Whether Stocks are Cheap is Besides the Point

Whether Stocks are Cheap is Besides the Point

Featured in No Direction Home: Market Shadows Newsletter April 11, 2013 

Market Shadows currently has two virtual portfolios, both managed by Dr. Paul Price. The Virtual Value Portfolio, started Oct. 26, 2012, is comprised of stocks. The Put Selling Virtual Portfolio provides examples of taking long positions through SELLING put options. We started it in January, 2013.

Our Virtual Portfolios reflect our belief that the incredible rise in stocks during the last four years is not over. Our reasons for being bullish are not based on an economic recovery, or a thriving world economy, or a belief that stocks are “cheap.” Stock prices are slightly on the high side, historically, but we’re investing in a world that lacks decent alternatives.

The lack of alternatives in this investing environment defies historical trends. It’s a result of the Federal Reserve’s “money printing” (quantitative easing, QE) and its Zero Interest Rate Policy (ZIRP). QE has devalued the dollar – as more dollars are printed into circulation, the value of all dollars declines. The flow of cash into the hands of the Primary Dealers, along with ZIRP, leads to strength in equities and commodities. The price of these assets rise as the value of the dollar falls. (See No Direction Home.)

In this new environment, our premise is that whether stocks are cheap or expensive is not a particularly useful question. Dr. Paul Prices addresses this issue in the following article. 

Whether Stocks are Cheap is Besides the Point

Is that statement heresy coming form the mouth of a self-confessed ‘value’ investor? Not when you understand what the central banks of the world are doing. 

The US Federal Reserve, the Bank of Japan (BOJ) and the European Central Bank (ECB) have chosen to print unlimited amounts of fiat-based currency to ‘solve’ their similar, but varied in nature, debt problems. 

Last fall, the Japanese election was won on the promise to destroy the value of the Yen. This action was meant to boost exports, create inflation, and kick debt maturities further down the road. Since the election, the foreign exchange value of the Yen has plummeted almost 20%. (See Bruce Krasting’s Japan at War.)

Everything imported now costs much more. Japanese stocks have skyrocketed as the only defense citizens have to try to preserve their purchasing power.

Nikkei 225 versus $UD to Yen 

Many people comment that US stocks are too expensive to buy. They cite the current trailing P/E ratio of the S&P 500 as proof that shares won’t go higher. The broad market is trading slightly above normal levels. However, competing investment choices lack ability to protect against the blatant, ongoing devaluation of the US dollar.

Shiller P-E (1) 

The crazy-high P/E multiple in early 2009 was the result of massive financial write-offs. It was not due to overly optimistic investors. That renders it completely non-meaningful as a determinate of relative value.

Artificially low interest rates are now at pitiful levels. Real rates on 10-year treasuries are in negative territory!  These levels ensure loss of buying power over time.

Real long-term treasury rate    Apr. 5, 2013 new

 

Screen Shot 2013-04-06 at 3.48.00 PM 

Note: Nominal interest rates on 10-year Treasury notes are positive (below), but those are not corrected for inflation. “Real yields” are measured with an adjustment for inflation. The adjustment is made by subtracting the “official” consumer price index (CPI-U). 

Nominal Interest Rates on 10-Year Treasury Note:

Screen Shot 2013-04-06 at 2.59.38 PM

The CPI-U is the broadest measure of consumer price inflation for goods and services published by the U.S. Government’s Bureau of Labor Statistics (BLS). However, as discussed in Washington’s Biggest Lie (and Why it Continues to be Told), inflation, as measured by the BLS, underestimates real-life inflation rates. Inflation is worse than government numbers suggest and the media discloses.  

The chart below from ShadowStats shows that while the official CPI-U is at about 2%, the alternative CPI, measured as it was measured in the 1990s, is closer to 5%. John Williams explained, “The CPI chart…reflects our estimate of inflation for today as if it were calculated the same way it was in 1990… In general terms, methodological shifts in government reporting have depressed reported inflation, moving the concept of the CPI away from being a measure of the cost of living needed to maintain a constant standard of living.”

Screen Shot 2013-04-06 at 4.04.01 PM 

The crazy-high P/E multiple in early 2009 (below) was the result of massive financial write-offs. It was not due to overly optimistic investors. That renders it completely non-meaningful as a determinate of relative value.

 

S&P 500 trailing P-E's   actual reported earnings (1)

 

The average market P/E ventured north of 20x when rates were a shade above 4% back in the early 1960s. Nominal 10-year treasury rates of 1.72% make the present S&P 500 multiple a bargain compared with all available fixed income products. 

Holding cash only works as a short term strategy while waiting and hoping for lower prices in equities. That might happen, but anyone who took that approach before year-end 2012 is way behind those who simply put cash to work in November or December.

Add the effect of the Fed’s $85 billion per month money printing to record-low yields, and we have all the reasons we need to keep a healthy portion of our net worth in stocks. There really is no viable alternative. (See In Love with TINA.)

Trade-weighted Dollar   as of Mar. 27. 2013        source- St. Louis Fed Reserve Bank 

The Cypriot confiscation of citizens’ life savings from bank accounts was indeed a template for behavior that is likely to spread to governments worldwide. Japan’s dramatic gutting of its own currency should serve as advance notice. 

The U.S. dollar will continue to lose value. Ownership in solvent companies provides a decent chance to preserve value in something that can be marked up to market as paper money is marked down.

Featured in No Direction Home: Market Shadows Newsletter April 11, 2013

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