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

[haha]

US CAPE and q chart

"On 10th December, 2009 the S&P 500 was at 1102. At this level both q and CAPE show the market to be 48% overvalued.

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.

The CAPE is based on the data from Professor Shiller’s website updated from data published on the Standard & Poor’s website. The EPS for the Q4 2009 is included in the calculation of CAPE and is taken from the S&P website at 12th December which was updated on 4th November 2009.
Smithers & Co. - US CAPE and q chart "

Whee!

Ha

 

[NW-Bound]

Sir, you are a party pooper!

 

[haha]

Don't worry NW, this thread will fade faster than an ice cube in hell.

Ha

 

[brewer12345]

I must confess ignorance of the CAPE metric. As for Tobin's Q, my recollection is that it has been suggesting equity markets are overvalued for a looonnnggg time. This leads me to wonder if there have not been significant changes to the economy and/or accounting that make the Q measure inaccurate.

 

[Ed_The_Gypsy]

All things considered, if this were true, what would a rational action be? Gold coins under the bed?

 

[ziggy29]

It's hard to look at things like "overvalued" and "undervalued" in a vacuum. For one thing, they depend on expected rates of return for safer investments.

I would say that a market with a P/E of 15 is more overvalued in a 10% T-Bill environment than a stock market with a P/E of 20 and a 2% T-Bill yield. The former isn't generating enough excess return to justify the risk, and the latter might be.

 

[mmcc]

I must confess ignorance of the CAPE metric. As for Tobin's Q, my recollection is that it has been suggesting equity markets are overvalued for a looonnnggg time. This leads me to wonder if there have not been significant changes to the economy and/or accounting that make the Q measure inaccurate.

CAPE = 10-Year Trailing PE (i.e. Shiller's metric)

I just started reading Smithers book "Wall Street Revalued". I don't know much about him or his results yet, but only 20 pages into the book I'm impressed with his thinking. Smithers blames the mess we are in on central banker's reluctance to deal with bubbles, partly because EMT denies markets can be overvalued.

 

[brewer12345]

CAPE = 10-Year Trailing PE (i.e. Shiller's metric)
.

Ah, PE10. Had not heard it referred to as CAPE. Thanks.

 

[audreyh1]

I would say that a market with a P/E of 15 is more overvalued in a 10% T-Bill environment than a stock market with a P/E of 20 and a 2% T-Bill yield. The former isn't generating enough excess return to justify the risk, and the latter might be.

Thanks Ziggy - I sometimes forget about the changes in the interest rate environments when I look at those long-term charts.

Audrey

 

[FIREd]

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.

 

[Dawg52]

Just put in a sell order for Monday morning. Thanks Ha.

 

[haha]

Just put in a sell order for Monday morning. Thanks Ha.

Before you act, think over the strong likelihood that this has nothing much to do with the near future.

Here are two interesting interviews by John Authers with Russell Napier, who wrote a very interesting book on the history of Dow bottoms, "Anatomy of the Bear". He is not a crackpot or someone with no skin in the game. In March 2009 he expected a strong rally, but he also thought that the ultimate bottom had not yet been reached, and might not be reached until 2014.

http://www.ft.com/cms/bfba2c48-5588-11dc-b971-0000779fd2ac.html?_i_referralObject=4867217&fromSearch=n

http://www.ft.com/cms/bfba2c48-5588-11dc-b971-0000779fd2ac.html?_i_referralObject=4883575&fromSearch=n

Touching on Brewer's point, fair value or even small undervalue has occurred, for example in late 2008 into 2009. It's just that enduring very low risk entries have in the past not been created by fair value, but by extreme undervalue.

As I see it metrics like this tell us that going on history alone, now is not a low risk time to be heavily in stocks. They don't tell us that the market will not continue to go up. Look at 1995 to 2000. Also, who knows what will come from the wanton money creation going on in world economies? Another market counter-force is the tendency for strong rallies to come off some sort of bottom in the 2nd term of a new president

Personally, I have about 50:50 stocks :cash like investments, but this might change in either direction. I have sold all equities that wouldn't cost me a capital gain tax. I have no note maturities greater than two years. At present my emphasis is on playing defense.

