What Do Tobin's Q and Shiller's CAPE Say About Current S&P Valuations?

[cjking]

I should add the Smithers complains that many people do abuse the dividend discount model by using the wrong discount rate, so I've no doubt that there are any number of examples of people doing so that can be quoted. The only question is how impressive they are as an authority. I wouldn't be that bothered if Buffet did so, but I would be interested if Graham did.

For what it's worth, I've just looked in "The Four Pillars of Investing" by Bernstein, and he says (on pages 50-51) "the DR of the Dow is simply the rate of return we expect from it, taking its risk into consideration." (DR = discount rate.) He goes on to say that if we expect an 8% return from stocks, then 8% is the correct DR. So he agrees with Smithers.

Smithers makes the point that for valuing stock markets, you have to use the expected return on stocks in normal times as the discount rate, not the expected return at the time of the valuation. So (my explanation) if you think stocks generally return 6% real, then you feed 6% into the equation and possibly conclude that from "current" levels (say if you were doing this at the 2000 peak) they will only return 2%.

 

[haha]

In that case, Smithers disagrees with Warren Buffett and Benjamin Graham, both of whom would more likely look at the "risk free" rate of return using something like government bonds and using that as the basis of discounting future cash flows in their analysis of valuation of a security.

Buffett has specifically disclaimed this, in print. He chooses a discount rate based on long term experience, not on current bond rates.

A recent real life example, not based on a guru or "authority", is Japan. Japanese government interest rates have trended down for many years (bond price bull market), during which time equities either crashed or trended down overall.

Ha

 

[ziggy29]

Buffett has specifically disclaimed this, in print. He chooses a discount rate based on long term experience, not on current bond rates.

Which would go against what he said in a quote from Outstanding Investor Digest, 28 September 1998:

[SIZE=-1]In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value - in our case, at the long-term Treasury rate. [/SIZE]

In so doing, you essentially assess the price you're paying for assuming the market risk.

And he doesn't explicit use the term "risk free," long Treasuries were also used by Graham, IIRC, in terms of assigning an appropriate discount rate in conducting security analysis since they were a benchmark for what someone could get in a long-term investment with virtually no market risk.

 

[haha]

I guess that is the trouble with gurus. B*stards are not consistent.

A clear logic fault with using a bond rate, even suitably adjusted for risk is the massive difference in duration. if you choose an equity today based on today's bond rates, you may be stuck with this for a long time during which the bond will be paid off, but the equity which depending on it's dividend rate has a verrrry long duration, will still be sitting in your account. But wait, it wont be sitting there at the price you felt was fair based on t-rates of 3.5% if rates are now at 7%. The same people, applying the same logic would refuse to pay anything close to what you paid.

So, if it sounds good to you, by all means have at it. But there are real problems.

Ha

 

[cjking]

One problem I have with valuation metrics is that many of them would have kept you out of stocks during the past decade including during the handsome 2003-2007 bull market. Many valuation metrics seem to indicate that stocks are expensive right now yet it is hard for me to believe that investing in equities when the S&P is near 1,100 is not going to pay off down the road.

This is a good point.

In "Valuing Wall Street", published in April 2000, Smithers did suggest a two-threshold timing strategy, getting out of equities at say 150% overvaluation and re-entering at 100%. This would have got you out in 1993 and back in near the bottom of 2009/2010. You would have had to earn more than 4.1% real annually from an alternative asset for this to have paid off. On previous occasions you would have had to beat annualised real returns of -0.9% (May 1965-Feb 1974), -27.4% (Sep 1936-Dec 1937), -14.1% (Nov 1928-Sep 1931), and 2.7% (Jun 1901-Jan 1917.) (Calculations done quickly, so accuracy not guaranteed.)

Perhaps a better strategy is to consider the returns on alternative assets, and to switch or lean towards different asset classes as valuations change.

 

[haha]

One problem I have with valuation metrics is that many of them would have kept you out of stocks during the past decade including during the handsome 2003-2007 bull market. Many valuation metrics seem to indicate that stocks are expensive right now yet it is hard for me to believe that investing in equities when the S&P is near 1,100 is not going to pay off down the road.

I don't really see this as a problem. These metrics are not speculation guidelines, they (especialy Q) are an attempt to say that it is built into capitalism to build fresh when corporate assets are valued at far more than it would cost to replace them; and to buy existing assets when they are valued much more cheaply than they coud be built for.

