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Wednesday, August 27, 2014

Valuation and investing

I have been seeing a few articles lately trying to make a case the market is not over valued.  Here is one that uses a valuation method I have never seen before.  By This Measure, Stocks Are Not Overvalued

The modern era starts in 1990.  Does this chart tell us anything meaningful?  Beats me.  Without some time scale or comparison with the Dow or SPX how can you tell.

Here is the final conclusion:

The Takeaway
While Professor Shiller contends that the stock market is currently in "rarefied air" based on analysis of data going back to 1900, our view is that one can't use valuation metrics in a vacuum.  In short, since participation in the stock market has become more mainstream and the market moves have become more extreme over the last 25 years, one needs to make some adjustments to valuation measures in order for them to be useful.
This is NOT to say that Shiller's point is invalid.  There ARE other measures that suggest stocks are overvalued to some degree. However, based on adjusted, median P/E's, stocks do NOT appear to be in the "danger zone" at this time.

It is obvious to anybody that studies long term valuation charts that valuation is not useful for short term market timing.  However, over longer periods of time (7 years or more) valuation absolutely affects the returns.  Here is another attempt to say valuation does not matter.  Even Warren Buffett Can Be Wrong: Ritholtz Chart 

 This chart is in this article.

The article tries to make the argument that this is not a very important indicator anymore despite the fact that Warren Buffett likes it.  Here is a snippet.

So what does market cap as a percentage of GDP tell us? The answer is: Much less than it used to.
Valuation relative to U.S. GDP assumes that the U.S. economy is the driver of capitalization. It really isn’t. Numerous studies have found very little correlation between current economic activity and the stock market.
Then there is globalization. The percentage of income that the S&P 500 derives from overseas activity is now about 50 percent, up significantly from where it was about 20 years ago -- in the 30 percent range. Given that half of SPX earnings are coming from overseas, comparing market cap to U.S. economic activity paints only a partial picture.

The presented chart does not show a market index.  At least it has the dates.  However, it takes considerable effort to determine whether the valuation metric actually works.   While the argument may sound good lets look at the data in a different manner.  This chart is a model John Hussman uses to estimate future returns.  You can read more about it here.  Yes, This Is An Equity Bubble

This chart shows the market cap to GDP ratio overlaid with the actual 10 year return of SPX.  Note the ratio is presented with the scale inverted.  This is inverse from the chart above so that low values on the blue line represent higher valuation.  While actual returns overshoot or undershoot the predicted value at times they generally track very well.  I think I can make the argument that the higher the starting valuation when money is invested the lower the 10 year return will be.  This method still seems to be handling the current era of highly valued markets just fine.  Do you see any reason why it will be different going forward?  I don't.  Note it is currently predicting negative returns for the next 10 year period.  The only other time it did that was in 2000 and it was correct.  We are not quite as extreme as then so I guess the pundits can celebrate that.  Of course there is no guarantee it will get that extreme again is there.

All valuation methods when looked at over the long term show periods of high valuation and periods of low valuation.  These periods last for many years.  However, each period is followed by a period the other way.  I don't think that has fundamentally changed.  The current super high valuation period is likely to be followed by a period of lower valuations then we are seeing now.  That period may be higher then the low periods in the past, but it is still likely to happen.  The question is how much longer will the current period last.

Don Worden of the Worden Brothers (maker of Telechart software) often said it was important to think for yourself.  That comes natural to me as I question everything.  I have come to learn through the years that most people are not that way.  In this internet era thinking is very important.  There are truly lots of fluff opinion pieces out there with little or no basis in fact.  You have a brain.  I hope you use it when reading the Wall Street gobbledy gook they try to pass off as research.  If you are a long term investor then valuation matters.  Period.  This is a very lousy time to put money to work long term.  It looks like it is the second worst time in the last 60 years.  It would seem to me to be a much better time to rebalance the portfolio to reduce equity exposure.


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