In 1949 we could present a study of stock-market fluctuations over the preceding 75 years, which supported a formula — based on earnings and current interest rates — for determining a level to buy the DJIA below its “central” or “intrinsic” value, and to sell out above such value. It was an application of the governing maxim of the Rothschilds: “Buy cheap and sell dear.” And it had the advantage of running directly counter to the ingrained and pernicious maxim of Wall Street that stocks should be bought because they have gone up and sold because they have gone down. Alas, after 1949 this formula no longer worked.
The Intelligent Investor
On a macro basis, quantification doesn’t have to be complicated at all. Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows the market value of all publicly traded securities as a percentage of the country’s business – that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.
Warren Buffett on the Stock Market
Idid not set out to discover my own valuation metric. In the beginning, my intention was only to reconstruct the price/GNP ratio that Warren Buffett introduced in a 2001 Fortune article, because it seemed to be a better indicator than the common PE ratio, especially at key market turning points.
I immediately ran into problems getting data for the market value of all publicly traded securites. GDP data was available back to 1790, but market value data from the Federal Reserve went back only to 1945, and it was annual data at that. As a substitute, I toyed with the Wilshire 5000, only to find out that the series began in 1970.
Then it hit me. Why not use the S&P 500 index to stand in for the market value of all publicly traded securities? After all, the S&P is a capitalization-weighted index, and it represents about three-quarters of the total stock market. And data was available from 1950 courtesy of Yahoo! Finance. For earlier prices, I could use the data Robert Shiller generously provides at his website.
From that point it was a trivial matter to calculate the ratio of market price to GDP all the way back to 1919.
Adjusting for interest rates
As Jason Zweig said, a PE is a simple tool for taking the market’s temperature. A little too simple, in practice. For one thing, the price/earnings ratio gives misleading readings of market value when earnings are depressed or conversely, when earnings are at peak levels. In these cases, PE will tell you the opposite of what you need to hear. It will tell you the market is expensive when earnings collapse in a recession, or that the market is cheap when earnings soar in an overheated economy.
To overcome this problem, Ben Graham recommended that investors normalize earnings by using a seven-year average. Similarly, Robert Shiller’s cyclically-adjusted price/earnings ratio uses a ten-year average. But smoothing out earnings is only part of the job.
Ben Graham also adjusted PEs to account for varying growth rates and bond yields. This I had learned in the 1980s from one of the first investing guides I owned. Ben’s rule of thumb for determine the fair value of a stock quickly found its way into my valuation toolbox, and allowed me to turn up my nose at the unjustly more popular PEG ratio.
Taking this familiar rule out of the toolbox once again, I simply multiplied the ratio of market price over GDP by the relevant Moody’s Aaa yield to arrive at an interest rate-adjusted value I call PYi, explained in detail here.
It’s not what you say, it’s how you say it
A huge insight landed in my lap one day in 2007 when reading through Carl Swenlin’s excellent Decision Point site.
On a chart of the S&P 500, Carl had plotted three PE lines, the central one representing fair value and two others for extremes of over and undervaluation. To calculate their values, he held the PE constant and solved for price. This technique immediately reminded me of the original Value Line, a multiple of cash flow drawn on a price chart, one I had studied for more than twenty years in pursuit of undervalued stocks.
I knew right away this was the breakthrough I needed, but I still wasn’t aware it was the key to the castle.
Hello, Brock Value
So equipped with the long range data I needed, the interest rate adjustment and an elegant way to visualize the data, Brock Value just fell into place. In an instant, I could see I had stumbled upon an important indicator. The S&P 500, superimposed on the BV line, tracked it closely, diverging from time to time, but always returning to a now-visible center of gravity.
Later, I compared BV to other ratios – price/earnings, price/dividend and three other classic metrics – only to come away even more convinced.
BV’s inherent limitations
It’s not as well understood as it should be, but any yardstick you use to measure the stock market’s valuation will produce a definite answer and an ambiguous course of action. One reason to be cautious, as Ben Graham found, is that the past and present can disagree. What a generation of investors considers a normal valuation is only a reflection of their experience and the dominant social mood. In other words, because the market looks back at itself to set the standard, it can fall prey to mispricing. This abnormal valuation can persist for many years.
There is nothing more
an obvious fact.
Second, stock market valuation is deceptive. Investors hope for simple rules they can follow to stay out of trouble and earn good returns. But when they obey valuation yardsticks blindly, what they get instead are misdirections, because valuation is but one measure of the market – one the market itself frequently ignores. I cover the gamut of valuation pitfalls here.
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