It can tell us when things are very expensive, and when they are very cheap. It can't tell us where prices are going tomorrow, or even next year, or in the case of the second half of the 90s, for 5 whole years.

I do think that a non COLA-receiving retired person's only choice other than to tread lightly in over-valued markets (and for me go heavy in very undervalued markets) is to use a quite moderate equity allocation. For example, if one has 1.5 million invested assets, a 50% equity allocation puts $750,000 at risk. A 50% drop from here would not be bizarre, we almost got there last march and we went well below that in 1982. So that means your $750,000 equity allocation is now $375,000 and your invested assets are now $750,000+$375,000=$1,125,000. And this would not even take us to the valuation levels of the four great bear bottoms of the 20th century-1921,1932, 1949, and 1982.

There may be speculative guidelines that are robust enough to rely on when one knows that there is a lot of air below. 95% of "market strategy" is concerned with this issue.

Ha

 

[Gone4Good]

"Q" does precisely that. Fair value is when what it would cost to buy all companies on the stock exchange equals what it would cost to create them from scratch.

I'm not a student of the Q Ratio so I wonder if someone could enlighten me . . . how do they determine replacement cost?

What exactly is the replacement cost of Google, for example? Seems like it would be a highly speculative measure. We have enough trouble agreeing on what "E" is for a PE ratio. Replacement cost seems much harder to pin down.

To what extent do they account for the value of intellectual capital? Certainly the value of Merk isn't the replacement cost of its buildings and labratories, but rather the value of its patents and research pipeline - which may or may not have any relationship to there GAAP book value.

Is it possible that Q biases toward overvalued because it captures less of the value of a corporation today than when the economy was much more manufacturing based?

 

[haha]

I'm not a student of the Q Ratio so I wonder if someone could enlighten me . . . how do they determine replacement cost?

What exactly is the replacement cost of Google, for example? Seems like it would be a highly speculative measure. We have enough trouble agreeing on what "E" is for a PE ratio. Replacement cost seems much harder to pin down.

To what extent do they account for the value of intellectual capital? Certainly the value of Merk isn't the replacement cost of its buildings and labratories, but rather the value of its patents and research pipeline - which may or may not have any relationship to there GAAP book value.

Is it possible that Q biases toward overvalued because it captures less of the value of a corporation today than when the economy was much more manufacturing based?

These are certainly important questions. Andrew Smithers addresses them in his books. As far as how is Q found, from Smithers' website : " The calculations for q are based on the Z1 Flow of Funds of the US Table B.102 for Q3 2009, which was published on 10th December. The net worth of non-financial companies is assumed to be unchanged from the 30th September and the value of non-financials is assumed to have risen from 30th September to 10th December in line with the change in the S&P 500."

Ha

 

[haha]

I thought I would see where the current PE10 fits in the entire history of the metric. It's the 80th percentile.

I just re-read Valuing Wall Street, Smither's year 2000 book (written in 1998-99). Unlike most investment books, when you return to this one some years later, you don't laugh, you cry.

He has a website, but he does not supply his data. It may be available; it just isn't right there on the website like Prof Shiller's is. However, it appears that both measures-Q and PE10- track one another very closely. Since the entire dataset is available for the PE10(CycliclyAdjustedPriceEarnings), we can do statistical queries. The PE10 value on 13Jan10 is 20.79, which is the 80th percentile.

I think that this would reasonably mean different things to different people. One subgroup of people on this board must be very careful about losing important amounts of money, even on paper. That would be all the retired people of whatever age who really do need their portfolio income to live. The low of March 2009 was not anywhere near as low as major bear market lows have been in the past, and stocks quickly recovered. None of this was guaranteed.

But ignoring that, there is still the question of how much stock a portfolio dependent retired person, or one who really wants to retire soon, should own with the S&P at the 80th percentile.

I think my 50% stock is higher than I would like, but I would pay a lot of CG tax and possibly make it prohibitively expensive to convert a big hunk of TIRA to Roth this year if I sold. So I am not sure what I would like to do, as is too often the case.

By the way, although I prefer Shiller's rather dry writing style, likely everyone who manages his/her own money should read Valuing Wall Street by Andrew Smithers. He also has a new book out, but I haven't yet read that one. I think Valuing Wall Street is a good book to read not because he tells you exactly what to do, but because it will clear any cobwebs or misconceptions from your head. It certainly helped me. I think I'll make it an annual read.

Ha

 

[fritz]

Just Follow the Chimp's Picks

I tend to follow the general consensus of Burton Makiel's "Random Walk down Wall Street" (essentially nobody knows what the market will do).

