Trader’s Narrative

David Rosenberg, strategist at Gluskin Sheff continues to be staunchly bearish. He digs into his trench even further it seems with each point the S&P 500 climbs. Today he lists the contrasts between now and 1982 to argue why this is not a secular bull market:

• P/E Multiples were 8x, not 26x.
• Dividend yields were 6%, not sub-2%.
• The stock market was trading at a discount to book, not a 2x premium.
• Monetary policy was aimed at reducing money growth and inflation rates, not
  creating both as is the case now.
• Fiscal policy was aimed at reducing nondefense spending, not accelerating it.
• Deficits were peaking and coming down, not surging to 10%+ relative to GDP.
• Global trade barriers were being torn down; not erected.
• Deregulation back then was in; today it is all about re-regulation and
  government ownership.
• Union membership was on the way down; today it is back on the rise.
• The dollar was entering a Plaza Accord bull market, not a mercantilist bear
  market.
• Credit, household balance sheets and participation rates were expanding, not
  contracting.
• Tax rates, income, capital gains and dividends, were declining then; rising now.

He also compares the batch of government bureaucrats and politicians now to back then:

In 1982, Ronald Reagan was President (two consecutive terms as Governor of
California), Don Regan was Treasury Secretary (35 years of financial sector experience), Martin Feldstein as the Chief Economic Advisor to President Reagan (the dean of business cycle determination), and Paul Volcker was Fed Chairman (9 years of prior financial sector experience). Compare and contrast to Barrack Obama (junior senator from Illinois for 3 years); Timothy Geithner (21 years experience in government, three years as a lobbyist); Larry Summers (no private sector experience; 27 years of academia and government) and Ben Bernanke (no private sector experience; 30 years of academia and government).

Which team do you think deserved the higher multiple — the one with actual experience in the real world or the one immersed in academia and government?

To play devil’s advocate, no two bull markets are equal in every way. It is a stretch to require a secular bull market to require experienced politicians for example. But cheap (or at least, reasonable) valuation is a condition that is difficult to explain away.

There are many different ways to value the stock market. We are waiting for the Coppock Guide to give us a signal by month’s end (just a few more days left). The usually reliable price earnings ratio has gone haywire, but the dividend yield ratio is still valid.

But what if I told you there is an even better way to sum up the valuation of the stock market in just one number? A method that is both rational and comes with an astonishing track record, having identified every single generational buy opportunity?

Tobin’s Q was created by the late James Tobin, a pre-eminent economist and professor at Yale. His work garnered him a Nobel prize “for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices.” But he’s probably best known for his work on the stock market. Put simply, Tobin’s Q is a ratio of the current value of the market divided by the replacement value of those same assets.

Think of a factory. It has a market price at which it would be bought and sold. And it also has a replacement cost - what one would have to spend to rebuild it from scratch. The ratio of the two is Tobin’s Q. Obviously, that would imply that when the ratio is greater than 1 the market is overpriced because one could theoretically ‘rebuild’ it for a cheaper price than it would take to purchase it. The Q ratio for US equities has fluctuated between 0.3 and 3 in the past 130 years.

It has signaled all the great bear market lows: 1982, 1974, 1949, 1932, 1921. Tobin’s Q moves at such a glacial pace that other indicators - even the Coppock Curve - seem twitchy by comparison. But when it does approach an extreme, it pays to give it the respect it deserves.

The best book on Tobin’s Q is Valuing Wall Street by Andrew Smithers (of Smithers & Co.). It came out at the same time as Shiller’s more famous Irrational Exuberance.

Both books had the same message and both were published at the exact peak of the 2000 bubble, but Shiller’s work got more attention because it was written to be more accessible to the general public while Smithers is more targeted to educated traders and investors. Although both books are good Shiller’s book stole much of Smithers’ thunder. You can pick up a copy from Amazon for less than $4 - which is a steal really.

