Is It Time To Throw Away Ben Graham's 'Intelligent Investor' Book?
- We revisit market valuations using the Gordon Model, which shows returns in Plausible, Pessimistic and Optimistic scenarios of -45%, -59% and +2%, respectively.
- A CAPE partial mean reversion model shows a drop of 16% and a 2008-09-style bear market loss of 49%.
- These models and the current Federal Government and Fed actions call into question the validity of long-time financial principles of equity valuation.
- Is it time to throw away the “Intelligent Investor” book by Ben Graham or are we approaching a once-in-a-century event as described by the brilliant investor Ray Dalio?
Recently, my nephew, who is an Executive VP of a large bank and a Certified Financial Analyst, sent me an email: “The stock market is insane. I have to throw away my Intelligent Investor book. It is no longer a market."
That and the recent market rebound of more than 25% prompted me to revisit my article from March, "How Low Can It Go? Possibilities from Dispassionate Market Valuation Models." Below, I show S&P 500 index return expectations from the Gordon Model, a discounted dividend method. The returns over the coming year under three scenarios, Plausible, Pessimistic and Optimistic, are -45%, -59% and +2% respectively. The CAPE partial mean reversion model shows a drop of 16% and a loss of 49% in a 2008-09 bear market scenario. These models and the current Federal Government and Fed actions call into question the validity of long-time financial principles of equity valuation.
Perhaps billionaire hedge fund investor Ray Dalio has the explanation in his brilliant LinkedIn article series. He lays out the case for why we may be entering an epic reset to the financial and political world order. Dalio warns: “But one cannot create more wealth simply by creating more money and credit. To create more wealth, one has to be more productive.”
Revisiting the Market's Measured Value
In my article from March (linked to above), I demonstrated a Plausible, Optimistic and Pessimistic set of return expectations for the S&P 500 index, using the Gordon Discounted Dividend Model, the CAPE ratio and P/E ratio. Those outcomes are repeated for your convenience in the table below.
At the time of that writing (March 16), the impact of the coronavirus on GDP, employment, earnings, dividends and expected long-term economic growth was very unclear. Amid the early virus outbreak chaos and its exponential rate of infections, the market dropped to a low of 2237 on March 23rd. Curiously, this is exactly the CAPE Partial Mean Reversion value and just above the “Gordon Plausible” value of 2,071. Yet, that low was well above the Gordon Pessimistic and CAPE Worst Case levels.
A lot has happened in the meantime. The Cares Act, signed into law on March 27th, funded an incredible, multi-faceted $2.3 trillion program in a very short time. About a week ago, an additional $320 billion was added for the Paycheck Protection Program (PPP) on top of the initial $350 billion that was exhausted in just 13 days. The NY Times reported that the Fed’s balance sheet is now at a record $6.7 trillion, up from $4.2 trillion in the first week of March. The weekly increases have slowed but are still running at a pace of $82 billion. The Fed also announced it will buy corporate bonds, muni-bonds, junk bonds and ETFs. More than 30 million people have filed for unemployment, and Q1 GDP printed at -4.8%. As a result, politicians are already plotting the next round of massive stimulus. Even a guaranteed minimum income is on the table, as promoted by Nancy Pelosi.
The curve has begun to flatten across the U.S. and the globe. There are growing signs of possible COVID-19 treatments and vaccines, most notably Gilead’s (GILD) Remdisivir. Some states have begun to relax stay-at-home measures. America is discovering virtual business and socializing, while slowly getting back to work.
It’s plausible that the swift and staggering actions of the past 45 days justify the market roaring back almost 27% since the low last month. Perhaps we’ve seen a short, sharp bear market, as some experts believe, and the bull market is alive and well.
So where does this put us now in terms of valuations using the Gordon Model? While still highly uncertain, we now have a little better handle on the input variables to the model. Below, I’ve revised those variables to generate a new set of return expectations for three scenarios.
Market Returns Under Various Scenarios
Let’s look at the input values for the model, with Plausible, Pessimistic and Optimistic scenarios for each.
Earnings Per Share (EPS)
According to S&P, the S&P 500 index as-reported EPS forecast for the 12 months ending June 2021 is $132/share. FactSet estimates S&P EPS for 2020 have fallen 22% since the beginning of the year and 2021 EPS will decline 13%. As-reported, actual 2019 EPS was 139.47, so a value of 132 represents a decline of only 5%. S&P estimates as-reported 2020 EPS of $110/share. So, a rebound to an annualized rate of $132 by Q2 2021 represents a 20% jump. That seems optimistic.
The Gordon Model uses 12 months' forward earnings. Erring on the side of optimism, we will use 132 for our Plausible and Optimistic case scenarios. And since we are using the EPS for 12 months ending June 30, 2021, we are being optimistic by allowing almost two additional months for an earnings recovery. For our Pessimistic scenario, we will assume EPS for the 12 months ending June 2021 flatlines at the 2020 total of 110.
