Tuesday, December 29, 2009

The Value Of Fundamental Stock Analysis

Via Mish I see this article by John Hussman about the stock market. After arguing that the [U.S.] stock market is overvalued ,a conclusion I agree with as all long time readers know, he cautions that this doesn't mean that stocks will necessarily fall.

"From current valuations, durable market returns appear very unlikely. As I noted last week, whatever merit there might be in stocks is decidedly speculative. That doesn't mean that the returns must be (or even over the very short term, are likely to be) negative. What it does mean is that whatever returns emerge are unlikely to be durably positive."

Or in other words, what high current valuations means is that future long term return will be low. People who buy stocks and hold them for a long period of time will experience low, non-existent or even negative returns. That however, doesn't necessarily mean that short term return will be low. It could in fact be very high, but that high short term return only means that later return will be even worse.

Fundamental analysis can say that expected return is only 2% (in reality, such precise estimates about the future is not possible, the precision only exists to illustrate the point) per year during the following 10 years or so, but it can't say what return the following year will be. However, if return the following year is
-10%, then expected return will rise above 3% per year. If it on the other hand is over 20% then expected return will fall to approximately zero. If return is over 30% then expected return will be negative.

One example of this was the Japanese stock market in 1988. Any valid fundamental analysis made then would have revealed that the Japanese stock market was very overvalued in 1988, yet return for investors was very high in the year that followed. But that only meant that it became even more overvalued, contributing to the negative returns that stock investors have experienced in the Japanese stock market during the latest two decades.

While fundamental analysis can't say anything certain about future short- to medium-term return, it can help establish probabilities. And the higher expected long term return suggested by fundamental analysis, the higher is the probability of rallys and the lower the probability of sell-offs, and vice versa.