As you might imagine, calculating the replacement value of such a diverse set of ever changing assets is mind bogglingly complex. Thankfully, the Federal Reserve does the heavy lifting. They provide the data in the Flow of Funds Report (pdf document). Look for the numerator on B.102 line 35: Market Value of Equities Outstanding (on page 103) and the denominator: Net Worth on line 32 (same page).

So the ratio resolves to:

9554.1 ÷ 15389.8 = 0.6208

Due to the nature of the data, it is only available quarterly with a lag of a few months. The latest report was released March 12th, 2009 which means the above number is for the fourth quarter of 2008. We should be getting the release of data for the first quarter of 2009 soon. But some analysts also guesstimate the number ahead of time. John Mihaljevic, the former research assistant to Tobin says the current value of Q is around 0.43 - which would be extremely close to the historic low of ~0.30. Following the previous link, you can not only get further details but purchase his complete report.

Obviously the market could fall more and take the Q ratio down with it. But this is further evidence that we are much, much closer to a generational buy point here rather than somewhere along the line of a continuing downtrend. Similar to the Coppock Curve, the Q ratio is not only setting up for a bullish signal but one of epic proportions.

Here is a chart of the Q ratio (from 1952 onwards when Federal Reserve data is available):

Robert Prechter, New York Times best-selling author and renowned market analyst, was recently asked to present his thoughts on the real estate market and the financial crisis to the Georgia Legislature. The following article has been adapted from the transcript. Elliott Wave International has made the full presentation available free, including the full transcript and 30-minute online video.

By Robert Prechter, CMT

I’d like to try to answer a question: “Are we near a low in the stock decline?” Because in these times when stocks and real estate are declining together, they tend to bottom roughly together as well. So I want to take a minute and look at a valuation chart for the stock market.

What we have here on the “X” axis is the bond yield/stock yield ratio for the S&P 400 companies. Sounds fancy, but all it means is that the further you go out to the right, the less companies are paying in dividends compared to what they are paying on their IOUs—on their bonds. On the “Y” axis we have stock prices relative to book value. Book value is roughly equivalent to liquidation value, in other words, if you went and sold all the assets on the open market. When stocks get expensive, prices tend to rise relative to book value, and dividends tend to fall relative to the cost of borrowing. Why does that happen? At such times, people don’t really care about dividends because they think they are going to get rich on capital gains. So dividend payout falls, and stocks get more expensive.

The small square boxes indicate year-end figures. The large box is a general area that has contained values for the stock market for most of the years of the 20th century. We had a few outliers: 1928 and August 1987, which preceded crashes in the stock market. And of course stocks were really cheap in the early ’30s and again in 1941. If you are really astute, you have noticed something about this chart, which is that I’ve left off some of the data. It ends in 1990. What happened in the past two decades? Now I’m going to show you same chart but with the data from the last two decades on it. The March 2000 reading we call Pluto. Real estate wasn’t so bad; I think it only got to about Neptune. But the stock market reached Pluto in March of 2000 in terms of the bond yield/stock yield ratio and the price multiple of the underlying values of companies. That’s going to take quite awhile to retrace.

I’ve also plotted the reading for November 2008. The market has made quite a trek back toward normal valuations, but if you look at these multiples in terms of book value, we are at 4 times. It has to go down to 2 times to get back into the box, and we are getting there on the bond yield/stock yield ratio which means that the dividend payout is rising somewhat to catch up with borrowing costs. And because the S&P is down 45%, of course, the dividend payout as a percentage has gone up. But there is a problem there. If you’re reading the newspapers, you know that companies have been cutting dividends. In fact, they’ve been cutting them at the fastest rate in half a century. So it is going to be difficult for values to get back to a normal valuation range. So the stock market has quite a bit lower to go in order to catch up with normal values, and this suggests that real estate may have the same sort of trend going on.

For more information, access Robert Prechter’s full presentation to the Georgia Legislature, free from Elliott Wave International. It expands on the excerpt above with the full transcript, a 30- minute online video, and 12 additional charts and figures.

