Tuesday, October 14, 2008

More On Stock Market Valuation

My call last Friday of an imminent stock market rally has as most of you probably know been vindicated.

Another thing in that post which have been confirmed was the view that at the time, the U.S. stock market had reached fair value after having been overvalued from a fundamental point of view for some time. I see in the Wall Street Journal that Robert Schiller, using a slightly different methodology came to the same conclusion.

I compared how the S&P 500 had developed relative to GDP since a point in time where I believed stocks were reasonably valued, namely 1994. In the long run, stocks should increase at the same pace as GDP. The reason for that is that stock market valuation can be rewritten as being equal to the P/E ratio times the profit share of GDP times GDP.

Of these three components the only real sustainable source of increase in stock market valuation is GDP (Globalization complicates this potentially, but any deviation would have to assume that domestic companies keep losing or gaining more in other countries than the other way around(. Because although the profit share of GDP often go up and down (it usually increases during booms, while decreasing during busts), profits can't in the long run keep increase faster than production as workers will not accept constantly losing ground. Similarly, while the P/E ratio can go up and down, if it increase too much stocks will simply become overvalued. While it is possible with one-time permanent shifts in levels, the fact remains that the only sustainable source of rising stock market values is a higher value of production.

Illustrating the point that the profit share remains constant in the long run, is the fact that Robert Shiller also concluded that the value of the stock market were at or slightly below the long term value. He used the so-called Graham P/E. The Graham P/E uses the average annual profits during the latest 10-year periods, and so avoids being distorted by unsustainably high profits during the peak of the booms, or temporarily low profits during the downturn. The historical average for the Graham P/E is 16.3, and during Friday it was 15, yielding almost the same conclusion as my methodology.

The article also makes another point that I made in my post. Although we are now seeing a rally and will continue to see one for a while, interrupted only by temporary profit-taking, this was probably not the end of the bear market, because usually when they end, valuations are below the historical average. At its low in 1982, the Graham P/E was just 6.6, less than half of Friday's level. It will probably not fall that low, but it will certainly fall below 15.


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