Why fairly valued stock markets are an opportunity
By Martin Wolf
Published: November 25 2008 18:52 | Last updated: November 25 2008 18:52
We have bad news and good news. The bad news is that the world economy is teetering on the brink of what may well be the most damaging slowdown since the second world war. Policymakers around the world – particularly in the inordinately complacent surplus countries – do not begin to understand what this may mean. The good news is that, after an extended period of overvaluation, stock markets are, at last, attractively priced. This should have enticing implications for investors and even for audacious governments.
How does one measure fundamental value? The chart shows two such measures – “Q” and the “cyclically adjusted price earnings ratio” (Cape).
The first of these measures derives from the work of the late James Tobin, a Nobel laureate economist. Q is the ratio of the value of an individual stock (or of the stock market as a whole) to net assets, at replacement cost. Tobin initially proposed this ratio as a way of explaining investment. Andrew Smithers of London-based Smithers & Co, from whom I have obtained the data, realised that Q could be turned round, to value the stock market, instead: high Q then forecasts not so much an investment surge as a stock market fall, and vice versa. If the stock market values the net worth of a company at far more than it costs to re-create its assets, either assets should expand or the market valuation should fall. In practice, argues Mr Smithers, it is more likely that the market is wrong than the investment decisions of companies.
The second of these measures has been used, in particular, by Robert Shiller of Yale University. The denominator is a 10-year moving average of earnings, in real terms. The purpose of this adjustment is to eliminate the cyclical effects on earnings that make price/earnings ratios look low at cyclical peaks, when earnings exceed sustainable levels. At times of rapidly increasing leverage, such as the 2000s, cyclically unadjusted earnings are likely to prove particularly meaningless because they are intensely vulnerable to changes in economic conditions. Leverage, after all, works both ways.
These two indicators should, if properly measured, give much the same result. The chart, which measures Q and Cape, relative to their long-run averages for the US, shows that they do.
What, then, does it show? I would focus on five principal conclusions.
First, valuations show pronounced long-term cycles. They are not a “random walk”. But these cycles are so long that it is nigh on impossible for investors to bet successfully against them: they will run out of money before momentum-driven markets change their mind. This is why markets may be inefficient and yet private investors cannot easily make money betting against them.
Second, the market has seen three peaks since 1920: 1929, 1965 and, biggest of all, 1999 (on the Cape). Prolonged bear markets followed in all cases. Peaks were, in other words, bad times to “buy and hold” – the recommended strategy in the 1990s.
Third, the market has also seen two bear market troughs since 1920: 1932 and 1981. These were excellent times to buy stocks. It helps if purchasers are patient: the period from trough to subsequent peak was 33 years and 18 years, respectively.
Fourth, the US stock market has been in a bear market since 2000, with two downward legs, 2000-2002 and 2007 until now. In the first leg, corporate investment remained weak, as stock prices collapsed. In the second leg, the credit and housing bubbles – partly explained by the Federal Reserve’s response to that investment weakness – imploded. This story is normal: bear markets usually coincide with periods of recession (see chart).
Finally, today’s valuations are considerably below average for the first time since 1988, on the Cape, and 1991, on Q. This does not mean they could not fall far further and, in bad conditions, they are even likely to do so. But, unless one expects another Great Depression and world war, history suggests valuations should not remain below current levels for more than, say, 15 years or so. That may not sound very enticing. But it is a different story from what people like Prof Shiller and Mr Smithers argued back in 1999, when history suggested one might never see such valuations again. Rational people would buy now, not then. Rational people, alas, are rare. As Warren Buffett has argued, buy when “Mr Market” is scared, not when he is bold.
The average valuation of the US stock market corresponds to a real return of 6½-7 per cent, which implies an “equity risk premium” – a margin of return over risk-free government bonds – of about 4 percentage points. This has long seemed high. During the great bull market of the 1990s, some even argued that no such premium was justified. But if one has to ask why equity holders should be risk-averse, one need only look at history. For mortals (rather than immortal institutions), the risk of being caught in a bear market (that is, a period of below average valuations) for 15 years, as happened from 1973 to 1988, is scary. Anybody retiring today knows this.
Directly comparable data are unavailable for other markets. But data on ratios of stock market valuation to gross domestic product for the world, the European Union and the UK, since 1980, have a similar pattern to those of the US. Correlation across markets is so close that what applies to the US should apply to the rest. Japan is different, however. The valuation peak there was in 1990.
I draw four implications. The first is that investors with long time horizons (the relatively young, or institutions) are, for the first time in almost two decades, confronting attractive, although not sensationally attractive, market valuations. The second is that there are, nevertheless, formidable pressures for further falls in valuations, as leveraged players continue to be forced to offload assets at bargain prices. The third is that bottom-fishing investors may at last start to supply some of the equity capital that companies – particularly financial companies – need, once a floor on asset prices is at last set.
Finally, governments might sensibly act as stabilising speculators, as John Muellbauer of Oxford university and Michael Spence, the Nobel laureate from Stanford University, suggested in Tuesday’s Financial Times and on the economists’ forum, respectively. Governments have the deep pockets and the time horizon that is needed. They can offload what they buy when markets have recovered. To the extent that the collapse of markets is self-feeding, such actions should also stabilise the economy. Given the unprecedented actions taken in recent months, this no longer seems a policy step too far.
Sources for charts: Robert Shiller, Andrew Smithers; Thomson Datastream