Robert Prechter, Certified Market Technician, is the founder and CEO of Elliott Wave International author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

In Why The Price Dividend Ratio Is Better Than PE Ratio I argued that the lesser ratio based on dividends offers more insight. Here’s a follow up with an interactive long term chart.

It contains a massive amount of information so it can take a while to load… be patient, it is worth it. Not only does it show the historic ratio, it is interactive so you can zoom in on a shorter time frame by using the slider at the bottom:

The data is from 1871 to June 2008. To bring it up to date, the most recent data for the S&P 500 Index (SPX) gives a P/D ratio of just under 32. A year ago it was at 54. The last time we saw a price dividend ratio of 32 was in 1991. To put the current 3.13% dividend yield into perspective, in June 1932 stocks were yielding on average 14% and in July 1982, stocks yielded 6%.

Right now the Dow Jones price dividend ratio is 25.7 which is very close to the long term average. But the ratio can over shoot on the downside. By the way, I’m still looking for similar historical data for the Dow Jones, so if you have a lead, let me know.

And keep in mind that both the numerator and denominator are constantly changing, so this is a fluid number. Although we’ve seen prices fall dramatically these past few weeks, dividends can also fall. So the good news is that this ratio has fallen a lot but the bad news is that it can continue to fall as dividends are cut or reduced.

On the plus side, an important variable that can act as an emergency break on this ratio is the interest rate. If the Fed takes rates down to 1% or less, which some believe is a matter of when not if, then dividends will be much more attractive, relative to the alternatives in the bond market.

Already if you look around you’ll find quite a few high yielding household names like Pfizer (PFE) which is now yielding 7.7%. Looking back almost 30 years (I got tired of looking back more) Pfizer has never skipped or lowered a dividend payment but has consistently raised it.

Unless Bernanke takes interest rates down to zero, what we could be facing is a return of this ratio to the “normal” range it has occupied for most of its history. That is somewhere between 12 and 35. Under this scenario, the stock market would flop around for decades as it waited for dividend growth to catch up to it. We’ve seen this sort of market before. From 1966 to 1983 the Dow Jones was a snooze fest. Except for a few harrowing dips, it went sideways and grinded down even the most optimistic bull.

To avoid such a stark reality, I say the Fed should re-inflate like it was 1999 - Disclosure: I’m massively long seaweed CDOs.

Earlier this month I mentioned the IBES valuation model and how it was telling us that US equities are extremely undervalued. The Barnes Index is another valuation model which is similar to the IBES.

Keep in mind that these valuation models are really broad strokes. They are not meant for nimble, short term traders. They attempt to outline the general tone of the market and perhaps its long term trajectory.

So what is the Barnes Index? Like the IBES model it compares the stock market to the bond market. But unlike the IBES it considers both the short term yield and the long term yield (the yield curve in other words):

Barnes Index = (Treasury Bond Yield X Treasury Bill Yield) divided by (S&P 500 Dividend Yield X S&P 500 Earnings Yield)

So in essence it pits the “returns” from stocks, in the form of dividends and earnings versus the “return” (yield) from bonds. Market risk is highest when you can make more by investing in risk-free assets. The normalized chart below comes from Decision Point (the excellent technical analysis service run by Carl Swenlin).

Click to Enlarge Graph

Since it began in 1970, the Barnes Index gives us a few more years than the IBES model. The last buy signal was given in early 2003, at the bottom of the bear market. At its current level, it is neutral.

In 1973, when the Barnes Index was also at similar levels, the market topped. Also in 1981. But then again, in 1990-1 although it stood where it does now, the market went much higher.

Notice that similar to the IBES the model imploded into irrelevance due to the “bubble years”. In 1997 it crept into the redline and stayed there almost constantly until late 2001. Which proves that no model or forumla can ever predict or explain the market. All we can ever hope for is a crude approximation.