Dec

8

A common fallacy regarding stable ratios that market people have, that makes them lose much more than they have to at all times, is the belief is that the ratio of the stock market to some other things such as GNP or assets is too high. The former Tennessee multiple comparison people always had many such ratios to show that stocks were overvalued after 1960. The Tobin price to book value ratio is another indicator favored by the chronic bear weekly columnists, and it is always pulled out by those who hate enterprise, as one of the arguments to sell stocks when prices rise.

I recently came across two variants of this fallacy at a junta I host. The statistic adduced was that the ratio of the stock market to money supply is vastly over-inflated now. Also, the ratio of the financial part of the stock market to the non-financial part is much greater than it was 10 years ago.

The fallacies here are manifold. It is easiest to see in another context where a plaintiff sued the owner of two restaurant chains because he sold one restaurant chain for a higher value relative to sales than the second was valued at.

Some of the reasons that Tobin ratios, money supply ratios, reduced inequality through taxes, etc. are fallacies are as follows:

  1. Companies are not valued based on sales.
  2. Consumers do not have stable desires as to proportions of things that they buy.
  3. The income elasticity of demand for different products varies. As people get richer they choose more service products and leisure and financial products relative to food and durables.
  4. The value of an asset is determined by the income stream that it yields, discounted, and this is dependent on the degree of proprietariness of the product and marketing, its insulation from competition, and the value of intangible assets such as reputation and customer loyalty. Such values change over time and what was extant in 1970, or in the Shiller case, 1900, has no relevance to today.
  5. The expected future growth rate of companies is always changing, and when that growth rate translates to a higher growth in profits, the value of the numerator in price to asset ratios increases more than the denominator. It is the same idea for a reduction in expected interest rates.
  6. Physical assets time series show a high degree of macroscopic inertia, whereas price series are usually highly erratic relative to the physical series. Service firms, since they are less like physical assets, tend to show much more variability in price than firms that have heavy physical assets.

Many of these fallacies also apply to those who try to value companies based on p/e, and it is one of the major reasons that prospective studies, such as those of Value Line, always show that growth beats value. But I am sure I will have to present my detailed evidence on this before the agrarians give it up.


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