Wednesday, June 16, 2010

Stock Market Valuation

Read the following as if you were a suburbanite young girl who always speaks as if she's asking a question;

So like, I think I should um, like invest in my 401k????

Becuase um, like the HR person said it was good thing to doooooo???

And, um like, I'll buy a stock and it will, like, you know, go up?????

Because that's what I've been told and everybody should be throwing their, um, hard earned money into the stock market because the government said we should???

But then again, never listen to me. What do I know.


Anonymous said...

Not being an economist, not even a junior deputy economist, what is Schiller's CAPE? How does q and CAPE correlate to the stock market (well, actually S&P 500)?

Anonymous said...

Never buy individual stocks...always stron growth mutual funds, at least your hedging a bit anyway. My grandfather always said you're better off debt free at the end of life.

Dr. Bob said...

From a web search - buyer beware.


Q, also known as Tobin's Q, is a basic measure of whether stock markets are in touch with reality. And very often they aren't. Smithers describes it as being like a piece of elastic that will pull any deviation from the long-term average back to it in the fullness of time, as indeed has happened. This follows the classic statistical phenomenon of 'reversion to the mean'.

Moreover, Q's history seems to demonstrate that just as the ratio overshoots on the upside when markets are frothy, the reverse happens when markets are depressed. The period between the mid 1930s and late 1950s, and from the early 1970s to 1990 were periods that Q spent below its long-term average for an extended period of time. Significantly perhaps, these periods followed violent bear markets that, in the case of the 1930s, were credit-induced.

Critics of Q, although there are fewer of them than there used to be, point to the increasing role of intellectual capital rather than physical capital in today's economy. But even intellectual capital that is genuinely created by one company or industry, rather than simply transferred from one owner to another, will be to the detriment of the value of the intellectual capital of another industry or company.


What lends weight to Q is that the cyclically-adjusted PE ratio on the market (CAPE) shows a virtually identical picture, the current value being almost at its long-term average and arguably poised to undershoot. CAPE, devised by the economist Robert Schiller, looks at the PE on the market using a long-term average of real earnings, ideally over the past 30 years. Value investing guru Ben Graham advocated, as far back as the 1930s, using a 10-year average of earnings to determine whether or not individual shares were cheap.

This is the kind of stuff that makes the market so much fun - there is a technical and rational component of the market and a psychological, feeling-based component.

In short, the market seems to be ah... nuts.

In the chart, one can see the "irrational exuberance" of the "dot-com" period and the subsequent correction, and the overheating in 2007 and decline in 2008.