Thought I'd lighten up the conversation with something I read on MSN recently.

Chimp makes stock pros look like chumps
Posted by Charley Blaine on Wednesday, January 13, 2010 1:10 PM


A chimpanzee in Russia has outperformed 94% of the country's investment funds, with her portfolio growing by three times in the last year.
Moscow TV reported how circus chimp Lusha chose eight companies from a possible 30 in which to invest her imaginary 1 million rubles -- around £21,000 or $33,600 (U.S.).


"She bought successfully and her portfolio grew almost three times. She did better than almost the whole of the rest of the market," Oleg Anisov, editor of Russian Finance magazine, told The newspaper in London.
"Everyone is shocked. What are they getting their bonuses for? Maybe it's worth sending them all to the circus."
The money-wise chimp was given cubes representing different companies and asked: "Lusha, where would you like to invest your money this year?"
Pausing briefly to think, she then picked out her eight cubes.
Lusha's top picks included banks where shares rose a stunning 600% after large-scale support from the Kremlin to weather the crisis.
She missed out on telecommunications, which scored a 240% profit, but went for mining companies, up 150%.


The Russian media heaped more scorn on the investment experts, saying: "Lusha made all serious analysts look like clowns."
One broker hit back: "If the experiment had taken place a year earlier, the monkey would not have had enough money to pay for her bananas."
And her trainer, Svetlana Maksimova. admitted: "Money questions should be decided by financiers and politicians. If monkeys get into it, our economy will collapse at once."


But Pavel Trunin, the head of the monetary policy department at the Institute for the Economy in Transition in Moscow, said enviously: "It shows that financial knowledge does not play a great forecasts to how the market will change.
It is usually a matter of more or less successful guessing. And the monkey got lucky."
The monkey, owned by legendary Russian trainer Lev Dorov, split her investments between state-owned corporations and private companies.


In fairness to the investment managers, it should be noted that Malcolm Forbes, the late editor of Forbes magazine, would annually pick stocks by throwing darts at newspaper stock tables.

 

[MichaelB]

Valuation is about future growth and income and, as Ziggy points out, quite relative. Equities may be overvalued relative to current GDP and profitability, but it’s hard to see alternatives like fixed income offer anything close over the next 10 to 30 years. The capital markets are still in a inflation (equities) vs deflation (fixed income) mode, but the Fed is clearly committed to pushing asset values up and keeping them there. People that rely on portfolio are best to keep our options open in both camps, focus on risk within the class, but not betting against the Fed.

 

[haha]

An investor is always faced with the quesion, "Is it really different this time?'

That is why investing well is hard.

Ha

 

[MichaelB]

An investor is always faced with the quesion, "Is it really different this time?'

That is why investing well is hard.

Ha

I know what you mean. Ambiguous data makes it difficult to draw meaningful conclusions and leads to lots of volatility. This is a good moment to rebalance and, for the more risk-averse, perhaps lower the equity allocation. But not a whole lot – there are many reasons to believe that businesses, especially big global ones, have lots of opportunity to grow profits and access to capital to do so.

 

[haha]

I know what you mean. Ambiguous data makes it difficult to draw meaningful conclusions and leads to lots of volatility. This is a good moment to rebalance and, for the more risk-averse, perhaps lower the equity allocation. But not a whole lot – there are many reasons to believe that businesses, especially big global ones, have lots of opportunity to grow profits and access to capital to do so.

A sidenote on the fact that PE10 is currently slightly above the 80th percentile is that a move to the 90thP would be a 15% gain. A move to the median would be a 24% loss.

Since by definition the median is right in the middle of data values, and P.9 is within 10% of the top that looks to me like a poor bet staring at us.

The arguments that it is instead a good bet resolve to two types: this time it is different(for example because of different features of the current environment that you cite); or none of this matters anyway because none of it matters anyway. In other words, faith based investing-Bogle, Malkiel, whoever.

The only reason that I am harping on this (which I realize that I am doing) is because of the practical reasons that keep me from radically and temporarily reducing my equity allocation. So I am trying to deal with my cognitive dissonance by seeing what counter arguments others put forth.

Faith doesn't do it for me, but this time it's differnet always has its pull.

Ha

 

[IBWino]

With regards to reducing equity exposure, one of my concerns is that both equities and bonds currently appear to be high risk vs. return. As of recent, I've been mostly adding to a short term bond fund, waiting for a correction in equities (yes, I know...market timing).

