Use Stock to GDP Ratio For Valuation Review

 

Since 1925 there have been five major eras in investing two were bearish, three were bullish. These eras last about 17 years. From 1925 to 1940 stocks were priced higher than an undervalued threshold even though much of the time the economy was hurt by the Great Depression. From 1940-1955 stocks were undervalued compared to GDP. The cycle reversed from 1955-1974with stocks slightly overvalued but still reasonably priced. In 1974 – 1995 stocks were mostly close to the undervalued zone typically at 49% of GDP. Since 1995 stocks have been typically near 125% of GDP and ranged from 91% to 167% of GDP, except for the crash of 2009. The 89 year norm has been 60.6% of GDP. Based on the norm stocks are overpriced by double their value. They need to drop from 125% of GDP to 70% of GDP (a decline of 44%) to be moderately overvalued (but reasonably overvalued). To be at or below the level of being very undervalued they would need to drop to 39% of GDP, a drop of 69%, where the SP would be at roughly 610 points. (In the 2009 crash the SP went down to 666).

People complain that the PE10 ratio doesn’t work because stocks have been overpriced for many years, however, feel that the markets have eras or cycles when they are overpriced or underpriced that are roughly 17 years long. The current era started about 18 or 19 years ago. If the current over pricing started in early 1997 then it is now the 17th anniversary of a mega-bubble. Just because these cycles last along time doesn’t mean that fundamentals like PE10 are not working. Fundamentals appeared not to work during the great 1998-2001 bubble but eventually the truth came out and stocks crashed 50% from 2000 to 2002, and NASDAQ never reached its old high of year 2000.

There is a new era that started with the crash of 1987 when Greenspan panicked and tried to sooth the markets with a sudden rate cut. Ever since then the Federal Reserve has tried to stop markets from crashing thus brainwashing investors into thinking there is no risk which created a bubble. At the same time cheap no load mutual funds, dirt cheap ETF’s, and cheap online retail trading became available which encouraged more speculative interest in investing. But eventually something will happen and stocks will go down and since the Fed can’t cut rates any more then stocks may get stuck in a 17 year cycle of being valued at a lower price relative to GDP than the past 17 years, meaning that stocks might go down 50% and get stuck in a trading range at 40% to 60% below today’s prices.

The pattern of publicly traded companies in recent years is that they boosted profits by cutting costs instead of increasing sales. This cost cutting resulted in very little “capital deepening” of plant and equipment. In other words companies saved money by using old run down equipment, forcing workers to work harder for less, etc. There are limits to how long that can go on before equipment becomes hopelessly worn out and the best workers leave for better conditions elsewhere. Thus the profits growth in recent years has been somewhat dubious. It reminds me of a large company in 1990 that hired an aggressive CEO with the nickname “Chainsaw” who cut costs and raised profits and was greatly praised in the news media. Then suddenly after two years he was fired because it was alleged that he had cut too deeply thus damaging the company. It was like a homeowner who “saves” money by not fixing a leaky roof only to incur greater and more catastrophic damage later on. I fear that corporate America maybe going through this phase of experimental cost cutting or of shirking responsibility to do capital deepening. It looks good for the P & L for a while until suddenly it gets worse.

Profits can be manipulated but it is hard to manipulate sales of giant companies of the country’s GDP. Investors can engage in irrational bubbles so asset prices of popular trading vehicles such as stocks are the most unreliable economic indicators. Boring assets like bonds are more reliable. When have you heard retail investors brag emotionally about a really exciting bond purchase? Bonds are dominated by professional investors. Bond yields have declined despite the great labor market improvement of the past six months. Is it possible that the bond vigilantes know something that stock investors don’t? Who can explain the mysterious disappearance, allegedly through early retirement, of 3.5% of workers during the scary 2009 crash? Usually it takes courage and stock price growth to encourage retirement, so a crash would be an unlikely time to retire.

Investors need independent financial advice about the risks that after a 17 year bubble eventually the truth comes out and stocks go down. I wrote an article “The mystery of the missing millions” about hidden unemployment. An interesting parallel is that undercapitalized individuals can “pay” for retirement by ignoring the need to pay for capital improvement projects around their home, etc. which is an analogy to the corporate world where companies defer capital projects to temporarily boost profits. Eventually both naïve undercapitalized retirees and corporations may find that their true long term costs (regarding deferred maintenance and capital improvements) are higher than they thought and then some painful adjustments will have to be made.

 

About the author

Don Martin, CFP®

Leave a Reply

Your email address will not be published.

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

Copyright 2014 FiGuide.com   About Us   Contact Us   Our Advisors       Login