Overvalued? Stocks look cheap to us
Support for the bearish view of the market is
beginning to collapse. One key reason: at least by one standard, stocks are
wildly undervalued.
By Victor
Niederhoffer and Laurel Kenner
Posted 5/8/2003
Atop the Palisades overlooking a certain Southern California
beach where Laurel spent many of her childhood days, a magnificent house
perched at the edge of the cliff. Every year, the rains caused mud to slide
onto the Pacific Coast Highway below, and the house lost a little more of its
base. As the years passed, the gradual erosion of the hillside exposed more and
more of the house’s foundation. One day, the house was gone.
A similar phenomenon has been taking place with the
foundation and framework of the bear market in recent days. First to go were
the technical supports -- those that depend on such indicators as the S&P
500 ($INX) being below its 200-day
moving average, a state of affairs that ended April 7. The market is now up 19%
from its Oct. 9 low.
Also vanishing quickly are the braces for the
bearish value boys. Most of the ones who attended college recently know that a
company has a choice in distributing its earnings as dividends or buybacks or
keeping the cash for future growth, and that the value of earnings is
determined by the current level of long-term interest rates. How disorienting
for them that the relation of projected earnings and bond yields -- the
so-called Fed model, detailed below -- shows stocks to be wildly undervalued.
We have nothing against bearishness in season, and
we have written a few bearish columns ourselves, starting at the end of 1999.
In fact, with the market at new highs almost every day and sentiment as
indicated by the CBOE Volatility Index ($VIX.X) highly complacent, we are
in one of our more neutral-to-bearish stages right now. In our own speculations
we do tend to swing from highly bullish to neutral, and we adjust our position
sizes accordingly.
As we have repeatedly indicated over the past year,
however, our long-term view is bullish. We said so most recently on April 10, when we introduced a forecast model based on
secondary offerings indicating a 19% rise in the S&P 500 in 2003. In our column of Dec. 27, 2002, we said that our best trade of the
year would be to go long stocks and short bonds.
Our reasons for bullishness are pretty much the
opposite of the bears’ reasons for bearishness. We feel that so much hope has
been taken away from the market environment that the remaining holders are
strong. And in the future news relative to expectations is likely to have more
of a bullish effect than a bearish one. Innovation and enterprise are likely to
bring the same kind of 1.5 million percent-a-century returns that the market
achieved in the 20th century, as documented by three London Business School
professors in the book "Triumph of the Optimists." (This is a
splendid work of comparative market research we have repeatedly lauded.)
We outlined our views in detail in our book,
"Practical Speculation," which hit the bookstores in March circa
S&P 800, and concluded: “In five years, maybe two or three, the Nasdaq
100 (QQQ) below 1,000 and the Dow
industrials ($INDU) below 7,500 will be bad
memories. Those who doubted the fruits of investing and enterprise will have
faded into well-deserved obscurity.”
With such tidal forces favoring the bulls, we are
reluctant to short stocks. It becomes too difficult to find the right time to
sell and then to buy them back, at least for us. We’ve missed too many gigantic
bullish moves in the past to try to fine-tune the ripples.
Today, we classify the reasons for bearishness in
order to provide a history and a Baedeker travel guide of the ideas that have
had the market in their grip for the past few years. Retrospectively, many of
those ideas were good -- better than ours. As to whether they will be good in
the future, you be the judge. We have been wrong on many occasions in the past,
and hopefully we will live to be wrong on many occasions in the future. At
least we have classified them, a la Linnaeus, so that others can identify
related species and fill in the gaps.
Bearish cornerstones
Since ancient times, it has been customary to place
in foundations a cornerstone inscribed with the history of the king responsible
for the building. Without in any way demeaning the contributions of such
eminent prophets of doom as David Tice, Robert Prechter, Bill Fleckenstein and
Jim Grant, we believe we may say without fear of contradiction that the king of
the bears is Alan Abelson, the lead columnist of Barron’s. Not only is Abelson
the most famous, witty and prolific of the pessimists, but his record of
bearishness is the longest -- it goes back to antiquity, as he started the
column in 1966, with the Dow below 1,000 -- and has been continuous. His
cornerstones have been laid weekly and are now so numerous that we are able to
assemble a reasonably complete catalog of reasons for pessimism.
Our book includes a full enumeration of Abelson’s
bearish arguments from 1990 through 1999, and as we note there, the columnist’s
accuracy in 2000-2002 was better than our own. It was so good, in fact, that
one might think that even a Grandmaster of Grump would be satisfied. But the
80% drop in the Nasdaq ($COMPX) and the halving of the
S&P 500 left him more bearish than ever. We should have known better. After
all, in October 1997, after the worst-ever point drop in the Dow prompted the
closing of U.S. markets, he wrote: “What do you call a 550-point drop in a
single day? A start.”
Abelson had not returned our telephone calls by the
time we went finished this column on Tuesday. When we interviewed him in the
summer of 2001, he told us some people feel he has been bearish all his life --
and with one or two minor exceptions during the 10 years we studied, a period
when the Dow went from 2,750 to 11,500, we can confirm the truth of that
assessment. Here is a compendium of his latest reasons for bearishness.
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Alan Abelson’s reasons for bearishness,
2003 |
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Even after all these years, we cannot help being
amazed at Abelson’s zeal. If every last ember of hope must vanish before the
next bull market can start, we may be in for a long wait.
The Spec Duo confess
But we’d like to make a confession. We don’t care
whether we’re in a bull market or a bear market. We find the intricacies of
definition arcane and essentially useless. What we care about are statistical
expectations of returns in reasonably tradable future time periods. That is why
we have been closely following the relation between prices, earnings and
interest rates lately. This relation is embodied in the so-called Fed model, a
rough method used by Fed economists and others for determining whether stocks
are undervalued or overvalued.
The actual equation is simple: divide the projected
annual earnings of the S&P 500 by the yield of the benchmark 10-year
Treasury note to arrive at a fair value for the market.
What you’re really doing is comparing the earnings
yield of stocks to the “risk-free” return on Treasurys. If the earnings yield
is close to or higher than the 10-year government note yield, the stock market
is undervalued by a comparable proportion. If the earnings yield is
considerably lower than the note yield (say, by more than 1%), the market is
overvalued.
We did the calculation ourselves this week, using
data from 1962 through 2002. We used only earnings estimates actually available
at the time of forecast. We found that the S&P 500’s fair value was 1,415
at the end of last year. With the actual index at 879, the market was 61%
undervalued.
Based on what happened over the last 40 years, we
would expect a 15% return for the S&P 500 this year.
New bullish foundation
While we are by no means totally enthralled with the
Fed model, we feel that interest rates at these low levels provide a highly
bullish backdrop for stocks. Our own tests using actual forecasts and normal
rules of thumb as to what’s going to happen when people making a negative 1%
return after inflation in money-market funds seek alternative investments of a
riskier nature confirms the bullishness of our expectations and supply-demand
argument. The Fed valuation model is a good start, and we would not want to be
against it when it’s 40% under- or over-valued -- especially when our tests,
which we’ll report next week, show that following it at the extremes would
yield good profits.
Thus, for psychological, economic, value and
technical reasons, we are bullish for the long term. As to whether this is
worth anything, we have our doubts ourselves. But at least we have presented
the framework within which we tried to perform an unbiased scientific
classification of the bearish categories. In a year or two or three, the
arguments of Abelson and fellow bears for a continued decline in stocks may
look prescient. At the moment, those arguments look to us like braces
supporting a house destined to tumble down the hill