The Looming Valuation Adjustment Process

A powerful argument is being made by my good friend and frequent Market Forecast panelist, Rich Bernstein, in his most recent report – “Valuation Now at Historical Extreme”. The chart above (click image to enlarge) is from Rich’s report and shows what I noted last Thursday, “Stagflation Lite?” – inflation coupled with a slow growing US economy warrants a much lower P/E ratio then the current “great times” level of 20x earnings.

As the chart plainly shows, the current level sits well outside the sloped trend line and ominously close to the prior market peak levels of March 2000 and August 1987.

Partially explaining this enthusiastic valuation level and a major factor in distorting valuation models is the optimism expressed in the bond market, both in longer-term Treasury yields (10 year, for example) and TIPS spreads, as well as a remarkably low VIX. All three are at odds with the potentiality of a highly uncertain period ahead, exemplified by a stagflationary environment, even a stagflation lite version. Troubling is the fact that corporate default rates are set to rise beginning next year, perhaps producing a flight to quality conundrum, which may explain in part the currently low yields the US Treasury markets are producing. Yet, unless one buys into a global recession scenario*, this low yield/low risk conundrum warrants valuation model adjustments to reflect the stagflation risk, if not the generally uncertain times ahead.

Investment Strategy Implications

While my investment strategy conclusions may differ from my good friend Rich’s, his primary point re inflation and P/E ratios is highly relevant and most timely. As investors face the last third of this woeful year, a look ahead into 2009 is fraught with danger. And despite the recent, and I would argue overdone, commodity price reprieve, one cannot exclude from that list a stagflationary environment that must find its way into valuation models.

Therefore, while the near-term countertrend rallies (and concurrent cyclical corrections in commodity related sectors) may encourage some to view any stagflationary environment as moot, I would prefer to participate while not losing sight of the looming valuation adjustment process.

*Conversely, one must buy into the rose-colored glass view of bottom-up analysts, as noted last Tuesday ("There They Go Again").

Comments

[MarvinMBA:]

Were really going into unchartered terratory unless you start looking at the parallel with the 1930's and everybody is avoiding that comparison.
Until we become energy independent, the countrys economic future is speculative. Value added research in drugs and infotechnology will give us our future but we all have to become scientists to realize it. Our school system is our most important asset for becoming competative world wide....Marvin the Maven

2008 Sep 04 12:26 PM

[discov:]

I have been seeing very bad swing trade signals on the s&p all day. I think we are in process, (it's not looming anymore.)

concisetrading.blogspo.../
Ryan

2008 Sep 04 12:46 PM

[Matt Blackman:]

I have never understood the valuation approach that says a stock gets more attractive the cheaper it gets. That's all fine and dandy if we are in a bull market and experiencing a temporary correction but this approach has a number of major pitfalls. The most obvious becomes very painful in a bear market... or just before a company goes bankrupt.

Take Enron for example. After having been at $80, it seemed like a really good deal when it dropped to $6.00, a better deal at $3.00 and a screaming deal at $0.60, that is just before it disappeared for ever.

2008 Sep 05 02:40 AM

[Ricknplano:]

Is the CPI measured the same way in your chart over the entire time. The U.S. government changed their measurement standard for the CPI at least twice since 1980 with both changes having the effect of lowering the calculated number. Does the chart adjust for these changes or just use the published figure?

2008 Sep 05 09:34 AM

[Kunst:]

"Until we become energy independent..."

The only way we will become energy independent it by cutting our oil consumption by 75%. When do you think that's going to happen?

2008 Sep 08 12:47 AM