Is The Price Right?
If you want to know if the stock market is overvalued, you should analyze the market in the context of two variables that determine value.
The first of these points out the fact that stocks ultimately derive their value from only one source: the earnings that businesses produce. And since owners get paid from future earnings, we would look to future, expected earnings. And that is one of our two fundamentals.
The other is, of course, interest rates - specifically, the rate on the 30-year government bond. That represents the risk-free return on long-term money.
To explain how this pair of market-measuring variables works, let's invent a mythical enterprise which we'll name, Durability, Inc. Now it so happens that Durability is a rather unusual firm in that it is guaranteed to earn $6 a share this year and every year, and just as assuredly, it will never earn more. But notice this - we didn't say anything about Durability's dividend policy. One year, the Board might decide to retain its earnings; the next year, it might pay a dividend.
But either way, the investor would make $6 every year on his Durability stock. So his return is simply $6, divided by whatever he paid for his share -- that is, earnings divided by price. That is known as the earnings yield. Thus if the 30-year Treasury bond was trading at 6 percent, shares of Durability ought to be trading very close to $100 per share. At that price, the earnings yield ($6 divided by $100) would match the return on the 30-year Treasury. Thus, no investor would pay more for Durability, because he'd wind up making less than he would on the bonds!
The point of this exercise is that the stock market as a whole tends to be priced pretty much like Durability. However, it should be noted that real companies are much harder to predict. They may have a tendency over time to grow; but on the other hand, they can deliver many surprises. And sometimes, investors are more attuned to the growth; other times, more wary of the risk. But on average, the market - which is a blend of stocks with varying degrees of both uncertainty and of potential growth - is more stable than you realize.
In case you think the yield on stocks can fall independently of bond yields, well it has never ever done so before. So for the overall market to make a sustained rise, one of two things must happen. Either bond yields must also fall - in which case you would be just as well off owning bonds - or earnings estimates must rise, which is a tough trick in a falling U.S. economy. And the bottom line in all of this is that what's important is not how high the market 'looks' but, fundamentally, how high it really is.
* * * * *
The first of these points out the fact that stocks ultimately derive their value from only one source: the earnings that businesses produce. And since owners get paid from future earnings, we would look to future, expected earnings. And that is one of our two fundamentals.
The other is, of course, interest rates - specifically, the rate on the 30-year government bond. That represents the risk-free return on long-term money.
To explain how this pair of market-measuring variables works, let's invent a mythical enterprise which we'll name, Durability, Inc. Now it so happens that Durability is a rather unusual firm in that it is guaranteed to earn $6 a share this year and every year, and just as assuredly, it will never earn more. But notice this - we didn't say anything about Durability's dividend policy. One year, the Board might decide to retain its earnings; the next year, it might pay a dividend.
But either way, the investor would make $6 every year on his Durability stock. So his return is simply $6, divided by whatever he paid for his share -- that is, earnings divided by price. That is known as the earnings yield. Thus if the 30-year Treasury bond was trading at 6 percent, shares of Durability ought to be trading very close to $100 per share. At that price, the earnings yield ($6 divided by $100) would match the return on the 30-year Treasury. Thus, no investor would pay more for Durability, because he'd wind up making less than he would on the bonds!
The point of this exercise is that the stock market as a whole tends to be priced pretty much like Durability. However, it should be noted that real companies are much harder to predict. They may have a tendency over time to grow; but on the other hand, they can deliver many surprises. And sometimes, investors are more attuned to the growth; other times, more wary of the risk. But on average, the market - which is a blend of stocks with varying degrees of both uncertainty and of potential growth - is more stable than you realize.
In case you think the yield on stocks can fall independently of bond yields, well it has never ever done so before. So for the overall market to make a sustained rise, one of two things must happen. Either bond yields must also fall - in which case you would be just as well off owning bonds - or earnings estimates must rise, which is a tough trick in a falling U.S. economy. And the bottom line in all of this is that what's important is not how high the market 'looks' but, fundamentally, how high it really is.
* * * * *
posted by Bob Moser at
5:33 PM
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