 

[haha]

With regards to reducing equity exposure, one of my concerns is that both equities and bonds currently appear to be high risk vs. return.

I see it the same way. I also see no problem with market timing. I've been doing it since 1972.

Ha

 

[fritz]

I see it the same way. I also see no problem with market timing. I've been doing it since 1972.

Ha

Do you use the monkey of the darts ;-)

 

[haha]

Do you use the monkey of the darts ;-)

Chicken guts.

 

[CCdaCE]

The market got absolutely crushed over the past year, and what makes me chuckle is that the chart shows it almost got to fair value. Yet, some people wouldn't touch the market with a 10' pole. Others are diving right in. There needs to be an adjustment made, and it seems thats what PE10 was trying to do, but, it doesn't seem to have worked to fairly evaluate whether it's a buying or selling opportunity.

How does M* do it's evaluation? http://www.morningstar.com/cover/market-fair-value.aspx

-CC

 

[HFWR]

The only reason that I am harping on this (which I realize that I am doing) is because of the practical reasons that keep me from radically and temporarily reducing my equity allocation. So I am trying to deal with my cognitive dissonance by seeing what counter arguments others put forth.

Ha

Perhaps adding a hedge of some sort would be in order. Problem solved!

 

[MichaelB]

A sidenote on the fact that PE10 is currently slightly above the 80th percentile is that a move to the 90thP would be a 15% gain. A move to the median would be a 24% loss.

Since by definition the median is right in the middle of data values, and P.9 is within 10% of the top that looks to me like a poor bet staring at us.

This assumes that these measures correctly reflect valuation levels.

The arguments that it is instead a good bet resolve to two types: this time it is different(for example because of different features of the current environment that you cite); or none of this matters anyway because none of it matters anyway. In other words, faith based investing-Bogle, Malkiel, whoever.

I can think of other arguments: first, that the PE10 and Tobin Q have no predictive value, also they do not measure potential future value, second, they don’t consider the money being pumped into the financial system by the Fed, third, they are focused on domestic profits but the largest (by cap) companies are global competitors with access to capital to finance global growth, fourth, equity investment is not limited to US markets, and last, there is no current viable alternative to equity investments. Investment managers judged on relative performance cannot take the risk of cash due to its low yield – exactly the outcome the Fed intends.

The only reason that I am harping on this (which I realize that I am doing) is because of the practical reasons that keep me from radically and temporarily reducing my equity allocation. So I am trying to deal with my cognitive dissonance by seeing what counter arguments others put forth.

HFWR suggestion is best – use a short fund or options to hedge equity exposure if selling is not possible.

 

[Steve O]

What to do

I sold a big chunk of short and intermediate corporate bonds and all GNMA in December when it appeared they were going to to keep losing NAV...

Of course they recovered right after that But I did lock in enough gains that I feel comfortable letting it sit in cash for the time being

I put some of that $$$ to work in utilities, consumer staples, energy, telcom, and financials...

Except for utilities so far so good, but I plan to lighten financials soon...

Yesterday I sold 4% of equities for a nice gain

Im now at 53/31/16 stocks/bonds/cash... 80/20 domestic/international 1/2 ETF's, 30% TIPS/11% High Yield Corporate, and the rest of the bonds in the hands of Wellesley/Wellington... I plan to hold these bonds for a long time...

Hopefully sometime before the end of the month I can sell off another 10% of stocks and raise more cash...

That would be at least 5 years of cash in a MM fund.

I can see no good reason going forward to have short term cash in the bond market

When interest rates rise we should start to see at least a little bit of yield in MM funds...

I agree stocks are getting overvalued and Im going on defense

 

[Steve O]

Oh yea I gotta change my signature because as of today I have one less year to live and worry about funding my ER... Happy Birthday to mee

 

[brewer12345]

I have been taking advantage of the upswelling to do some trimming and repositioning. Mostly have not been selling equiities, as my significant positions still appear reasonably priced and I think the economic recovery is for real. But have been gradually letting go of highly appreciated individual bonds that have littleroom for further gains. Proceeds are going to a short corporate CEF (FTF), commodities, merger arb and debt paydown. I don't see the markets as the huge bargain they were, but there are many gems to be plucked and the markets don't appear hugely expensive if you are of the opinion that we are in recovery mode.

 

[Poundkey]

Brewer, how are you going about investing investing in commodities? Broad range? Specific areas?
Thanks