Here I go again! Gosh it was only six years ago that I cemented my place in stock market history by predicting that the Dow would fall from 8,500 to 5,000, instead of going up to 14,000 where it peaked in October of 2007. Well, I could use the standard set of excuses: 1) No one else saw it coming, 2) I was misinterpreted, and taken out of context, 3) I was tired, overworked, and had family problems, or 4) I had just come out of rehab. But these days what really works is a full confession. I mean, like, uh, it was totally my fault and I take full responsibility. The fact is I was only off by 9,000 points. Thats my story, and Im stickin to it.
Well, fools rush in. This time though Im definitely older and maybe a little bit wiser. No magic number, nor a specific target date from the Swami of the Dow. This one will be more conceptual, but still present a take that you can criticize or damn with faint praise. And no, despite the title, it doesnt imply that the stock market is headed to 5,000 and that I was always right or just a little bit early. It only suggests that Im readdressing the critical topic of equity valuation – that mysterious fragile flower where price is part perception, part valuation, and part hope or lack thereof. Press on, Swami.
Let me first announce a fundamental premise with which I think all rational investors would agree: I believe in stocks for the long run – but only if purchased at the right price. That statement packs a real punch. It says that capitalism is and will remain a going concern, that risk-taking – over the long run – will be rewarded, but only from a starting price that correctly anticipates the economys growth and its share of after-tax corporate profits within it. Acknowledging the above, lets look at a few basic standards of valuation that historically have stood the test of time, to see if at least the price is right.
One of them is what is known as the Q ratio, or the value of the stock market relative to the replacement cost of net assets. The basic logic behind Q is that capitalism works. If the Q is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses cant be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, Q should mean revert to 1.0. If so, then oh, oh what a Q! Todays Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation, as seen in Chart 1.