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Getting A Grip On This Yo Yo Stock Market

Well over a year ago, I pointed out that U.S. stocks were 20 percent overvalued. I believe that this overvaluation reflected irrational exuberance.

Although investors might complain about current stock market volatility, they are getting the roller coaster ride that they paid for. Some readers might be surprised by this statement; but the issue is about investors ignoring the degree to which stocks have been unfairly priced.

The typical definition of a bear market is a decline of at least 20 percent in stock market value from the most recent high. The U.S. stock market is now flirting with entering a bear market. For what it is worth, well over a year ago, I made the point that U.S. stocks were 20 percent overvalued. I believe that this overvaluation reflected irrational exuberance, and that it subjected investors to the risk of a bear market once exuberance gave way to pessimism. Well, pessimism is in the air.

The pessimism is understandable. I realize that we have just experienced an extraordinary decade long bull market. I acknowledge that the Fed has been raising interest rates, and that interest rate hikes are typically what bring bull markets to an end. I admit that the Trump administration has the U.S. engaged in a trade war with China, which may well have caused both economies to slow, leading the earnings of some major corporations, like Apple, to decline. Indeed, in my past blog posts I have written about the stock market consequences of both interest rate hikes and the trade war; and while these issues have contributed to the recent market decline, they are not why I say investors are getting the roller coaster ride that they paid for.

What I do say is that investors are getting the roller coaster ride they paid for because they have been ignoring the degree to which stocks are unfairly priced.

I use a simple heuristic to estimate the degree to which the stock market is fairly valued. The heuristic involves computing what stock values would be if returns were the sum of earnings growth and total payout yield. Call this the “as if” value for stocks. I then compare the market value of stocks to “as if” values, with the ratio of the two providing an estimate of overvaluation.

Historically, “as if” values have anchored market values, in the sense that market values have tended to revert to “as if” values. According to the “as if” heuristic, markets become overvalued when investors develop estimates of future earnings growth that are too high.

In January 2018, the “as if” heuristic implied that stocks were 26 percent overvalued. For recent times, that was a peak. If you recall, stocks subsequently declined in February and March of 2018, thereby leading overvaluation to decrease. Indeed, by the end of June 2018, overvaluation had dropped to 12 percent. But then came the summer of 2018 when stocks went on a tear, peaking in September.

During the summer of 2018, investors downplayed rising interest rates and the unfolding trade war with China. Then October arrived, the month in which stock market investors have tended to sober up; and this past October, they certainly did, initiating a series of systemic events in which stocks declined by more than 2 percent per day. This was especially true for the major technology stocks—Facebook, Apple, Amazon, Netflix, and Google.

Investors whose stock purchases push up prices that are already too high are akin to people who go to amusement parks and pay good money for a thrilling roller coaster ride. Now some investors might object to the analogy, and argue that they bought stocks because of their expected returns, not because of their volatility. And while there is some truth to this argument, there is also something important which is missing in the argument, namely estimates of fundamental value.

As far as I can tell, most investors do not consider estimates of stocks’ fundamental values in their investment decisions. That is why I say that they do not have a grip on this market. If they did, they would know that they are wildly overreacting to every twist and turn in the financial news.

To be sure, computing estimates of fundamental value is difficult. However, investors who are serious about fundamental value could consult the calculations of sell side analysts who use discounted cash flow techniques. However, as I have argued in the past, especially for stocks like Amazon and Tesla, sell side analysts’ discounted cash flow estimates are routinely biased, mostly on the up side.

If investors wanted unbiased estimates of fundamental values from sell side analysts, meaning fair values, they could insist that sell side analysts produce them. That might help them get a grip on this yo yo market. But my sense is that when it comes to fair values, investors prefer blissful ignorance to sober reality, because sober reality is much less exciting. That is why today’s stock market investors are getting what they paid for.

This article was originally published by Forbes on January 4, 2019.

Business, Economics, Finance, LSB
Illuminate, business, psychology
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