Stock Market BubbleOmics: S&P 500 Race to 1,300 by Christmas?
Stock-Markets / Stock Markets 2010 Nov 05, 2010 - 11:36 AM GMTBy: Andrew_Butter
Well it’s nice to see that Ben has managed to un-leash some good-old-fashioned Irrational Exuberance with the latest round of Quantitative Easing. That’s something that’s been sadly missing over the past few years…I wonder why?
It’s probably good news too that he has apparently given up on his strategy to persuade people to buy AAA rated collateralized debt obligations lovingly crafted by Goldman Sachs, by creating a “market” and of course a “mark-to-market”. That didn’t work very well because sadly, most people figured out that if the Sucker of Last Resort is the only player in town (as in the Wall Street line “the value of something is what you can sell it for to some poor sucker dumber than you”), well that doesn’t actually constitute a “market”.
But this time he’s going to buy Treasuries, whoopee!! Gold is up 3% in a day, and oil is getting ready to go through $90, let the good-times-roll!!
Perhaps that will make all the difference, perhaps that will increase the money supply, increase the velocity of that money, and so America can get back to Living the Dream. Although one can’t help having that nagging thought that what Einstein said might apply, as in, “The definition of lunacy is to try the same thing over and over, and hope for a different result”.
Either way, QE-2 will keep the pressure on yields of long-term debt (down), and it will provide plenty of scope for the companies represented by the S&P 500 (who by and large, have lots of cash, good business models, and a “healthy” portion of their earnings generated outside USA (50% at the last count)), to increase their debt (i.e. decrease their equity), and thus gear their profits and thus their return on equity.
Whether the beneficiaries of that will be USA (via increased capital expenditure and hiring in USA), or everywhere except USA, is “debatable”. Well actually you can debate that if you like, but the answer is pretty obvious.
I noticed a headline the other day, “Dubai Stands to Gain from QE-2”, written by a brokerage firm that I had only heard of in connection with a scam they played on the Dubai Stock Exchange (and they got away with it). I thought it was a joke, but it wasn’t, the idea was that QE-2 (in America) would increase credit in Dubai. You can understand the logic there…assuming of course that the people who got shafted the last time they lent to Dubai will not have heard about Einstein’s Rule?
Anyway, that’s all “background”, the reason that I’m writing this article is that I have this “thing” about when the S&P 500 hits 1,200.
And the reason for that is because over a year ago or so the Immutable Laws of BubbleOmics indicated that the prospects for the S&P 500 (then 1,100) were:
Won’t go above 1,300 in 2010 but it won’t go down much until hits at least 1,200 at which point it risks a 15% to 20% reversal which will be relatively short-lived.
http://seekingalpha.com/article/180450-bubble-onomics-10-predictions-for-2010
So far so good; the index bounced about a bit then it crept up above 1,200 and then it had a mild reversal of 16% off its peak…which was fairly short lived (five months), and here we are with 1,220 on the Board today. With the only item remaining on the check-list being whether it will go above 1,300 before Christmas?
By way of background the basic idea behind that had two elements:
1: “Fundamental Value”.
I personally don’t like that word, mainly because it means different things to different people. But “fundamentally” the idea there is that the price of anything in an efficient market reflects a fundamental value. The catch is that markets are not always “efficient”, in fact they are inefficient a lot of the time, and that makes it complicated to figure out when it was valued at its fundamental, or in other words to figure out when the market was “efficient” and when it was not.
The real big inefficiency is when there is a bubble. That’s when people get persuaded to pay a lot more than the fundamental; or in the bust that inevitably follows a bubble when people persuade themselves that they should not pay the fundamental, or more to the point buyers who borrowed money to pay too much in the past, often get squeezed into having to sell at a price below the “fundamental”, so they can pay their debts.
The fundamental is thus the price that people would pay, if the market was not distorted by a bubble or a bust, and a credit crunch is when the people who borrowed, so they could buy things at a price much more than the fundamental, don’t pay the money back.
There are three main ways (outside of the one I use) to figure out what the “fundamental” of the S&P 500 is.
(A): Trailing P/E ratios are compared to the long-term mean; that’s the approach Professor Shiller uses and on a micro level it’s much loved by accountants. There are two problems with that, the first is that what happened in the past is not necessarily a good predictor of the future (I love the way accountant’s write that in big letters after they have done a valuation based precisely on the opposite of that premise), and second, it doesn’t account for the opportunity cost of equity which changes in tandem with long-term bond yields.
