst, Andrew Smithers (then click on “q and FAQs”,) who brilliantly (fortuitously) published a book in March 2000 proclaiming stocks to be in the greatest bubble in history- the very month that the NASDAQ peaked over 5100.  Every three months, he updates graphically and descriptively two of the parameters he and his associates have computed that historically have had a very strong track record in predicting the course of stock prices over an appropriate period of time.  These parameters are the cyclically-averaged price-earnings (CAPE) ratio for the past 10 years and a version of Tobin’s q – a ratio which measures replacement value of corporate assets, and which he argues more than adequately account for intangible but “real” assets such as intellectual property.  Here is his updated chart, using data as of 9/30/2011:

Here is his description, with an update to account for stock prices just a bit lower than year-end prices:
With the publication of the Flow of Funds data up to 30th September, 2011 (on 8th December, 2011) we have updated our calculations for q and CAPE. There has been a 1.6% rise in net worth over the quarter, due to a rise of 10.7% in the current value of real estate. This was despite a downward revision to net worth in Q2 2011 of 1.4%, mainly due to an upward revision of 2.8% in debt.
Both q and CAPE include data for the year ending 30th September, 2011. (99% of EPS for the S&P 500 being available by 8th December, 2011). At that date the S&P 500 was at 1131.42 and US non-financials were overvalued by 26.5% according to q and quoted shares, including financials, were overvalued by 37.5% according to CAPE. (It should be noted that we use geometric rather than arithmetic means in our calculations.)
As at 8th December, 2011 with the S&P 500 at 1234.35 the overvaluation by the relevant measures was 38% for non-financials and 50% for quoted shares.
Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has reached the other previous peaks of 1906, 1936 and 1968.
CAPE measures earnings and q estimates the real value of capital employed (assets) in a business; these are complementary measures.  Interestingly, they track each other fairly closely.  Eyeballing it and trying to mentally average the two lines over the entire time period, I conclude that stocks have cycled between 0.6 and -0.6 for the past 111 years.  There are two equal and opposite extreme periods outside of those levels.  One was the World War I years extending into the early 1920s, when stock prices were extremely depressed by the combination of first near-hyperinflation during the war and then by severe price deflation (the gold standard at work correcting much of the price inflation), and then the late 1990s into the early 21st century, when the opposite occurred:  steady economic growth with declining price inflation (as Asia imploded in the late 1990s, the U.S. was able to import “deflation”).  Note that the so-called Great Crash never got as depressed by these measures as in the 1920-21 depression and in the run-up to it.

My guess for a variety of reasons is that one of these days, we will look at this chart and find both CAPE and q well below the zero line.  Given that the SPY fund that mimics the S&P 500 index currently yields 1.96%, and given that even with asset growth to gradually prop up q, and also given decent increases in CAPE as 2002-4 earnings get replaced with presumably higher earnings (if for no other reason than inflation and population growth), there is a substantial chance that at some point in the next five years, a large drop in the stock indices is likely to occur that will be greater than dividends received.  Thus stocks remain risky relative to cash-like, near-zero-yielding instruments, 2012 significant cyclical economic downturn or not....MORE

The 'normal' (actually lognormal) distribution is the familiar bell curve. Here's a chart of yearly returns via Bogleheads:

The same rightward shift is seen in the monthly and daily distributions, to the point that over the 30,000 or so trading days between the creation of the Dow Jones Industrial Average and Spring 2007 the market was up on 52.67% of those days. (Hulbert)

There is a huge caveat to my statistical fooling around:

We only have one U.S. market history and that history is strognly influence if not created by the socio-economic backdrop of the country's rise to the position of largest economy in the world, the distribution, lumpy as it may be, of the wealth created by this economy and on and on.
Past performance really is no guarantee of future results.