As stocks were soaring on Tuesday afternoon I called James Melcher to hear a dose of fact-based bearishness. Melcher is president of Balestra Capital, a hedge fund in New York, who wrote an essay for his clients two years ago that predicted the broad outlines of the financial crisis (and then arranged Balestra’s portfolio accordingly). Like the bulls, he said that no one could know what the market would do in the short term. “But to think stocks are cheap now,” he added, “is not rational”. He went on: “In the past 20 years - and particularly in the last six or seven - you had the most massive creation of liquidity the world has ever known.” Consumers went ever deeper into debt, thanks to loose lending standards, and a shadow banking system, made up of hedge funds and investment banks, allowed Wall Street to do the same. All that debt lifted economic growth and stock returns. “It was a nice party,” Mr Melcher said. “The problem is that all the bills are coming due at the same time.” He thinks stocks could easily fall an additional 20 per cent and maybe 35 per cent before hitting bottom. My favourite measure is the one recommended by Benjamin Graham and David Dodd, in their classic 1934 textbook Security Analysis. They urged investors to use a price-to-earnings ratio - stock prices divided by average annual corporate earnings - based on at least five years’ earnings and, ideally, closer to 10. Corporate profits may rise or fall in any given year, but a share of stock is a claim on a company’s long-term earnings and should be evaluated as such. (Why not use a forecast of future earnings? Because they tend toward the fictional, as we are seeing once again.) The 10-year price-to-earnings ratio tells an incredibly consistent story over the past century. It has averaged about 16 in that time. There have been long periods when it stayed above 16 and shot above 20, as in the 1920s, 1960s and recent years. As recently as last October, when other measures suggested the market was reasonably valued, the Graham-Dodd version of the ratio was a disturbing 27. But periods in which the ratio has jumped above 20 have always been followed by steep declines and at least a decade of poor returns. By 1932 the ratio had fallen to six. In 1982 it was only seven. Then, of course, the market began to self-correct in the other direction, and stocks took off After Tuesday’s big rally the ratio was just a shade below 16, or almost equal to its long-run average. This is a little difficult to swallow, I realise. Stocks are down 40 per cent since last October, and every experience from the past 25 years suggests they now have to bounce back. But that is precisely the problem. Since the 1980s, stocks have always bounced back from a loss, usually reaching a high in relatively short order. As a result, the market became enormously overvalued. As Robert Shiller, the economist who specializes in bubbles, points out, human beings tend to put too much weight on recent experiences. We think the market snapbacks of 1987 and the current decade are more meaningful and more predictive than the long slumps of the 1930s, 1940s and 1970s. Of course, anyone who made the same assumption in 1930 or 1975 — this just has to turn around soon — would have had to wait years and years until the investment paid off. http://business.smh.com.au/business/dive-back-into-the-us-stockmarket-experts-say-20081031-5fgm.html?page=2
One thing gets me- Historic price /10 yr avg earnings i s 16. But I thought historic Price / LFY earnings was 14-16. ARe they making an apples to apples comparison here? Are we that overvalued based on lfe or ttm earnings?
we live in monetarist times now - there is no tolerance for recessions anymore amongst policymakers. i would say assets will be valued higher now (asset price inflation) given how much money sloshes around globally now. we’re setting ourselves up globally for the mother of all inflation storms. economies going into recessions simultaneously also means growing at potential/above potential simultaneously. the coming upswing may just bring things into resonance, and then - bye bye fiat currencies. hello gold. frankly, i’m very shocked at how little tolerance there is globally for a good ol fashioned recession. we’re becoming very spoiled…