Ha

 

[W2R]

At present my emphasis is on playing defense.

Me too, but no more now than before. Until I can accurately predict (not hindcast) market movements, I have to always consider another crash to be as possible as the equivalent market increases. So, it only makes sense to balance adventuresome tendencies with caution and defensive actions.

 

[FIREd]

Since I do base my investment decisions on valuation metrics (despite their possible flaws), I slightly overweight bonds/cash at the moment.

Edit: My portfolio is like a barbell; in the neutral position it is composed of 50% high quality bonds with shorter durations and 50% higher beta stocks. But I let the center of gravity slide from one side to the other based on market valuations.

 

[Dawg52]

Before you act, think over the strong likelihood that this has nothing much to do with the near future.

Here are two interesting interviews by John Authers with Russell Napier, who wrote a very interesting book on the history of Dow bottoms, "Anatomy of the Bear". He is not a crackpot or someone with no skin in the game. In March 2009 he expected a strong rally, but he also thought that the ultimate bottom had not yet been reached, and might not be reached until 2014.

http://www.ft.com/cms/bfba2c48-5588-11dc-b971-0000779fd2ac.html?_i_referralObject=4867217&fromSearch=n

http://www.ft.com/cms/bfba2c48-5588-11dc-b971-0000779fd2ac.html?_i_referralObject=4883575&fromSearch=n


Personally, I have about 50:50 stocks :cash like investments, but this might change in either direction. I have sold all equities that wouldn't cost me a capital gain tax. I have no note maturities greater than two years. At present my emphasis is on playing defense.

Ha

OK, I'll keep the chips on the table for another year or two. But I'm ready to hit the panic button at any moment. BTW, I could sell every stock I own and not have to worry about capital gains tax. Too many losses already booked.

 

[haha]

During 2008 we had a number of threads about " What did you learn from the crash".

I fel that there really was not alot to be learned, except losing large amounts of money fast hurts. One thing I think I did learn, but don't know what to do about it is that owning quality dividend paying stocks that seem reasonably valued is better than owning trash when the dam breaks. But even the good reasonably valued stocks go down hard. Not quite as much, and you aren't scared to death that they will never recover, but still disconcerting if for no other reason than you would like to be able to buy them at the new lower prices.

This most recent dust-up is the only bad one that I have ever experienced. I started investing in size around the 1982 bottom, breifly got kicked in 1987 like everyone else., but pretty much escaped 2000-2002 because I had played it well.

Different story in fall 2007. I was heavily invested in what I thought were issues at good if not great prices, and I was getting tired of paying taxes on gains, and paying more for everything else becasue of backdoor taxation. So I went in realy exposed. I continued piling in, but by Mid-spring 2009 was starting to lighten up to my current allocation. I don't view this as a permanent posture. If really low 1982 type values start appearing I will consider being close to 100% stocks again. But not while that chart at the top of the page says what it now says.

Ha

 

[NW-Bound]

Don't want to sell anything yet, but I have been w*rking and will be w*rking tomorrow.

 

[Gone4Good]

With respect to PE10, I wonder how much the last century's average of ~15x really matters. If you run a regression on Shiller's PE chart you get a very pronounced upward slope (PE's have been higher in recent years and lower historically). With the exception of the 2009 bottom, PE10 has been above its long-run average since the late 80's and above 20x since the early 90s.

The stock market is certainly expensive relative to what you'd typically have been able to buy if for in the 30's, 40's and the 50's. But since 1960 the PE10 has averaged 19.4x, which is about 6% below where we are right now. So from the perspective of the past 50 years, the SPX looks pretty average.

If this market continues to rally and we get PE10s above 25x I may start lightening up. But right now I'm at my full equity allocation.

 

[Gone4Good]

If really low 1982 type values start appearing I will consider being close to 100% stocks again. But not while that chart at the top of the page says what it now says.

We saw those kind of valuations in March. I doubt many people had the cajones to go all in, though. I'm a pretty dispassionate investor and I like to buy the panics. I bought in the big October sell off. I bought again in November. But it felt like I was throwing money into a wood chipper. It would go in and disappear almost immediately. I did buy in March too, but it was much smaller than my other purchases. By that time it felt like there was no hope. Which I'm guessing is pretty much what you need to get valuations down to 10x. Pretty tough to deplete your safe money in that kind of environment. Some people can do it. But I'm no longer confident I will be one of them.

