Tuesday, October 28, 2008

Reminder: stocks are very cheap

This is my version of an equity valuation model that is very similar to the "Fed Model" and the one used by Art Laffer for many years. It's based on the assumption that the best measure of corporate profits is to be found in the National Income and Product Accounts. It capitalizes those profits using the interest rate on 10-year Treasury bonds, and compares that theoretical measure of value to the actual value as measured by the S&P 500 index.

Based on this model, stocks have NEVER been so cheap. That's another way of saying that this market is priced to the expectation that we will be in a depression that will cause massive bankruptcies and gargantuan losses all over the world. (World stock market capitalization yesterday was down 55% from its year-ago high.)

You've got to be a real pessimist to not like stocks at these levels.


Martin Snider said...

Scott, do you have an explanation or theory as to why Capitalized Profits stayed so consistently above Market Capitalization for the last 5 years before breaking lower?

Scott Grannis said...

Excellent question. I have some theories, but no one really knows of course.

One, stocks were undervalued because monetary policy was easy and inflation was rising; inflation is almost always bad for stocks because it promotes speculation rather than investment. Two, markets were so burned by the last market drop that they stayed shy, refusing to buy into the recovery story. Three, the world never believed that US investments were attractive, which is why the dollar (until recently) fell all the while profits rose; more exciting opportunities were to be found overseas (dissatisfaction with Bush might be a part of this as well). Four, maybe the market was correctly looking ahead and worrying about the problems that finally erupted with the subprime mess. Just as markets are now looking ahead and seeing a depression. (I'm hoping the market is wrong this time.)

What do you think?

Martin Snider said...

I am inclined to say that it was the consistently weakening dollar and the greater attractiveness of equities around the world.

But, I really like that chart. I am pretty long-term bullish as pretty much everything is priced in a recession/depression greater than is likely to happen. I am also encouraged by the speed of the correction which should allow it to effect the economy much less than a long correction.

Finally, I read the stuff written by Obama's economic advisors and feel pretty confident that he will push for the kind of economic policies that you will wish were enacted by a Republican so you could take credit. Actually, if you look back, I think you could argue that Clinton was more Republican in his economic policies and Bush was more "Democratic" in his expansion of government and historic increase in the national debt. It is sadly ironic that even though Republican administrations are terrible accumulators of debt and Democratic administrations consistently pay down debt, people believe it is the opposite.

But, I am getting off topic. I think the firming dollar, if it can hold, and the warm reception Obama will receive from the world will bring much capital back to our markets and close that gap. If you're lucky, after 8 years of Obama and solid economic progress, maybe enough people will forget how easily things can be undone and vote for another Republican. I can only hope that it is Mitt Romney.

Scott Grannis said...

Don't forget that the main reason Clinton was able to shrink the deficit was that a) he cut defense spending to the bone and b) he benefited from the temporary capital gains of the tech boom which later went bust.

I sure hope you're right about the policies of an Obama administration, but you are betting that he will not do anything that he really believes in.

Mark Gerber said...

I also wondered why stock prices never reached a valuation on par with 10-year bond yield (or capitalized profits).

I also came up with the same reasons that Scott mentioned, but I also had a fifth:

The myth that housing is a better investment since it "always goes up." (or "they aren't making any more land you know") Thus, investors/speculators were busy buying homes to flip or second homes as investments. I know here in Tucson lots of professionals were flipping homes on the side. With the appropriate gaming of the tax code, this could even be done tax free.

Scott Grannis said...

Mark: I think that might be a variation on the "inflation is bad for stocks" theme.

Martin Snider said...

So, in researching the "Clinton Surplus," I did find a very credible argument that there was in fact no surplus, which sort of makes Gore's "lock-box" concept all make sense now. So, I will no longer mention Clinton's surplus, because while he did pay down public debt, it was more than offset by an increase in the money owed to Social Security.

Here's the link: http://www.letxa.com/articles/16

That being said, I hope to god that Obama shrink's the defense budget. Forty percent of the workers in defense will be retirement age over the next 5 years. Let's let them retire. Defense is ruining this country. Just like Eisenhower said it would! He was a great Republican. The last one.

Bob said...

Clinton's "surplus" was sham. Don't forget the additional revenue brought in by Roth IRA conversions. His ecomics were so good that Bush inherited a flat virtual zero GDP.

Admitedly there is a lot of waste in defense spending. That's because there is a lot of waste in any government spending. But at least with defense spending we remain strong militarily. Not to mention the technological advances that are made in defense R&D that find there way back into the economy as new business and new jobs.

The truth of Ike's warning about the military industrial complex was that it actually has ocurred between the government and academia. He wasn't wrong about the colusion, just between what parties.

I agree that the Republicans have been a dismal failure when they had the Congress, and Bush's refusal to use the veto is still something of a wonderment, but Obama's economics with Pelosi and Reid in there? Gimme a break! It is pure socialism. It punishes capital formation and incentive. Capital will go where treated best and that will likely not be America with Obama. I don't really care about hope. I want opportunity without penalty.

Scott Grannis said...

Bob: major dittos