The great stock advisor, Richard Russell who writes the “Dow Theory Letters” (ww1.dowtheoryletters.com) received an e-mail September 2, 2009 from one of his subscribers that I think needs to be quoted. The e-mail reads, “Let me get this straight – Obama’s health care plan will be written by a committee whose head says he doesn’t understand it, passed by Congress that hasn’t read it, and whose members are exempt from it, signed by a president who smokes in secret, funded by a treasury chief who did not pay his taxes, overseen by a surgeon who is obese, and financed by a country that is broke.” Only in America.
So here we are, with the Stock Market raging, interest rates at depression lows, the Federal Reserve printing money, Economists suggesting the recession is over, and those that make a living selling stocks proudly announcing the Bear Market is over.
When I went into this business in 1968 I was taught that a stock price was equal to the present value of the dividends + the present value of the residual (sales price at a future date). That in my opinion was the basis for all asset valuations, from Income Producing Real Estate, to the value of a Patent. This valuation concept involved several assumptions, namely, (1) what are the dividends of the future? (2) what are the future earnings? (3) what discount (yield) interest rate do you use? (4) what will the future asset price be? (5) what time frame do we use? Since 1968 the 5 year average annual compound growth rate of the S&P 500 earnings is 6.23%. Below are some assumptions regarding the SP 500.
At a price of 998.47, the SP 500 is selling for 27.34 times 2010 estimated earning’s, and provides a dividend yield of 2.20%. This is not cheap!
Using the above assumptions, the SP 500 must sell for $1,805.40 at the end of 5 years (2014) to yield 15.00%. This price results in a future PE ratio of 36.94 times earnings, and a Peg ratio (PE divided by the Growth rate) of 6.16. Based on valuation concepts, the required future price (to yield 15%) seems almost impossible. Conclusion, the SP 500 is too high. Also note that the Payout Ratio is very high and probably is overstated. If the growth rate is changed to 12.00%, the required future price to yield 15% is $1,770.38, which is 27.51 times earnings, and results in a Peg Ratio of 2.29. In my opinion this future price is still too high, and a 5 year compound growth rate of 12.00% is not going to happen. Conclusion, the S&P 500 is too high.
Now let’s assume I lower the yield required from 15% to 10%. At 6% growth, the required S&P price in 5 years is $1,423.40 which is 29.13 times earnings, and results in a Peg ratio of 4.85 times. The stock is still too high. If I lower the required yield to 5.00%, the 5 year compound growth rate of earnings must be about 14.00%. It is likely, the inflation rate over the next 5 years will be a minimum of 5.00% and Income Taxes will be higher. Subtract income taxes and inflation from the 5.00% yield, and you end up with a loss.
CONCLUSION: STOCKS ARE OVERVALUED! THE CURRENT PRICE IS BASED ON UNATAINABLE ASSUMPTIONS OR INFERIOR YIELDS ON INVESTMENT.
The above chart is the Log of the SP 500 Earnings per Share from December 1900 to August 2009, with estimates through December 2010. The blue line is the trend line. Note the big leaps over the trend line from 1995 to 2007 driven by low interest rates. Also, note the estimated earnings to 12/2010 are almost back on the trend line. It is no coincidence that the stock analysts that predict future earnings stay close to the trend line.
Wait, don’t Economists believe that the fair market value of publically traded assets reflects the consensus of all the minds in the universe, and therefore at any given time, the asset value is correct. Does not each investor buy and sell assets based on rationale thought?
It has been a major assumption by economists that all economic decisions are based on rational thought. Economists describe a formal process for making rational decisions: People consider all the options available to them. They consider the outcomes of these options and how advantageous each outcome would be. They consider the probabilities of each of these options. And they make a decision. The reality is that the bulk of the population do not have the foggiest idea about probability, let alone the various options available to them. As many sociologists have pointed out, most economic decisions are made because “it feels good.”
There is an emerging new school of economics that is interested in the behavioral aspects of economic decision making. In this discipline, psychology and sociology play a part in explaining the so called “white noise” (rationally unexplained economic phenomena) that occurs in markets and society from time to time. Public manias and panics are well documented such as the Tulip Bulb fiasco, the South Sea Bubble, the dot.com boom, etc.
However many of us have known for a long time that: what makes markets go up and down, have nothing to with rational thought. How do you explain investors paying one month’s wages for 1 Tulip Bulb? How does an investor pay $75 for a stock that has not recorded a profit for 10 years? Answer: They expect the price to go higher (confidence). At any given time, collective emotions play a large part in determining market values. There are graveyards full of investors who got caught up with the popular sentiment of Bubbles and Panics. Why would any rational human being buy a stock which by its nature is merely a piece of paper?
As investors screen through investment alternatives, they can choose money market accounts paying less than 1% per annum, a 30 year US Treasury Bond yielding 4.15%, Real Estate that appears to be in a constant free fall, Commodities like Oil, Copper, etc that fluctuate as much as 5% to 7% daily, and don’t know how to buy them anyway, the stock market, that is famous for providing large returns (mainly from the hype of those that prey for a bull market, and profit accordingly). There is currently $9.544 trillion in “Money Zero Maturity” accounts (money market accounts) that are potentially available for investment. $114.9 billion has come out of these accounts since 6/15/09 which translates to some or the entire rise in stock prices. Why are people buying, and not selling?
Most individuals that still have stocks have major losses. Hope springs eternal. As stock prices rise, there sense is to hang in there, buy on the way up, and try to recover their large losses. In addition, all the media constantly reminds us that the bull market has started, the recession is over, and good times are ahead. No one hypes bonds, commodities or real estate anymore. Common stocks win by default.
As stocks started to advance, the Obama affect set in. Obama gives great speeches, and gives the impression that he knows what he’s doing. However, as time went on, every thinking man came to realize he has no idea how an economy works, and is quite frankly over his head. By that time, the market was already rolling, and most folks hung in there anyway.
Now we confront the reality. I think the market is going much lower for several reasons:
(1) The real estate troubles are temporarily deferred but not over (see prior months report);
(2) Banks have received a reprieve with mark to market accounting changes, by not being forced to write down their junk assets. However, a meaningful percent of their assets are still crap;
(3) Most stocks are overvalued;
(4) The printing presses of the Federal Reserve are running full time;
(5) The unemployment rate is rising, which translates to lower consumer spending;
(6) The creation of staggering debt by Congress facilitated by the Treasury Department and endorsed by our President continues ad-nauseam;
(7) The US dollar continues to fall, as our trading partners advocate abandoning the Dollar as a reserve currency.
For the same reasons, I think our economy continues to be in trouble, and expect a return to a recession by 2010. On a lighter note, Gold broke out over it’s resistance of $985 per ounce, and my new Granddaughter Nola, age two months, is looking good.
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1 comment:
As always, I find your insights to be to-the-point and clear. Doesn't hurt that you close with a nod to @lilbabynola!
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