(B): Tobin’s “q” which is based on an assessment of book value, which is all very well in principle although that says little or nothing about intangible value or depreciated replacement cost, which is what, for example Warren Buffet was interested in when he bought his new train-set.
(C): Warren Buffet once said that it’s a function of Gross National Product (GNP), which is smart (I would say that because that’s what I say), but that was just a throwaway line. What he didn’t throw away is how it’s also dependent on the opportunity cost of money. Although I’m sure he knows that, just he didn’t “share”.
But he did go on record once on that subject. That was when he was asked by some talking-head…“how do you know when to buy (or sell)”? He said “I know how to do a valuation”. Based on his track-record, I reckon he does too.
Currently P/E ratios are saying that the S&P 500 is too expensive, and so is Tobin’s “”q”, in fact they have been saying that for more than a year. So if you buy that line, then get ready to short the market!!
Nobody is quite sure what Warren Buffet thinks, and anyway he’s just sitting on the sidelines eating donuts, playing with his ukulele and his new train set, and cracking jokes, like he always does.
My opinion is that historically the “fundamental” (which International Valuation Standards calls Other-Than-Market Value), is a function of (a) GNP (nominal, i.e. current prices), divided by a function of (b) some function (which I’m still not completely sure about), of the yield on a Thirty Year Treasury. And so if (a) is going up a bit and (b) is set to keep going down, or at least stay low; then the “fundamental” is going to go up.
2: BubbleOmics
There is a twist to all that. There was a bubble in US stock prices which peaked in 2000 (that’s not news), but according to the Immutable Laws of BubbleOmics, what’s happening now is still predicated by that bubble (that is (relatively) new).
The Immutable Laws of BubbleOmics say that for every bubble, there must be a bust, and that the size and the timing of the bust is predicated by the size and the timing of the preceding bubble.
That’s the theory, like a pebble thrown in a pond (the pebble is the cause of the bubble (often lunatic credit)), which causes an “up” wave, which must inevitably be followed by a “down” wave since all bubbles are zero sum; they are just a transfer of wealth, generally from the poor to the rich.
http://www.marketoracle.co.uk/Article12114.html
The first time I looked at the S&P 500 from that angle was in January 2008 when I said that looking back at the amount of mispricing of the previous bubble, the bottom of the trough would be 675 which was pretty close (that happened two months later).
There was probably an element of luck there, although using the same logic “BubbleOmics” predicted that from that point it would be plain sailing up to 1,000, which is what happened.
So the theory seems to work at least for stock prices, but just for the record don’t ask me about BubbleOmics’ track record on gold which was worse than awful, although that’s a little more complicated http://www.marketoracle.co.uk/Article24034.html).
So what next for the S&P 500?
It’s tedious to run the numbers and there are complications…”when did the fundamental get crossed? Do you use today’s 30-Year yield, or a moving average? How do you account for the fact, that now 50% of the earnings of S&P 500 companies are outside USA?” That’s a sort of analysis best saved up for a quiet rainy day round about Christmas.
But now that the “uncertainty” is less, the “will he won’t he” for QE2 is no more, house prices are still drifting down…the picture is clearer than it was, and although the lunatics are still in charge, so what, that’s not news, and like Samuel J. Jackson said in Jackie Brown, “Darn, of course I can’t trust Melanie, but I can trust Melanie to be Melanie”.
Here’s how I see it:
- The S&P 500 is undervalued compared to its “fundamental” and it’s still in the post-bubble trough, but it may take a couple of years to get back to the “fundamental”.
- Regardless, the “fundamental” is going to go up, driven by low long-term interest rates, plenty of debt for “qualified” corporations to gear their earnings and hire new people (outside USA), and a world economy that is growing even if the US economy is in the doldrums (50% of their earnings come from there).
- There is no chance there will be a reversal of more than 20% however bad some event that comes out of the blue might be. When markets are in the “down” phase, they don’t have big reversals.
- There is a chance there will be a build up to say 1,700 in 2011 as the market gets back to the fundamental, but I think it’s too early for that.
- Will it hit 1,300 before Christmas? I hate to say it (because it would prove me wrong) but there is a good chance of that.
Remember the corporations in the S&P 500 don’t care about Food Stamps or unemployment in USA. And they all “got medical”, it’s the small companies and start-ups that will be hammered by Obama-Care, and those are they guys who can’t borrow from the big trough that Ben is creating.
But who cares? Perhaps in five years time 75% of the earnings of the companies that make up the S&P 500 will come from outside USA?
By Andrew Butter
Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
© 2010 Copyright Andrew Butter- All Rights Reserved
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