The Meaning of Valuation

"Stock prices have reached what looks like a permanently high plateau."
– Professor Irving Fisher, October 15, 1929

A New York Times article published the following day elaborated on Fisher’s comments:

“After discussing the rise in stock values during the past two years, Mr. Fisher declared realized and prospective increases in earnings, to a very large extent, had justified this rise, adding that ‘time will tell whether the increase will continue sufficiently to justify the present high level. I expect that it will… While I will not attempt to make any exact forecast, I do not feel that there will soon, if ever, be a fifty or sixty-point break below present levels such as Mr. Babson has predicted.’ While the tone of his address proper reflected a moderate optimism, in the informal questioning that followed Professor Fisher fell into an almost unqualified optimism. In reply to one question, he declared that he expected ‘to see the stock market a good deal higher than it is today, within a few months.’”

It’s worth noting that the stock index that Fisher was referencing in that speech was the Dow Jones Industrial Average, which had peaked on September 3, 1929 at 381.17. The “fifty or sixty-point break” that Fisher ruled out – soon, if ever – would have amounted to a market decline of only 13-16%. In September 1929, economist Roger Babson had actually told the National Business Conference in Massachusetts that “sooner or later a crash is coming which will take in the leading stocks and cause a decline from 60 to 80 points.” Yet even that decline would have only amounted to 16-21%.

As it happened, the Dow would subsequently lose over 89% of its value, plunging to a low of 41.22 on July 8, 1932.

Back in May (see Why A 60-65% Market Loss Would Be Run-Of-The-Mill) I noted that an 89% market loss essentially comprises a two-thirds loss in the value of the stock market, followed by yet another two-thirds loss of its remaining value. At the 1929 peak, one of these two-thirds losses was rather predictable, as it is at current market extremes:

“The first loss was a rather standard, run-of-the-mill retreat in market valuations from the 1929 extremes to levels that have historically been observed by the end of nearly every market cycle in history. Yes, a two-thirds market loss seems severe, but in the context of 1929 valuation extremes, it was also fairly pedestrian. The first two-thirds loss merely brought valuations to ordinary historical norms. The problem was that additional policy mistakes contributed to a Depression that wiped out yet another two-thirds of the market’s remaining value. The combination, of course, is how one gets an 89% market loss. Lose two thirds of your money, and then lose two thirds of what’s left.”

The chart below shows our Margin-Adjusted P/E (MAPE), which is better correlated with actual subsequent market returns than price/forward operating earnings, the Shiller CAPE, the Fed Model and numerous alternative measures.

To demonstrate that a good valuation measure is simply shorthand for a proper discounted cash flow analysis, I’ve also calculated – at each date in history – the present value of all actual subsequent S&P 500 Index dividends up to the present date (which fully include the impact of buybacks on per-share values), projecting future dividends beyond 2019 to reflect both current structural GDP growth and actual S&P 500 revenue growth in recent decades, and discounting all of those cash flows using a benchmark discount rate of 10% (representing typical long-term stock market returns across history). Let’s call this the “discounted cash flow” or DCF value of the S&P 500. I then calculated the ratio of the actual S&P 500 Index to that 10%-benchmark DCF.

Valuations measure the tradeoff between current prices and a very long-term stream of expected future cash flows. Every useful valuation ratio is just shorthand for that calculation. Every valuation ratio that fails that criterion is inferior, and you can show it in historical data.

As I’ve demonstrated a thousand ways, regardless of the impact of speculation or risk-aversion over shorter portions of the market cycle, the higher the level of market valuations, the lower the long-term and full-cycle market returns that have ultimately followed. Notably, both of these measures presently match or exceed their 1929 extremes.