Investing Caffeine

Measuring the Market with Valuation Dipstick

April 4, 2010 at 11:27 pm 2 comments

Investor opinions about the stock market’s value are all over the map.

Doomsayers think the market is valued at crazy levels, and believe that “buy-and-hold” investing is dead. Bears remind investors that stocks have led to nothing good except for a lost decade of performance (read article on Lost Decade). Many speculators on the other hand believe they have the ability to “time the markets” to take advantage of volatility in any market (see also Market Timing article). In trader land, overconfidence is never in short-supply. Certainly, if you are a trader at Goldman Sachs (GS) or UBS and you are trading with privileged client data, then taking advantage of volatility can be an extremely lucrative endeavor. However most day-traders, and average investors, are not honored with the same information. Rather, the public gets overwhelmed by online brokerage firms and their plethora of software bells and whistles – inadequate protection when investing among a den of wolves. Equipping speculators with day trading tools is a little like giving a 7-year old a squirt gun and shipping them off to Afghanistan to fight the Taliban – the odds are not in the kid’s favor.

With so much uncertainty out in the marketplace, how do we know if the overall market is cheap or expensive? According to Scott Grannis, former Chief Economist at Western Asset Management and author of the Calafia Beach Pundit blog, the dipstick components necessary to measure the value of the market are corporate profits relative to the level of Gross Domestic Product (GDP) and the value (market cap) of the S&P 500 index. Grannis is a believer in the tenet that stock prices follow earnings, and as you can see from his charts below, earnings have grown much faster than stock prices over the last 10 years:

20 Year Chart

50 Year Chart

As you can see there is an extremely tight correlation on the 50-year chart until the last decade. What does the recent diverging trend mean? Here’s what Grannis has to say:

“Note that profits doubled from 1998 to 2009, yet the S&P 500 index today is still lower than it was at the end of 1998…equities continue to be extremely undervalued. Another way of looking at this is that the market is discounting current profits using an 8% 10-yr Treasury yield, or a 50% drop in corporate profits from here. Simply put, according to this model the market is priced to some very awful assumptions.”

How will this valuation gap be alleviated? Grannis correctly identifies two scenarios to achieve this end: 1) Rising treasury yields; and 2) Rising equity prices. His base case would be a move on the 10-year yield to 5.5%, and a move upwards in the S&P 500 index +50%.

Judging by Grannis’s dipstick measurement, there’s plenty of oil in the system to prevent the market engine from overheating just quite yet. 

Read the Complete Scott Grannis Article

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in GS, UBS, or  any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: Themes - Trends. Tags: Calafia Beach Pundit, market, price follows earnings, profits, Scott Grannis, valuation.