 

[headingout]

Ditto. I started aggressively buying equities in March 2008, at the gentle start of the downturn, and by March 2009 was out of ammo except for safe money I wasn't going to risk. I did manage to increase my 401K contribution right before the bottom, but that was chump change. I learned that the greatest buying opportunity of the century could pass right by me, and I still couldn't/wouldn't take advantage of it. I did hold and will continue to hold a conservative, long-term focus for that reason.

 

[NW-Bound]

I bought in the big October sell off. I bought again in November. But it felt like I was throwing money into a wood chipper. It would go in and disappear almost immediately. I did buy in March too, but it was much smaller than my other purchases. By that time it felt like there was no hope.

Gee, didn't I and somebody else post the same earlier?

Which I'm guessing is pretty much what you need to get valuations down to 10x. Pretty tough to deplete your safe money in that kind of environment. Some people can do it. But I'm no longer confident I will be one of them.

It helps if you still have a regular income to count on.
This thread scares me into keeping my part-time work now.

 

[haha]

The stock market is certainly expensive relative to what you'd typically have been able to buy if for in the 30's, 40's and the 50's. But since 1960 the PE10 has averaged 19.4x, which is about 6% below where we are right now. So from the perspective of the past 50 years, the SPX looks pretty average.

That is the interesting thing about Q. I am not the person to act as an advocate for it, but people who are (Andrew Smithers, Russell Napier) claim that it is not just a descriptive number, but actually has a fundamental meaning. It is way too subtle to be well served by an internet discussion, but there are books.

Ha

 

[cjking]

It's hard to look at things like "overvalued" and "undervalued" in a vacuum.

"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.

For one thing, they depend on expected rates of return for safer investments.

I believe Smithers disagrees, in his first book, "Valuing Wall Street."

In a chapter called "Yield Ratios and Yield Differences" he explains why bond interest rates are irrelevant.

In another chapter on the dividend discount model he explains that bond interest rates are irrelevant, as the correct discount rate is the cost of equity capital. (Not only is it wrong to use a bond interest rate to value equities, it is wrong to use a bond interest rate to value bonds of a different quality or duration.)

 

[ziggy29]

I believe Smithers disagrees, in his first book, "Valuing Wall Street."

In a chapter called "Yield Ratios and Yield Differences" he explains why bond interest rates are irrelevant.

In another chapter on the dividend discount model he explains that bond interest rates are irrelevant, as the correct discount rate is the cost of equity capital. (Not only is it wrong to use a bond interest rate to value equities, it is wrong to use a bond interest rate to value bonds of a different quality or duration.)

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.

I think the current "low risk return" rate has a lot to do with how much extra risk people are willing to take. If I can buy a Treasury Bond for 10%, as was the case in the early 1980s, there's no way I buy into a market with an earnings yield of 10% (i.e. P/E of 10). But if a T-Bond returns 4% held to maturity, suddenly a stock market with an earnings yield of 10% is very attractively priced.

 

[cjking]

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.

Can you give reference where Graham or Buffet use the "risk free" rate in the dividend discount model?

Incidentally, if they do disagree, I'm so impressed by "Valuing Wall Street" that I'd be inclined to believe Buffet and Graham wrong. (I don't expect they do disagree, but I'm willing to be proved wrong.)

I think the current "low risk return" rate has a lot to do with how much extra risk people are willing to take. If I can buy a Treasury Bond for 10%, as was the case in the early 1980s, there's no way I buy into a market with an earnings yield of 10% (i.e. P/E of 10). But if a T-Bond returns 4% held to maturity, suddenly a stock market with an earnings yield of 10% is very attractively priced.

I don't see how you can not mention inflation in your argument. When a treasury bond is 10% I'd expect inflation to be say 8%, meaning that the real yield on the bond was about 2%. I would regard the 10% yield on stocks as a real yield (on average over the long term), so in your example I would buy the stocks, which are set to return 8% more than the bond.

Edit: based on a similar inflation assumption, stocks would be equally attractive in the other scenario.