Saturday, September 25, 2010

Stocks Increasingly Frothy

Gallup's continuous polling is showing a continuing stagnation with a downward trend in discretionary consumer spending.

In this context, the buoyancy of many consumer stocks makes little sense. There's a difference between optimism and investing based on hope against the facts. When even a semi-free market has essentially no value placed on money for as long as two years, with Treasuries paying less than one dollar in total interest per $100 invested for two full years, then the profit outlook for reinvested profits, which is what helps drive the stock market, is poor.

Ultimately what matters in investing is value. Two standard ways to decide on the value of companies ties to their earnings and to the value of their assets. The accountant and investments expert Andrew Smithers, who loudly and contemporaneously called the stock market a bubble in 2000, has just provided another quarterly update of his estimate of the fair value of the S&P 500.

Please look carefully at the linked chart he provides on his website. His earnings-based (CAPE) estimate of fair value and his asset-based estimate (q) are in close agreement that the stock market is massively overvalued. Averaging fair value provided by CAPE with that provided by q gives a fair value of about 725. This in turn means that based on Friday's closing prices, the stock market can be estimated to be about 57% overvalued.

People point to ultra-low interest rates to justify high valuations. Unfortunately, that's circular reasoning. A dead economy is required to justify near-zero short-to-intermediate interest rates. If one carefully studies the Smithers chart, one can look at the 1930s and 1940s, as well as the early 1920s, to find times when there were low to very low interest rates and very low stock prices in relation both to earnings power and assets.

Not only are American common stocks very risky, their prices are increasingly disconnected from the experience of everyone I know and every poll or survey I see. No one I know sees business doing especially well or about to do well. The idea that stock traders know better is a dubious one. It's far more likely that ultra-cheap money is fueling the bull moves in all sorts of assets. The investor's task is to separate wheat from chaff, AIG from Chubb, Honda from GM, stocks vs. Treasuries circa 2000 and circa 2007.

The situation re stocks is reminiscent of the old punch line, "Who are you going to believe, me or your lying eyes?"

Another analogy is Wile E. Coyote suspended in midair.

Yet another analogy is a chart of the Japanese stock market since 1989. It looks like ours, about a decade out of phase. It shows several massive bull moves in a 21 year structural bear market.

This blog has argued for a long time that the best places for investment money were the trend-following ones of being long Treasuries (and implicitly other high quality bonds) and gold. Both of their structural bull markets remain intact. The gold bull is mildly extended short-term and is up about 30% year over year, which is a red flag. The 30 year Treasury is also extended, but the longer duration bonds represent the only part of the Treasury curve which I believe is not yet in bubble valuation.

The chronic weakness of consumer spending continues to support the Treasury bull, and the Fed's response is to print money, which then supports the gold bull. In that context, stocks (other than precious metals stocks) are an afterthought.

Someday the trends will change. Are they changing here and now?

I doubt it.

Copyright (C) Long Lake LLC 2010

No comments:

Post a Comment