By Aidan Levy-Minzi
“Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence, all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price at which it would deserve to sell.“
This quote from Graham and Dodd’s Security Analysis, which was published in 1934 amidst the Great Depression, still holds true today. Ever since Covid-19 took a massive hit on the US economy, there has been a debate about the separation of Wall Street and Main Street. With unemployment still well above pre-pandemic levels and an expected 5% hit on total real GDP, the S&P 500 was still up nearly 16% for 2020. With stock market valuations seemingly so disconnected with current economic conditions, it may be beneficial to revisit the valuation strategies used by analysts, and what specific exogenous variables are used.
Based on modern valuation models and techniques, interest rates are the building blocks on which intrinsic value is situated. The Dividend Discount Model uses the expected return on equity to value future dividend payments. A Discounted Cash Flow uses interest rates as a risk-free asset. So, as an investor, it is easy to justify higher equity prices when central banks cut interest rates. It was this same ideology that led investors to chase mortgage backed securities during the 2007 market peak and housing bubble. It also allowed for institutional investors to sell subprime loans to meet the high demand of yield-seeking investors in a weakly regulated market.
Central bankers cite the Phillips Curve as their motive behind dropping inflation rates. The relationship between inflation and unemployment has caused much debate amongst economists over the past 100 years, but the Federal Reserve still uses interest rates as one of the biggest weapons in its arsenal. Unfortunately, while the Fed is focused on trying to exploit the Phillips Curve, they don’t take into consideration the very strong relationship between monetary easing and yield-seeking speculation. This is due to the Fed’s dual mandate: to maximize employment and control inflation. These macroeconomic changes have massive pull in financial markets, but are not intended to accommodate them.
There is one more piece to the puzzle. Monetary easing doesn’t create overvaluation on its own. If investors are risk-averse, then monetary stimulus does not prop up financial markets. It is only when this stimulus amplifies the distortion investors have on potential speculation and yield-seeking assets that malinvestment and hyper valuations occur. The 1929 crash, the 2000 dot-com bubble, and the 2008 global financial crisis were all exacerbated by risk-averse investors meeting low risk-premiums. The Cyclically Adjusted Price to Earnings ratio, or CAPE, is a long term valuation measurement defined as the price of a particular asset divided by the 10 year moving average of earnings. Therefore, it is best used in forecasting earnings in the next 10-20 years. The graph below shows that there have only been two other times in the past 100 years where valuations have been this far stretched, even with long-term investment strategies. It is also important to note that, in both cases, it was a liquidity-fueled stimulus coupled with a risk-averse investment community that preceded massive corrections.
However, there are some in the investment community that have disregarded the CAPE as a metric that is too focused on the past. NYU Stern’s Aswath Damodaran says that there isn’t much of a difference between the normally used PE and the CAPE, arguing that the cyclicality of the moving average only intensifies its highs during market expansions, when earnings typically peak, along with its lows during recessions. Damodaran also points out that most investors are looking for one-year returns — a predictive power that the CAPE lacks.
With this in mind, another valuation multiple that may shed a bit more light on intrinsic market valuations is Market Capitalization to GDP. Also known as the Buffett indicator, Market Cap to GDP is a measure of how the market is pricing the true value of the economy. The predictive power of this measurement is certainly better than the CAPE. Running a regression analysis of real S&P returns against the Buffett indicator shows a strong positive correlation between the two measurements: about 0.77. A metric with a similar method to that of the Buffett Indicator is Market Capitalization to Gross Value Added, which has a similar correlation to subsequent S&P total market returns. Gross Value Added is a measure of GDP that includes both indirect taxes and subsidies on products, which should help to improve GDP’s measure on international products. In the second graph, both Market Cap/GDP and Market Cap /GVA are at the most extreme levels in the past 50 years.
Let’s bring in the discussion of interest rates. A main criticism of the Buffett Indicator is that it only takes into account asset prices when valuing financial markets. In reality, there are plenty of other options for investors, such as REITs, commodities, and foreign exchange, among others. The more important asset class for this discussion is the bond market. In a perfect world, stocks and bonds are meant to move harmoniously in opposite directions. When interest rates rise, companies find that money is more expensive, and will therefore turn to the bond market to fund new research and development or expansionary costs, which will raise rates and make bonds more attractive. These higher yields will make a dent in corporate profits, which will in turn lower stock prices. In other words, when interest rates fall, stock prices rise and bond prices fall. The argument can be made that, during the dot-com bubble and subsequent crash in 2000, interest rates were hovering around 6%, meaning that investors had the opportunity to invest in bonds, but still opted to pump more and more liquidity into the riskier equity market. Meanwhile, in 2020, bond interest rates reached as low as 0.5%, which has caused many analysts to argue that there is no alternative but to continue buying risky and speculative assets.
