Fair Value and Bubbles: 2017 Edition

In recent decades, two of the financial concepts that have become most vulnerable to squishy thinking are the notions of “fair value” and “bubbles.” Ironically, but also necessarily, the misuse of these concepts becomes most prevalent exactly during periods of extreme overvaluation that investors identify, in hindsight, as bubbles.

One of the reasons why valuations are poorly understood, and their importance is wholly underestimated, is that overvaluation alone is not enough to drive prices lower over shorter segments of the market cycle. For that reason, it’s essential to monitor the speculative inclinations of investors through the uniformity and divergence of market internals. The inclination of investors toward speculation or risk-aversion, as measured by the quality of market internals, is the hinge between an overvalued market that continues higher and an overvalued market that collapses. This is a lesson that was dramatically reinforced in recent years, as deranged Federal Reserve policies encouraged yield-seeking speculation even in the face of warning signs that were reliable in other market cycles across history. In the face of zero interest rates, one had to wait for market internals to deteriorate explicitly before adopting a negative market outlook (we made our own adaptations in 2014 in that regard).

Unfortunately, investors seem to have concluded that central bank easing is omnipotent, despite the fact that the Fed eased persistently and aggressively, to no effect, through the entire course of the 2000-2002 and 2007-2009 market collapses. It’s almost impossible for convey how badly investors are likely to regret dismissing valuations and ignoring market internals by the time the current speculative market cycle is completed. This movie has been re-made many times, always with the same ending.

The most egregious misuse of “fair value” in recent decades was during the speculative episode that ended in 2000, as Wall Street abandoned historically-informed valuation approaches, and embraced methods that directly conflicted not only with the basics of asset pricing, but with all economic experience.

For example, near the peak, James Glassman and Kevin Hassett published a book titled Dow 36,000, which not only treated earnings as dividends, but used a static infinite-horizon model that falls apart with the slightest change in assumptions. As I wrote at the time, their model “assumes that stocks should earn no risk premium, imagines that all earnings are paid out to shareholders with no reinvestment in new capital, and assumes that earnings will grow at 5% annually nonetheless. Of course, there is no plausible, historical, or economic basis for this. But hey, we’re trying to sell a book here. They assume stocks should be priced to offer a 6% long term rate of return, giving a resulting model: Price = Earnings / (0.06 - 0.05), which gives the result that the fair price/earnings ratio of the market = 100. Wow. Now let’s suppose that interest rates go to 7%. Using Glassman and Hassett’s assumptions, we then get Price = Earnings / (0.07 - 0.05), or P/E = 50. In other words, interest rates rise by 1% and stock prices drop by half. No risk. Yeah.”

Even at the March 2000 extreme, Wall Street largely denied the possibility that the stock market could, in fact, be experiencing a bubble. While observers often quote Alan Greenspan’s December 1996 lip-service to the possibility of “irrational exuberance” (which was merely a question and not an assertion), the fact is that his views remained quite floppy on the subject years later, when the bubble was full-blown:

“Bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong. Betting against markets is usually precarious at best. While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy. This all leads to the conclusion that monetary policy is best primarily focused on stability of the general level of prices of goods and services as the most credible means to achieve sustainable economic growth.”

Still, a few observers recognized the reality of the situation. On March 30, 2000, Nobel Laureate Franco Modigliani published an op-ed in the New York Times, observing:

“I can show, really precisely, that there are two warranted prices for a share. The one I prefer is based on such fundamentals as earnings and growth rates, but the bubble is rational in a certain sense. The expectation of growth produces the growth, which confirms the expectation; people will buy it because it went up. But once you are convinced that it is not growing anymore, nobody wants to hold a stock because it is overvalued. Everybody wants to get out and it collapses, beyond the fundamentals.”

A few weeks later, I detailed how bubbles can emerge when investors focus on year-to-year returns and not discounted cash flows. Suppose that investors come to expect some annual rate of return k, say 10% annually, and even though the actual stream of cash flows cannot be expected to provide that return, suppose that investors bid prices up at a sufficient pace to produce that rate of investment returns anyway. The result is that prices gradually detach from fundamental values. I wrote:

“Mathematically speaking, the defining characteristics of a bubble are 1) price movements satisfy a ‘differential equation,’ in this case, Price = (1+k) x Last Price - cash flow, but 2) the long-term return k expected by investors does not equate price with the present value of future cash flows. In other words, the price contains a ‘bubble component,’ and the present value of that component is not zero. That’s what Modigliani means when he says ‘I can show, really precisely, that there are two warranted prices for a share.’ One is the price based on discounted fundamentals, but as he notes, ‘the bubble is rational in a certain sense. The expectation of growth produces the growth, which confirms the expectation.’ The only question is how long it takes for the gap between price and fundamentals to become intolerably wide. As we’ve seen, it can take a long time. But once the bubble psychology breaks, that gap can close with sickeningly great speed.”

Over the following 18 months, the S&P 500 would lose half of its value, and the tech-heavy Nasdaq 100 would lose 83% of its value, both in line with the projections I published at the March 2000 high. Though the broad uniformity or divergence of market internals (the best measure we’ve found of risk-seeking or risk-aversion among investors) greatly impacts market returns over shorter segments of the market cycle, valuations are extremely informative about long-term returns on a 10-12 year horizon, and potential downside risk over the completion of any given market cycle.

By 2007, yield-seeking speculation had driven stocks to a second bubble peak. A few weeks before that market extreme, which would be followed by a 55% plunge in the S&P 500, I reminded investors:

“Remember, valuation often has little impact on short-term returns (though the impact can be quite violent once internal market action deteriorates, indicating that investors are becoming averse to risk). Still, valuations have an enormous impact on long-term returns, particularly at the horizon of 7 years and beyond. The recent market advance should do nothing to undermine the confidence that investors have in historically reliable, theoretically sound, carefully constructed measures of market valuation.

“Indeed, there is no evidence that historically reliable valuation measures have lost their validity. Though the stock market has maintained relatively high multiples since the late 1990's, those multiples have thus far been associated with poor extended returns. Specifically, based on the most recent, reasonably long-term period available, the S&P 500 has (predictably) lagged Treasury bills for not just seven years, but now more than eight-and-a-half years. Investors will place themselves in quite a bit of danger if they believe that the ‘echo bubble’ from the 2002 lows is some sort of new era for market valuations.”

Because Wall Street continued to encourage speculation based on the idea that stocks were “cheap relative to interest rates,” I added:

“I've done my best to warn loudly, I've put the data out there, and have analyzed this thing to pieces. The Fed Model has no theoretical validity as a discounting model, is a statistical artifact, would never have been materially negative except in 1987 and the late 1990's (even in 1929 or 1972), yet views the generational 1982 lows as about ‘fairly valued,’ is garbage in data prior to 1980, and vastly underperforms proper discounted cash flow models and normalized P/E ratios. If investors still wish to follow the Fed Model, my conscience is clear, and my hands are clean.”