Why Stocks Are Currently Undervalued

The world is going into depression. The government response is either too small or too large, socialistic or not helpful enough. Everyone needs a bailout.

Pretty ugly out there.

At times like the present, it's even more important to take a step back to a longer-term perspective. The United States is the most dynamic economy in the world, if not in human history. The government cannot cause economic success. The best it can do is create an environment in which business can succeed. When business succeeds, society succeeds.

Tied to this is the historical fact that GDP grows over time. Efficiency gains and technological innovation, combined with a flexible economy that punishes poor capital investment while rewarding prudent investment, serve to grow the size of the economic pie over time. As one would expect, corporate profits tend to grow along with GDP. In any one year, corporate profits may expand or contract; over the long term that is merely volatility around an upwardly trending mean.

When I look at 1) asset prices, 2) long-term corporate profits, and 3) interest rates I can come up with an implied equity risk premium (ERP) and watch how this ERP varies over time.

It should come as no surprise that this figure varies widely over time. Since 1962, the premium has varied from 2.4% to 12.0%. Note that a higher premium suggests that investors are requiring higher future returns. Hence a high premium would suggest equities are relatively cheap, while a low premium would suggest equities are expensive.

Further, I find it interesting that we have effectively navigated both bounds of that premium over the past 10 years. Using the S&P 500, equities hit a 2.4% premium to government bonds in early 2000, near the height of the internet bubble. The bubble extended beyond merely the internet as I remember how General Electric (GE) was trading at 35x earnings (a different time indeed)!

Conversely, currently equities (once again measured by the S&P) trade at a 11.7% premium, near the max of 12% last seen in 1974 (note: data from 1962 to the present).

One of three things will occur to bring ERP back near the historical level of 6%:

1. Equities bounce as the economic reality that recessions do have ending points and while the current dilemma is a big deal it will ultimately get dealt with.
2. Government effectively changes the future potential of corporate earnings through increased taxation/socialism
3. Government bonds increase in yield as investors require more return for risky government behavior.

I think a combination of 1&3 will occur as equities bounce to 1100 on the S&P by 2011 and 10-year treasury yields eclipse 6%.

Given this prediction, I recommend long equities positions (SPY) along with opportunistic shorting of government bonds (TBT). The latter should be played in smaller size due to its leveraged nature.

Stock position: None.

Comments

[HiSpeed:]

The key to finally getting a decent value on stocks will be to look at stock valuations, not stock prices. Only from historically "cheap" valuations (below the l00 year average PE of 17 +/-10%) can we finally see the birth of a new secular bull.

I would expect the market to overshoot to the downside.

Feb 24 09:29 AM

[Jim Hawthorne:]

A gutsy recommendation, indeed!

Having heard the 'stocks are cheap' mantra for some time now as the markets continue to swan-dive, I would recommend waiting for SPY to build a solid base and see some evidence of the economy healing before doing anything rash!
Good luck!

Feb 24 09:29 AM

[JWhitling:]

Take a look at stock prices during and after the great depression. It took decades to get prices back up. Some of that is a plain and simple loss of faith in the system. The economy can recover without the stock market but the market cannot recover without the economy.

Feb 24 09:35 AM

[chrismatthe...:]

All these arguments makes sense but fundamental arguments usually do. As someone suggested I would wait until you see the SPY begin to build a base or some other more specific technical confirmation.

Feb 24 11:36 AM

[kelm:]

1100 on the S&P by 2011 is a completely meaningless prediction. The fact that you recommend investors go long SPY and yet claim no stock positions speaks volumes.

TBT is a leveraged short designed to track the 20 year treasury on a daily basis. I am long TBT (and PST) but it is as yet unclear how they perform over longer durations due to the re-balancing that is done to them at the close each day. Recommending such a product should always come with a caveat. But of course you're not long TBT either, just recommending it.

Feb 25 11:53 AM

[Random Idea:]

Thanks for your comment. I did want to respond to the stock position issue as you raise a good point that I would like to address. As an active investor I typically invest in single equities (not ETF's), but use my view of the S&P 500 as an asset allocation tool. Hence, although I am not specifically invested in SPY right now I am long US equities.


On Feb 25 11:53 AM kelm wrote:

> 1100 on the S&P by 2011 is a completely meaningless prediction.
> The fact that you recommend investors go long SPY and yet claim no
> stock positions speaks volumes.
>
> TBT is a leveraged short designed to track the 20 year treasury on
> a daily basis. I am long TBT (and PST) but it is as yet unclear how
> they perform over longer durations due to the re-balancing that is
> done to them at the close each day. Recommending such a product should
> always come with a caveat. But of course you're not long TBT either,
> just recommending it.

Mar 03 12:16 PM