Classic Market Bubble

The price to book ratio (P/B) is not a good valuation metric for individual stocks, because the price discounts future earnings and growth. A P/B ratio less than 1 for stock X with low earnings and no earnings growth does mean that stock X is undervalued. If stock Y, with P/B=2 has healthy and growing earnings, it may actually be undervalued and a much better buy than A.

However, P/B does have value when assessing the relative valuation of indexes over time. To that extent, I found the following chart from David Rosenberg, Chief Economist at Gluskin Sheff, which I have modified as indicated.

Rosenberg suggests that the normal range for P/B ratios is between 1.5 and 2.4. The lower number is what is expected coming out of an economic trough and 2.4 is approximately the long-term average. By his analysis we have not had a P/B ratio consistent with economic reality since 1996. We came close on March 9 but quickly left that place.

Note: My reference lines are slightly above 1.5, 2.0 and 2.5 and are minimally above Rosenberg's reference numbers.

Rosenberg also discusses other valuation measurements at length, including price to earnings ratios (P/E). Read his entire post here.

A graph such as this reinforces the opinion that some have regarding when equities in the U.S. really topped. Looking at this graph, one would say the market topped in 2000. The same conclusion is drawn when the market indices are priced in inflation adjusted dollars or gold. (See here.)

The inference from the Rosenberg graph is that one of the following conditions must pertain:

1. We are well into recovery and should entering a maturing growth phase of the business cycle within a couple of years; or
2. We are still declining from the 2000 market high and the current rally will have to give back substantial portions of the gains before long-term market growth can be maintained; or
3. We are still declining from the 2000 market high and have not yet reached the bottom.

I give a greater than 50% probability to #2. The other two get much smaller probabilities: #1 Less than 10% and #3 less than 30%. (You can put the missing 10% into rounding errors. After all, guesses should have large rounding errors.)

The final thought I have from this chart is that it represents a classical picture of a bubble.

Disclosure: Currently short the S&P 500 with SDS.

Comments

[Clive Corcoran:]

John,

From a completely different perspective (and not necessarily one that I would endorse) there are a lot of wave theorists who maintain that 2000 marked a major super-cycle top (perhaps an EWT specialist could sketch out the precise diagnosis).

Other work that I have been doing suggests that the attempt to avoid the recession from the Nasdaq bubble bursting has only extended the bubble to even more exaggerated proportions which now include limitless claims against the public purse.

Seen from afar in the fullness of time it just may be that 2000 was the culmination and finale of the great American century

Oct 11 07:13 AM

[Tom Armistead:]

John, before drawing conclusions from P/B there needs to be some thought given to what's in book value. It could be goodwill from acquisitions, it could be productive assets which have been depreciated to well less than their fair value, it could be bubble assets like land owned by homebuilders, or mortgages on over-valued houses....

Q4 08 was characterized by huge losses fueled by huge writedowns. Excessive goodwill has been wrung off the balance sheets, as have excessive valuations on bubble assets.

With that in mind, an index P/B ratio means something different than it did a year ago. It all reflects the vagaries of GAAP accounting.

Oct 11 07:34 AM

[lower98th:]

"Q4 08 was characterized by huge losses fueled by huge writedowns. Excessive goodwill has been wrung off the balance sheets, as have excessive valuations on bubble assets."

It seems to me that this is only partly true. While much has been written down, the write-downs have not been to market (yet).

Oct 11 07:58 AM

[enigmaman:]

OK, I look at the 10 year charts S&P GDP, PB, PE as well as many others and what I see is a familiar negative trend confirming why over the last decade we are about 32% off the S&P ten year high, similar for other indexes, charts of many types seem to be in agreement that things seem to have been steadily eroding over time. Now going forward we all hope we are on our way out of the worst recession since the GD, however many of the fundamental pieces needed to confirm this are missing or at least not visible except for those who are wearing their " Yuri Geller" forecasting spectacles. The markets have pushed forward in spite of everything, but what has really changed, yes we have pulled back from the brink of disaster but are we safe yet, very few if any will say anything to this affect, the best you will get is they are "cautiously optimistic" thats not an answer, a "definitely maybe" response is the same as saying " I dont know"

Oct 11 08:11 AM

[Tom Armistead:]

lower98th, the conservative bias of GAAP also means that nothing has been written up to market value - that's against the rules. It's like a ratchet, it only permits motion in one direction.

Over the years fortunes have been made by those who looked past GAAP balance sheet values and saw the true economic value of the assets involved.

That could be individual investors buying the shares, or it could be M&A.

