James Bond fans may remember “Q” as the outfitter of esoteric devices with potentially lethal effects. Students of capital market history may instead remember “Q” as Tobin’s Q: a way to prevent potentially lethal portfolio effects by evaluating a stock market valuation against the replacement value of a company’s assets. Yale University economist (and Nobellist) James Tobin created the original model.
Now combine “Q’s” insights and wrap them in a CAPE. CAPE derives immediately from Robert Shiller’s analyses of long-term market behaviour: it’s cyclically adjusted price/earnings ratios. The long-term p/e ratio is roughly 15. Ultimately though, CAPE is an invention of the guru of value investing, Benjamin Graham and it aims at smoothing out the effect of short-term earnings fluctuations with a view to the longer term.
Former S G Warburg banker Andrew Smithers puts the two together and suggests “Non-financial companies, including both quoted and unquoted, were 62% overvalued according to q at 31st March 2010, when the S&P 500 index was1169. Adjusting for the subsequent decline to 1087(10th June, 2010), the overvaluation had fallen to 50%. …
The listed companies in the S&P 500 index, which include financials, were 58% overvalued at 31st March 2010, according to our calculations for CAPE, based on the data from Professor Robert Shiller’s website. Adjusting for the subsequent decline to 1087 (10th June, 2010), the overvaluation had fallen 46%. (It should be noted that we use geometric rather than arithmetic means in our calculations.)”
Cloak and dagger stuff, invisible to the investment community. Not really. Market commentator and fund manager John Hussman, for one, cites him, in his article “Reckless Myopia.” http://www.hussmanfunds.com/wmc/wmc091130.htm
“But clearly, I was wrong about the extent to which Wall Street would respond to the ebb-and-flow in the economic data – particularly the obvious and temporary lull in the mortgage reset schedule between March and November 2009 – and drive stocks to the point where they are not only overvalued again, but strikingly dependent on a sustained economic recovery and the achievement and maintenance of record profit margins in the years ahead.
“I should have assumed that Wall Street’s tendency toward reckless myopia – ingrained over the past decade – would return at the first sign of even temporary stability.”
What was that Herb Stein quote? Remember him, the former Nixon/ Ford economic advisor. Oh yes, “If something cannot go on forever, it will stop.”
Words every risk manager should remember.