Payout Ratio (DE)
S&P 500 dividends in 2019 were $58/share. Analysts expect dividends to drop this year by 25%, to $43.5 per share. Therefore, we will use that for both our Pessimistic and Plausible scenarios. The Plausible DE would then be 43.5/132, or 32.9%, and Pessimistic DE would be 39.5%. For our Optimistic scenario, we will assume dividends drop only 10% to $52/share, resulting in a payout ratio of 39.4%.
Required Rate of Return (K)
The required rate of return (K) consists of the risk-free rate, which is considered the 10-year Treasury bond, plus the risk premium. The risk premium consists of business risk, financial risk and market liquidity risk. A lower K value increases the projected returns in the Gordon Model.
In my last article, I explained that the Gordon model indicated a K value of 9.8%. This rate changes very slowly over time as investor expectations adjust slowly. The enormous fiscal and monetary stimulus enacted over the past 45 days serves to lower the risk-free rate. Last week, the Fed reaffirmed it will do whatever it takes and set ongoing expectations for rates to remain near zero for the foreseeable future. Offsetting this is the effect of how investors judge the risk premium. That one is hard to gauge, since there are arguments both ways. There continues to be unprecedented financial and business risk versus pre-virus days. The economic outlook is cloudy at best. Yet, massive stimulus is designed to reduce risk - at least near term assuming the current monetary system continues to function. As a result, we will err on the side of optimism and say those factors are a wash. Here are the resulting inputs for the value of K in our model:
- Plausible Scenario: 8.8% (a drop of one full percentage point)
- Pessimistic Scenario: 9.3% (a drop of 0.5%)
- Optimistic Scenario: 8.3% (a drop of 1.5%)
EPS Growth Rate (g)
A recession this year will slow the expected long-term average. This is expected to be offset partially by major government fiscal and monetary stimulus. Overall, we would expect g to drop, but not precipitously, assuming a recovering economy by Q4 2020 or Q1 2021. Since "g" is a forward looking, long-term average, several quarters of negative or slower growth will not have huge effects on the average. The recent five-year annual average was 6.5%. We will assume growth rates of 6%, 5.5% and 6.5% in the Plausible, Pessimistic and Optimistic scenarios, respectively.
The resulting values for the index and returns are summarized in the table below.
The Plausible scenario shows a whopping 45% decline. That certainly seems pessimistic, especially considering a P/E drop to 11.8 when interest rates are expected to remain near zero. However, it is plausible given the near-term plunge in earnings and dividends, and possible ongoing economic drag due to the lasting effects of the virus on our way of life.
The Pessimistic scenario looks unlikely, especially if we consider it happening in a short span of a year or so. Nonetheless, the input variables for this scenario are by no means outrageously pessimistic. In the 2008-09 bear, the peak to trough decline was 56%, although that took 17 months. Finally, it is alarming that the Optimistic scenario produces essentially no upside from here.
Summarizing these three scenarios from a qualitative standpoint, the following seem highly likely:
- Earnings will decline significantly in 2020 and will take time to recover.
- Dividends will decline significantly.
- Business and financial risk are elevated, and uncertainty is likely to continue for a while.
- The risk-free rate will remain near zero (and possibly go negative).
The required rate of return (K) can go either way, but given the near-zero risk-free rate, it is hard to see K dropping significantly from here. If we have a faster-than-expected return to economic activity, that could lead to a reduction in business and financial risk. All the other model input variables (payout ratio, earnings, earnings growth rate) are expected to decline. Bottom line, the overall qualitative view suggests a tilt to the downside, at least based on the Gordon Model.
Alternative Method - CAPE Ratio
Another way to gauge what might happen is to look at changes in the Shiller P/E, or CAPE ratio. Studies show that CAPE has a high inverse correlation with market returns over a long period, i.e., 10 years.
Let’s say CAPE goes back halfway between its current value and its long-term mean. The current CAPE is 27 and the long-term mean is 16.7. As a point of reference, CAPE started the year at 30.3. A move halfway between the current level and the mean to 21.9 would lead take S&P 500 index to 2365, a drop of 19%. As a worst-case estimate, if CAPE dropped to the 2008-09 bear market low of 13.3 and the 10-year earnings average (108) remained the same, the S&P would go to 1,438, a decline of 49%.
Summary Range of Outcomes
This leaves us with a very wide range of “weighing machine” (to borrow a term from Ben Graham), outcomes, as indicated in the table below. However, the potential return scenarios are skewed to the negative side, with some signaling a deep bear market.
Our March Optimistic scenario showed a return of 26% from the level of 2711. So, is the current market overvalued and poised to tank? Or perhaps we simply righted the ship and the recent rally brought us to fair value on the heels of the herculean rescue operations? Our input variables seem reasonable, if not optimistic, given the recent economic data. Or perhaps these models are simply outdated and worthless?
A New Paradigm?
As I noted in my last article, these models have significant limitations. For one, they depend on the input variables, which have high unpredictability. Most investors, even professionals, aren’t using models. They are looking at individual stocks and their associated narratives. Amazon (AMZN) is a great example. It is based on a powerful and compelling story line, not a mathematical model of dividend payments. Heck, Amazon didn't even have earnings for most of its early history.
