Trader’s Narrative

Last month we looked at a simple method for valuing the market called Tobin’s Q. (To get details, check the previous link).

Working with the available data we had back then we surmised that the market had gotten much cheaper but that it was still not quiet at a level which had historically marked bear market bottoms. But using the forward estimate of a Q ratio expert (the most preeminent disciple of Tobin) we were expecting to find a flush down in the first quarter of 2009 taking us down to that level.

The Federal Reserve released its data for the first quarter of 2009 and unfortunately the estimate by John Mihaljevic was not borne out. This bear market is not finished - at least not according to Tobin’s Q ratio.

I’m not really sure how the eggheads at the Fed actually crunch the numbers for the numerator and the denominator but adjustments are the norm. Each quarter we not only have new data but usually small adjustments are made to prior numbers.

This most recent data release was no different with almost all previous data points changing slightly. For example, the 2008 fourth quarter data changed from 0.6208 to 0.6730. The only (thin) silver lining in this cloud is that we are continuing to head in the right direction: lower. But in order to give us a signal, the ratio has to fall precipitously to the 0.40 level. Which is not to say that it can’t do so.

In the first quarter of 1974 the Q ratio was 0.58, not far from where we find it now. During the next few quarters, it fell so fast that by the fourth quarter of 1974 it was 0.33 - at an extreme historic low, signaling a generational opportunity in the equity markets. You can mouse over the chart below to see what I mean.

By the way, if you haven’t yet, I highly recommend picking up a copy of Valuing Wall Street. It is the definitive book on this indicator and at only $10 even a cheap bastard like me can’t resist it. A little trivia: this book came out at the same time as “Irrational Exhuberance” but either because it had a useless publicist or because the concept was too dry, it never got the same traction as Prof. Shiller’s book - even though it argued correctly that the 2000 market was about to take a massive tumble.

You can get the most recent data as well as the archived files at this Federal Reserve page.

Yesterday, while meeting with Gordon Brown, President Obama said:

What you’re now seeing is profit and earning ratios are starting to get to the point where buying stocks is a potentially good deal, if you’ve got a long-term perspective on it

While cheerleading the US economy and stock market is part and parcel of being the president, that his is a fairly accurate description:

Source: Prof. Robert J. Shiller

And while some are pointing out a dichotomy between Obama’s pronouncement and his advisor Buffett’s description of the US economy as being in “shambles”, there really isn’t a conflict with the two views as long as you realize that the economy and the US market are two different things.

In any case, the data for February and March 2009 are an estimate only and take us down to 12 - which is without an argument a very low P/E Ratio. But not as low as we’ve seen the price earnings ratio go.

In August 1982, the PE Ratio dropped below 7. And in both July 1932 and July 1921 it went below 6. To see that scenario again, the S&P 500 would have to drop another 40-50% to the 430-360 level (assuming earnings miraculously stay the same).

The only time that the PE Ratio has dropped as precipitously as in this bear market was in the aftermath of the 1929 bull market top. At its zenith in 1929, the PE Ratio was only approaching 33 while in the 2000 market top it reached 44.

Finally, I should mention that this isn’t necessarily the way that others calculate PR ratios - Shiller methodology smoothes out the data over 10 years to remove short term volatility.

If you were around the dot com bubble years, you remember that there were a few people who were “non-believers”. Those few who didn’t believe that “this time its different”. One of them was Robert Shiller, an economist who got his first 15 minutes of fame for renting to Allan Greenspan, the now infamous phrase, “irrational exuberance”.

Most economists would give their left (insert apendage here) to have this much insight. But Shiller goes one step beyond, he not only nails the predominant theme of the day, his timing is impeccable.

His first mainstream book, Irrational Exuberance, was published in early 2000, just as the Nasdaq reached its zenith and started to feel top heavy.

I remember watching many of his interviews back then. It was as if the market itself seemed to go out of its way to make the case on his behalf. He lucidly explained to millions of new taxi drivers turned traders and “get rick quick” investors why their dreams were melting faster than an ice sculpture in the Gobi desert.

He’s Back!
Shiller is back with another book, The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It

I haven’t read it yet (but hope to as soon as possible) so I can’t give you my review but from everything that I’ve read online about it from other reviewers and from the interviews that Shiller has been doing, I think he has done the amazing feat of producing a hit sequel to his original.