Everything You Wanted To Know About Equity Market Valuations (And Didn't Know To Ask)

Tyler Durden's picture

The stock market. Source of unknown riches - but not necessarily for investors. So-called "professional" investors offer to manage your money. However, their fees are based on the level of assets managed, not performance. Hence their goal is to maximize assets, not performance, and prey for markets to behave. You will never hear a bad word about stocks from a professional money manager. the by-laws of many mutual funds do not allow the manager to have cash levels above 5% of assets. He has to be invested at least 95% at all times. On one hand, it is probably right to force money managers to concentrate on stock picking, not market timing. On the other hand, this puts the onus of market timing onto the inidiviual investors. Lighthouse's Alex Gloy's excellent presentation below proves finance doesn't have to be complex (people make it complex).

Via Lighthouse Investment Management's Alex Gloy,

The money management industry would like to have their clients' assets indefinitely, through bull- and bear markets. Ride the wave during good times. And simply state that "nobody could have foreseen this", "we don't have a crystal ball" or "it's too late to sell now" in case of a crash.

There must be a better way to invest.

This publication tries to assess the following questions:

1. What kind of return can be reasonably expected from stock market investments? Is that rate
2. What kind of simple tools exist to tell if the stock market is cheap or expensive?
3. Are stock market returns mean-reverting?
4. Are we going to continue to see similar cyclical fluctuations in the future, or are we in the midst of a structural break?

I will try to keep things as simple as possible. Finance doesn't have to be complex (people make it complex). A picture says more than a thousand words - I hope the following charts help.

Performance: How to Visualize It

How do we look at performance?

Above you see the S&P 500 Index since 18711. By looking at the black line (nominal, non-logarithmic scale) you would think there was no point in investing before 1981. That's why you should look at longterm data on a logarithmic scale. The green surface is the real (inflation-adjusted) S&P 500. Should we look at nominal or real returns? What good is a 10% rise in the stock market if inflation runs at 20%? Conventional wisdom has it that inflation is good for stocks. It that true? Compare the chart on the next page:

Performance: Nominal or Real

Look what the inflationary period of the 1980's did to stocks: not much in nominal terms (black line), but devastating in real terms (green surface). From 1973 to 1982, the nominal S&P remained stable (117 versus 118 points). However, in real terms, the index fell from 640 to 286 (-55%). Yes, you would have lost purchasing power, too, if you kept your money in cash. But that is a different question.

For performance measurement, real returns count.

Today, the S&P 500 is around 1,800 compared to 82 (real) in 1871, yielding a real return of 2.2%3. But the S&P 500 is a price index (as opposed to total return), so we must account for dividends (and reinvestment of those). Including dividends, the total real return is around 6.5%. Impressively, this shows how important dividends are (2/3 of total return) in the long run.

We don't live 142 years, so the average total real return from 1871 to 2013 is not so useful for the individual investor. But you can slice those 142 years into periods of 10, 20 and 30 years. Take the returns over those periods and plot their frequency (see above).

You will notice that among all 10-year periods (blue) you had a few with negative returns. When investing over 20-year periods, you would have suffered only one (ending in 1921) with close to zero return. The longer your investment horizon, the closer the returns are clustered around the average, or expected, value. You can see it visually as the distribution of returns gets "slimmer" (green surface) and contains less "outliers".

The more data points we add, the closer the annual returns lie around the same mean (average). This serves as indication that stock market returns are mean-reverting.

Conclusion: It makes little sense to invest in stocks with a time horizon of less than 10 years.


1. In 20 years, many different people will have been at the helm of the job as money manager
2. Career risk: most money managers get terminated after a few quarters of unsatisfactory
performance (hence nobody dares to stick his neck out)
3. End-user risk: very few investors would be willing to accept multiple years of disappointing performance (changing strategy mid-term and hence messing up performance)

And here lies the conundrum: almost nobody is investing according to what theory prescribes.

It doesn't help that you can check on the value of your investments every minute via your smart phone.

Do you check every day what your house is worth? No, because, luckily, that is impossible.

It would probably be beneficial for most investors if their investments traded only once a year. The constant availability of pricing information, coupled with swings from one minute to the next add to psychological pressure, leading to mistakes.

Valuation: Price-Earnings

The previous chapter assumes you don't try to time the market (you just invest whenever funds are available and lock them up for at least 20 years). But the stock market rarely trades at fair value. It is either over- or undervalued. What if you could actually determine those valuations? And what do you base valuation on?

In the long run, stocks are driven by earnings:

The problem: company profits are very cyclical. Meaning: in every recession they decline by large amounts, only to recover strongly afterwards.

From 2006 to 2008, for example, real earnings for the S&P 500 declined from $94.70 to $28.50 (-70%).

The price-earnings multiple, or P/E-ratio, rose from 15.7 to 52.7 despite a drop in share prices. Stocks seem expensive when they are not and vice versa.

So Professor Robert Shiller (Yale) came up with a simple solution to smooth out cyclicality: take the average earnings from the last 10 years. Boom and bust should even out.

Valuation: CAPE

The "cyclically-adjusted price-earnings"-ratio (CAPE, or Shiller-P/E) was born.

It actually does a much better job in pointing out when the stock market is "cheap" or "expensive". It also shows the extent of the stock market bubble in 1999/2000.

The average 10-year CAPE-ratio since 1871 is 17 (low: 7 in 1933, high: 42.5 in 2000). Today, we are at 24.6.


This puts us pretty far towards the expensive side.

What you do know is the starting CAPE-ratio, and assume a regression to mean (17). With today's CAPE (25), we are facing strong headwinds for returns over the next 10 years. Sliding down the above regression line, the expected annual real return for -8 CAPE points is only around 1%. This does definitely not compensate for the risk associated with stocks. As a result, you should lighten up on stocks.