Oct 11 08:17 AM

[User 353732:]

The valuations are driven by massive overdoses of liquidity concentrated in a very few asset classes, by sustained market manipulation as extraordinary volume is concentrated on less than a dozen(or even half dozen stocks where the WashDC-Wall ST nexus is the most blatantly obvious) and by deliberate asymmetries in information, access to credit and execution capacity.

Under these circumstances the market reflects the fever of economic disease rather than the glow of economic health.

Traditional valuation metrics are irrelevant because it is not real wealth that is being measured but the spreading vapors of fiat money and fiat resource allocation. The P/B ratio conveys no actionable information when markets are no longer permitted to function ethically and sanely.

Oct 11 08:19 AM

[Tom Armistead:]

The dozen or half-dozen problematic stocks can be ignored and avoided like the plague.

Going out into the rest of the market, while the wheelers and the dealers are busy elsewhere, a patient investor can locate many values.

These values are based on public information in the 10-K, 10-Q, presentations, etc. If the heavy hitters want to focus on the hot stocks so much the better, the opportunities will be out there longer.


On Oct 11 08:19 AM User 353732 wrote:

> The valuations are driven by massive overdoses of liquidity concentrated
> in a very few asset classes, by sustained market manipulation as
> extraordinary volume is concentrated on less than a dozen(or even
> half dozen stocks where the WashDC-Wall ST nexus is the most blatantly
> obvious) and by deliberate asymmetries in information, access to
> credit and execution capacity.
>
> Under these circumstances the market reflects the fever of economic
> disease rather than the glow of economic health.
>
> Traditional valuation metrics are irrelevant because it is not real
> wealth that is being measured but the spreading vapors of fiat money
> and fiat resource allocation. The P/B ratio conveys no actionable
> information when markets are no longer permitted to function ethically
> and sanely.

Oct 11 08:32 AM

[Leftfield:]

In my lifetime I've seen overreaching in rules by and for the connected (politicians and Wall St.) build continuously. Promises made, the appearance of the American dream kept alive despite plummeting real incomes for the former middle class and no realistic chance of the most major promises (SS, public pensions) being kept. Dreamland.
Off-balance-sheet accounting, goodwill, ludicrous CPI and GNP numbers, mark to magic, this by the most overpaid leadership in history while they monetized everything standing, to eternity.
We need to interpret more noise than ever; rules are not exactly constant. The government backs everything they choose with the remnants of the taxpayer balance sheet, and makes up the rules along with GS. The debts were the main vapors fueling the rise; they must be mostly repudiated. Might get messier still.

Oct 11 08:54 AM

[Moon Kil Woong:]

John, sadly historic price to book doesn't work too well because todays version of the financial sectors book value is much different from the past history you are comparing it to. In fact, Frice to book is most likely much higher apples to apples. Even so, we can still get the picture.

I believe equities are being bid up not because of fundamentals as much as one of the only ways the public can hedge against inflation. Also it is one of the only ways to get a potential desent return on their assets asides from commodities speculation. Even so, it can barely keep up with the accelerating dollar devaluation it has been taking to keep GDP on life support. Thus with no greater demand and wages, it does seem to be forming quite a bubble indeed.

Oct 11 09:50 AM

[CautiousInv...:]

I'm a little late to this party so I will be respectfully brief. I think there are oceans of liquidity sloshing about and are being indiscriminately channeled into all financial assets by investors have widely varying views on economic growth, corporate earnings and inflation/deflation.

Unlike bond investors, those investing in equities have a singularly optimistic view of the future and are pricing in a return to the old normal, not the new normal that has been coined and defined by PIMCO. To the extent metric are being used, they are being applied to forward looking outcomes that apparently justify what I view as outrageous valuations.

I'll be very honest in saying I avoided the collapse, made money shorting banks and financials on the way down but have made very little since the lows of March. I have a substantial appetite for risk but do not believe in this market or its underlying fundamentals.

Oct 11 12:39 PM

[Kimball Corson:]

The collapse was indeed a great opportunity to make money, shorting much in the financial sector and elsewhere too, just as the market rise to about DOW=9500 has also been a wonderful money making opportunity as well, but it now clearly seems we are stuck and trending sideways which is not only dangerous, but also a tough environment in which to make gains unless you are a day trader. The market lacks the strength to break DOW=10,000 and it seems everyone is sitting around with great hope for good news that might not be forthcoming except anecdotally and sporadically, but not dependably enough as hoped. At some point, in that case, many might decide the gains are therefore not worth the risk and run for cover, generating a great correction and chance to make yet more money. For now, I am hedged, ready and waiting.