There has been the assumption thus far that cash does not appreciate any value as an asset class. However, there is an option value that is embedded with holding cash. Let’s say that someone is given a security that will guarantee them a one time payment of $100 ten years from now for a price of $74.40. That means that the security will be increasing in value 3% annually. Now suppose that the guaranteed payout of the stock is subject to market volatility, and that, maintaining the expected value increase of 3% annually, its value can appreciate by 25% with a probability of 0.51, or depreciate by 20% with a probability of 0.49. If the security is bought today, the investor will realize a profit of 34.41% in ten years. The expected returns, weighted by their respective probabilities, is 37.17%: a 2.76% increase from the passive strategy. Notice that the security’s original price allowed for a 3% annual return, which is significantly lower than the average historical annual returns of the S&P 500, which were between 10%-11% from 1926 to 2018. It is because of these low expected returns that the option value of cash is so great. Therefore, the option value of cash is highest when the security in question has an extremely high valuation. By taking a look at the Black-Scholes model, which is used to hedge against risk when investing in options, the same two factors affect the price of the asset: the current price, and the implied volatility.
An important note here is that the value of a stock is nothing more than a future set of expected cash flows the firm is able to give to its investors. So, the higher the price of a security today, the lower the expected returns on that security will be. Paying more money doesn’t guarantee more cash flows. It only raises the premium investors are paying for it. There is also a higher option value in cash with a higher volatility, as shown in both the above example and in the Black-Scholes model.
There is a clear difference between investing and trading to be seen here. The value behind an asset and the price at which it is set are two measurements that are incorrectly used interchangeably far too often. When watching Bloomberg or Jim Cramer announce the daily price fluctuations from 9:30 AM until 4:00PM, it is humbling to remind ourselves that what they are describing is, in a sense, nothing. The change in price of the S&P or NASDAQ doesn’t create value. That being said, there are drivers behind both value and price. The drivers of intrinsic value include free cash flows to equity, the growth in those free cash flows, and the quality of that growth. Market prices are based more on investor sentiment and market momentum, which usually fuels the day-to-day fluctuations in the stock market. When intrinsic value and market value don’t line up, a gap reveals itself. To see how this gap forms, we look to market information, available liquidity, and corporate governance, along with their relationship with price catalysts and behavioral finance. In 2020, the cheap money issued by the Fed through monetary easing and low interest rates was met with a yield-hungry America, along with an influx of uninformed and irrational investors finding cheap trading platforms such as Fidelity or Robinhood.
Perhaps Keynes was right when saying, “the market can stay irrational longer than you and I can stay solvent”. It is important to keep a watchful eye on GDP, inflation, and the Purchasing Managers Index, while also looking at the put/call ratio, investor sentiment, and the general ‘mood’ that the market has. Which should be given more weight? No one knows. But Graham and Dodd, as well as Warren Buffett and Ray Dalio, have all argued that an asset price will always move towards its intrinsic value. Staying informed and keeping emotions in check are the keys to looking past the noise. □
- Image URL: https://ethanhansn.weebly.com/stock-market-crash.html
- Current Market Valuation. (2020, January 14). The Buffett Indicator. Current Market Valuation. Retrieved from http://www.currentmarketvaluation.com/models/buffett-indicator.php
- Damodaran, Aswath. (2016, August 24). Superman and Stocks: It’s not the Cape (CAPE), it’s the Kryptonite(Cash flow)! Musings on the Market. Retrieved from http://aswathdamodaran.blogspot.com/2016/08/superman-and-stocks-it-not-cape-cape-it.html.
- Dodd, David and Graham, Benjamin. (1934). Security Analysis. McGraw Hill.
- FRED. (2020, January 14). Z.1 Financial Account. Federal Reserve Economic Data. Retrieved from https://fred.stlouisfed.org/series/NCBEILQ027S.
- FRED. (2020, January 14). GDP. Federal Reserve Economic Data. Retrieved from https://fred.stlouisfed.org/series/GDP.
- FRED. (2020, January 14). GVA. Federal Reserve Economic Data. Retrieved from https://fred.stlouisfed.org/series/VAPGDPFI.
- Hussman, John. (2020, December 16). A Good Response to a Bad Situation. Hussman Funds. Retrieved from https://www.hussmanfunds.com/comment/mc201220/.
- Shiller, Robert. (2020, January 10). Historical Shiller PE. Yale University. Retrieved from http://www.econ.yale.edu/~shiller/data.htm.
- Wilshire Family. (2020, January 14). Wilshire 5000 Market Data. Wilshire 5000 Family. Retrieved from https://www.wilshire.com/indexes/wilshire-5000-family/wilshire-5000-total-market-index.