Updating Smithers: Continued Caution For Stock Bulls

Includes: DIA, SPY, TBX
by: Econophile

I have frequently referred to a chart produced by a British analyst, Andrew Smithers (then click on "q and FAQs",) who brilliantly (fortuitously) published a book in March 2000 proclaiming stocks to be in the greatest bubble in history -- the very month that the NASDAQ peaked over 5100. Every three months, he updates graphically and descriptively two of the parameters he and his associates have computed that historically have had a very strong track record in predicting the course of stock prices over an appropriate period of time. These parameters are the cyclically-averaged price-earnings (CAPE) ratio for the past 10 years and a version of Tobin's q - a ratio which measures replacement value of corporate assets, and which he argues more than adequately account for intangible but "real" assets such as intellectual property. Here is his updated chart, using data as of 9/30/2011:

(Click to enlarge)

Here is his description, with an update to account for stock prices just a bit lower than year-end prices:

With the publication of the Flow of Funds data up to 30th September, 2011 (on 8th December, 2011) we have updated our calculations for q and CAPE. There has been a 1.6% rise in net worth over the quarter, due to a rise of 10.7% in the current value of real estate. This was despite a downward revision to net worth in Q2 2011 of 1.4%, mainly due to an upward revision of 2.8% in debt.

Both q and CAPE include data for the year ending 30th September, 2011. (99% of EPS for the S&P 500 being available by 8th December, 2011). At that date the S&P 500 was at 1131.42 and US non-financials were overvalued by 26.5% according to q and quoted shares, including financials, were overvalued by 37.5% according to CAPE. (It should be noted that we use geometric rather than arithmetic means in our calculations.)

As at 8th December, 2011 with the S&P 500 at 1234.35 the overvaluation by the relevant measures was 38% for non-financials and 50% for quoted shares. Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has reached the other previous peaks of 1906, 1936 and 1968.

CAPE measures earnings and q estimates the real value of capital employed (assets) in a business; these are complementary measures. Interestingly, they track each other fairly closely. Eyeballing it and trying to mentally average the two lines over the entire time period, I conclude that stocks have cycled between 0.6 and -0.6 for the past 111 years. There are two equal and opposite extreme periods outside of those levels. One was the World War I years extending into the early 1920s, when stock prices were extremely depressed by the combination of first near-hyperinflation during the war and then by severe price deflation (the gold standard at work correcting much of the price inflation), and then the late 1990s into the early 21st century, when the opposite occurred: steady economic growth with declining price inflation (as Asia imploded in the late 1990s, the U.S. was able to import "deflation"). Note that the so-called Great Crash never got as depressed by these measures as in the 1920-21 depression and in the run-up to it.

My guess for a variety of reasons is that one of these days, we will look at this chart and find both CAPE and q well below the zero line. Given that the SPY fund that mimics the S&P 500 index currently yields 1.96%, and given that even with asset growth to gradually prop up q, and also given decent increases in CAPE as 2002-4 earnings get replaced with presumably higher earnings (if for no other reason than inflation and population growth), there is a substantial chance that at some point in the next five years, a large drop in the stock indices is likely to occur that will be greater than dividends received. Thus stocks remain risky relative to cash-like, near-zero-yielding instruments, 2012 significant cyclical economic downturn or not.

While it is impossible to define how important taxable money is to marginal prices in the stock market vs. demand coming from tax-deferred accounts such as pension funds, IRAs, etc., please recall that the Obamacare law provided for large tax increases on investment income for higher-income investors, beginning in January 2013. At the same time, the Bush (1)-era law limiting capital losses to a very low amount means that investors have a double risk that will intensify in one year unless that provision of the law is changed.

Their capital gains and dividends get taxed, but capital losses above modest amounts are not equivalently deductible.

I would suggest that too many investors have downplayed the Japanese example of the coexistence of falling stock markets and ZIRP and have piled or stayed into stocks out of frustration with the alternatives. Yet the Japanese situation of an excess of savings chasing insufficient (perceived) investment opportunities is happening here, as I described last summer in "Yotai Gap to Provide Fuel to the Treasury Bond Bull?."

Only time will tell, but an investment pendulum with an exceedingly long cycle length may have definitively swung in the other direction. In the 1958-60 period, stocks played seesaw with Treasury bond yields, for the first time dropping below the bond yields. Many seers called the end of the stock bull market for that reason; but it turned out to be the end of the bond bull market instead, which had been propped up in price (down in yield) for a quarter of a century for all sorts of reasons.

This disconnect peaked in 2000, when Treasury yields across all parts of the yield curve peaked around 6.5% at a time when the SPY was yielding much less than 2%. This correlates precisely with the peak in the above chart in 2000. Remember "Dow 36,000"? What we got was much, much more like Dow 3600.

While I think that Dow 3600 is now a remote possibility, I think that a four digit Dow is a reasonable possibility if indeed a new recession (or, intensification of the 2007 "Great Recession" aka a mild depression) in fact supervenes in the U.S. this year or soon enough that asset values and CAPE are not inflated too high over time. Meaning, a 20%+ drop from these levels will far outweigh the dividend return in the same time frame.

After half a century of investors accepting the "New Normal" paradigm that stocks should pay out less in dividend yield than a long-term Treasury bond, that ratio finally flipped to the historical level of stocks yielding more than bonds briefly about three years ago, following the plunge in Treasury yields in late fall into December 2008. Then stocks soared as did Treasury yields. But here we are with the SPY yielding 2% and the 10-year Treasury yielding less than that. And the Dow DIAmonds yield 2.6%, just a bit under the 30-year T-bond.

Demographics have begun to work against stocks. A disproportionate and increasing amount of financial wealth is held by retirees and near-retirees. Writing as someone who was strongly stock-oriented for most of a long investing career, I can assert that at today's low dividend yields, it is difficult to see stocks as strong trees on which to rely. Rather, I continue to favor a mix of tax-free bonds for taxable income, and cash and commodity inflation hedges for tax-deferred retirement accounts.

Is there a role for stocks in a diversified investment portfolio? Yes, of course, especially for savvy pros. But I think that my views on reversion to the mean using the Smithers parameters provide cautionary evidence for the bulls who point to current "low" price-earnings ratios and "sunny skies almost forever" views of corporate profits and predict stock market returns well above bond yields for years to come.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

This article originally appeared in the Daily Capitalist and was written by DoctoRx, a cardiologist, medical entrepreneur, and a very successful investor with a 30 year track record.