Oct 11 09:47 PM

[Kimball Corson:]

The collapse was indeed a great opportunity to make money, shorting much in the financial sector and elsewhere too, just as the market rise to about DOW=9500 has also been a wonderful money making opportunity as well, but it now clearly seems we are stuck and trending sideways which is not only dangerous, but also a tough environment in which to make gains unless you are a day trader. The market lacks the strength to break DOW=10,000 and it seems everyone is sitting around with great hope for good news that might not be forthcoming except anecdotally and sporadically, but not dependably enough as hoped. At some point, in that case, many might decide the gains are therefore not worth the risk and run for cover, generating a great correction and chance to make yet more money. For now, I am hedged, ready and waiting.

Oct 11 09:51 PM

[Swashbuckler:]

I concur with the inferences the author draws from the Rosenberg graph, and believe that the graph is quite likely a harbinger of market activity.

Oct 11 09:54 PM

[Albertarocks:]

On Oct 11 09:51 PM Kimball Corson wrote:

> The collapse was indeed a great opportunity to make money, shorting
> much in the financial sector and elsewhere too, just as the market
> rise to about DOW=9500 has also been a wonderful money making opportunity
> as well, but it now clearly seems we are stuck and trending sideways
> which is not only dangerous, but also a tough environment in which
> to make gains unless you are a day trader. The market lacks the strength
> to break DOW=10,000 and it seems everyone is sitting around with
> great hope for good news that might not be forthcoming except anecdotally
> and sporadically, but not dependably enough as hoped. At some point,
> in that case, many might decide the gains are therefore not worth
> the risk and run for cover, generating a great correction and chance
> to make yet more money. For now, I am hedged, ready and waiting.<

I couldn't agree more. Adding fuel to my own suspicions that we may have seen a top on Sept. 23 is the wave structure. It could be argued that according to Elliott Wave theory, if Sept. 23 wasn't the top, there would be only one more relatively small spike required to reach the top. But who knows for sure with EW theory? Personally, I find it somewhat useful but exasperating most of the time.

It's more the market internals, negative divergences, momentum, etc. that have me relatively convinced that a top has either been put in, or very nearly so. The only fly in the ointment, is that I don't know how panicked the banksters really are. I think they're so messed up in their heads right now, that they could do a lot more irrational damage than they've already committed upon the markets and investors. Did I say "committed"? That's a word I usually associate with crime.

Oct 11 11:42 PM

[Steven Hansen:]

John,
my conspiracy part of me attributes the run up to governmental parties putting a floor under the market. they have to reinflate the lost wealth.

your other readers have touched on inflation - which should include currency devaluation. much of our stock is in globalized companies which will benefit from the dollar decline.

and i touched on this point in my article today - it is not though the economy has contracted much. a 3% economic contraction should equate to a 3% reduction in profits (after rationalization).

the problem is we have a New Normal shift between sectors, and among different patterns within sectors. this shift should be considered major and requires a massive amount of expenditure to rationalize to this New Normal.

in addition, we have financial issues which weigh on financials - and radiate through the rest of the economy.

my take is that we can guess and guess, calculate and calculate - the issue of stock value has so many variables right now.

my bottom line is that we must be extremely careful - expecting the worst which I don't really believe will happen. but i cannot take that risk.

Oct 11 11:59 PM

[David Van K...:]

Other than the fact that P/B values tend to decline during a recession, I don't see any patterns in the chart. Where does Rosenberg get the conclusion that "the normal range for P/B ratios is between 1.5 and 2.4. The lower number is what is expected coming out of an economic trough and 2.4 is approximately the long-term average"? The chart shows no "normal" ratio. It's all over the place. The approximate average does appear to be about 2.4, but no recession of the five shown on the chart displayed a 1.5 ratio "coming out." The periods following the first two recessions sat around 1.5 for a little while, then moved on. Three other recessions (the majority) are nowhere near that value.

Humans are pattern-seekers. It is a trait that has helped us survive. But seeing false patterns is a detriment to good investing. Unless they are based on information outside this chart, Rosenberg's conclusions about what is "normal" are not justified. This strikes me as a classic example of interpreting data to reach a pre-conceived conclusion rather than the other way around.

Oct 12 09:37 AM

[John Lounsbury:]

David - - -

I like your skepticism. Of course, as a student of Graham and Dodd, I am aware that their prescription for value includes a market price less than book value. Since their time, that low a book value can often be associated with a company that has no future but bankruptcy.

I looked for data that went back further than Rosenberg's graph but didn't find it. I had originally thought it would be interesting to extend this discussion to how P/B has changed over the past 50 and 100 years, but no data, no discussion.

Oct 13 01:19 AM