Ultimately, the collective wisdom (or folly) of investors is the final arbiter of value. Even those who use models can make them generate the results they intuitively believe - or want to see. So, perhaps investors should just ignore models and valuation methods and throw away the Intelligent Investor book. Perhaps intrinsic value is a passé concept?
It is very possible that our federal government’s helicopter money, combined with the Fed’s avalanche of new fiat currency creation, has ushered in a new era of investing. One could argue that this began in 2008. Now we are taking it to whole new level - a level never seen in history. As legendary investor Jim Rogers said, “The United States is the biggest debtor in the history of the world.”
Does this creation of “wealth” out of fiat currency creation make us all better off? Have we created true intrinsic business and economic value by printing our currency and handing it out to the tune of $6 trillion and counting?
If that is the new world of investing, then we shouldn’t bother trying to use conventional, time-tested financial principles to judge the value of businesses. Don’t fight the Fed. In this world, all that matters is what investors think is reality. The Fed is now buying corporate bonds, munis, and even junk bonds via ETFs. Stocks may be next. Janet Yellen likes the idea. If that happens, then “don’t fight the Fed” will take on a whole new meaning. Who cares about underlying business value if a pseudo-government agency is buying businesses. But will this produce prosperity? How long can it last? Perhaps for months, years or forever. What is the endgame?
The Multi-Century, Multi-Empire View from Dalio
For a big perspective view, based on the history of civilizations and how finance in dominant empires has evolved (and collapsed), I recommend everyone take some time to read Ray Dalio’s The Changing World Order series on LinkedIn. I can’t do it justice in a few paragraphs, but here are some snippets for you.
History has shown that when the bank’s claims on money grow faster than the amount of money in the bank—whether the bank is a private bank or government-controlled (i.e., central bank) eventually the demands for the money will become greater than the money the bank can provide, and the bank will default on its obligations.
Throughout history, rulers have run up debts that won’t come due until long after their reign is over, leaving it to their successors to pick up the pieces.
Because most people don’t pay attention to this cycle much in relation to what they are experiencing, ironically the closer people are to the blow-up the safer they tend to feel.
Dalio’s last sentence may capture the essence of the current situation and explain why current market prices don’t appear to have traditional mathematical valuation model support. Investors are placing great faith in the Fed monetary and federal government fiscal “put options” on the markets. However, Dalio warns: “But one cannot create more wealth simply by creating more money and credit. To create more wealth, one has to be more productive.”
Conventional valuation models seem to be out of touch with reality right now, or vice versa. Perhaps after the coronavirus pandemic ends, things will normalize. Maybe the MMT people are right and debt doesn’t matter. Hey, we have the world’s reserve currency. Maybe we will smoothly sail into a new normal with low interest rates, low but steady growth, healthy employment levels, low inflation and the usual 9-10% average equity returns as far as the eye can see.
Or perhaps, as Dalio is suggesting, we are at an epic end of an era of debt creation and fiat currency, and about to enter a new world. One that short-term investors can’t see - or are in denial about seeing. One characterized by a major economic reset. One in which the dollar is devalued, if not destroyed and supplanted by a new monetary system. One in which there will be a worldwide changing of the guard. One that involves not just economic, but political and cultural upheaval and a shift in world power. One that could involve military conflict. Now, all of that would serve to realign the markets with the models we’ve explored. While painful, it would likely usher in sound finance again.
No one knows when it could happen or even if it will happen. But all the signs seem to be there right now. As a prudent and old school investor who still believes in traditional measures of value, I’m not throwing away my Intelligent Investor book. It was interesting to hear Buffett, a disciple of Ben Graham, comment over the weekend: “We have not done anything, because we don’t see anything that attractive to do.”
I’m not betting on the Dalio scenario completely, but it certainly has factored into my investing. If I had to quantify it, I’d give it perhaps 70-30 odds in favor of happening. But timing it is impossible. Ignoring it completely is like walking across an interstate highway blindfolded.
The implications for our lives and for investing are enormous. The playbook that traditional financial advisors and many others have been following for years might be as passé during a painful bridge to a new world as Ben Graham’s valuation methods seem to be right now. Buying and holding S&P 500 equities and a smattering of investment grade bonds might not work over the next five or 10 years. After the Great Depression, it took 25 years for the Dow to return to its 1929 level. In Japan, the Nikkei peaked at about 39,000 in 1989. Last I looked, it was 19,619. And the Japanese Central Bank has been buying their equities since 2013.
Ironically, to some extent, we might need to invest in ways Graham never advised. It’s possible that, at least for some time, real assets like gold, silver, real estate and other commodities might be the best safe havens in a world with broken fiat currencies, massive financial restructuring and societal upheaval.
Are you crossing the highway blind? Or are you preparing for a possible new world order that could happen sooner than we think?
This article was written by
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