Gloy goes on to discuss the link between GDP and Profits, War, Inflation, and its effect on all markets.


Lighthouse - Equity Market Monitor - 2013-12 by Alexander Gloy

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Yen Cross's picture

  Everything you wanted to know before bad news was good news...

LetThemEatRand's picture

Old Yellen won't live forever.    Sorry to give away the ending.

frankTHE COIN's picture

What ! I' m sittin here cozy , Jellen with Yellens publications on a Friday night. And you Drop the ending.

The Mist's picture

Even with this log scale, the stock needs to recouple to the EPS (Green going down to the black line). Which would probably require S&P losing about 50%?

Though I agree with the importance of log scaling, it's still overvalued.

falak pema's picture

Maybe they should put a log scale on Yellen's cheshire cat smile to make it more palatable, or even put it under a CAPE; now you see it, now you don't thingie.

It would make the time to wait for Taper feel less like Godoting.

James_Cole's picture

Why? What's happening right now is clearly an outlier. 

stocktivity's picture

Bad news...Good news...It's all Bullshit!!!

watmann's picture

Told others that no matter what the Fed would be in the markets Griday as they need to close it up big so that consumers went out and shopped for this Christmas given the fact that we have one less weekend to do the damage in. They were there pumping the Dow stocks so the nightly news reprts could give the news of the markets going through the roof so you could go shopping and pump up the economy.

infiniti's picture

This shit is garbage, they aren't even using a total return index to represent the S&P 500.

Yen Cross's picture

What you see above you is TRUTH! What you see happen every day!   IS A LIE!

bubblemania's picture

Diversify yourself and settle for 5% - 10%. The uber successful take big risks to make big returns, they are the gamblers and for everyone that hits it, 1,000's lose big time. The same goes for those who huncker down.

eclectic syncretist's picture

The Fed has eliminated investment opportunities.  It's time to protect and save what you have from them.

Dr Benway's picture

The expected return of the stock market is not independent of its size. If we force feed money into the stock market, by mandated pension systems and ZIRP, doubling it in price, this does not mean that profits or dividends automatically double.

2¢Wurth's picture

 Hence their goal is to maximize assets, not performance, and prey for markets to behave.

It wouldn't hurt if they had a little prayer with their preying either.






TheRideNeverEnds's picture

My main take away is that the only thing one should ever do is buy them, shorting is idiotic.   Stocks never really go down so it doesn't matter, just buy them.   

Cthonic's picture

Might look into survivorship bias.

hungrydweller's picture

I see on the ads that "Bitcoin now worth more than gold....".  My God, if I could only short Buttcoin.

Dr Benway's picture

I have ads on ZH offering trading on Buttcoin, long or short, with leverage.

jonjon831983's picture

Should try googling and opening links with keywords like adidas bra sports... you`ll probably get better ads on here.

starman's picture

You sure you're not talking about my car sales man Bobby?

Yen Cross's picture

 I feel the weakness in my behind.

DOGGONE's picture

Show people these histories, which are the coming & going of IRRATIONALITY!

enloe creek's picture

deflation is coming whether the central banks like it or not stocks will collapse

mrdenis's picture

I just turn the charts upsidedown to reflect the real S&P 500 value .........

swedish etrade baby's picture

What do you think of CAPE? Is it useful. People who claim that american stocks are cheap say that the financial crisis was not a normal recession and earnings from 2007 and 2008 distorts the calculation. 

formadesika3's picture

It's useful whereas PE alone is often misleading. Like any other financial metric, it has to be put in context. Substitute 17 (mean avg) for those two years and do the calculation yourself. It does change the CAPE somewhat. So maybe the SP500 is fairly valued now if adjusted for that, but not cheap.

jonjon831983's picture

One of the things I don't understand with studies of the "index" is it tthat this assumes you purchase the index and reinvest?  How possible was that in the past.  Not only that, the indicies change over time:

"S&P Releases List of 86 Companies in the S&P 500 Since 1957

World's Most Followed Stock Market Index Turns 50 on March 4th"






* Also, how does the author define the S&P 500 going all the way back to 1871.  It seems the S&P 500 was created back in 1957. http://www.spindices.com/about-sp-indices/our-history/  

Dr Benway's picture

Yeah such "index" analyses assume constant reinvestment and rebalancing, assumed to be performed without cost, natch, and introducing various furphys such as survivorhip bias. The index changes like grandpa's axe, with the handle changed 15 times and the head 22.

The idea is that regardless of composition or size, the stock market is still magically the same. So if you have a $1t market cap stock market composed of profitable manufacturing stocks in year 1, and you replace these with unprofitable internet stocks with a $2t market cap in year 2, this is still the same market, and the expected return will be the same, just because we still call it the "stock market". Magic!

It becomes quite ridiculous when such anal-ysis tries to model a "stock market index" going back 150 years (probably using a proxy for the S&P500 pre-1957). Completely non-actionable, as you would have to know in advance which stocks would remain in the index, to trade on it.

More lately index inclusion has become a great time for stock market ramps for insiders, since it sets up an exit point for selling to rulebased granny investors. I call this index inclusion fraud.

Zero Bid's picture

Tyler I couldnt get past the first paragraph of this bs. If a money manager gets paid based on AUM, and asset size increases if performance is good, the aforementioned money manager has a built-in incentive for strong/consistent performance.

Hopefully Lighthouse Investment Management paid good money for this post.

ItsDanger's picture

I learned a long time ago, share price is only worth what the next guy is willing to pay for it.  End of story.