by Rob Bennett
Last week’s column argued that the market is telling us the proper value of stocks not in one step but in two. When the nominal price of the Dow is 12,000 and the P/E10 value shows that stocks are priced at three times fair value, you need to divide by three to know the true and lasting value of the Dow — something in the neighborhood of 4,000. This is a big deal. The implications are huge, both from a practical and from a theoretical perspective.
The practical implication is that investors need to be warned of the folly of investing heavily in stocks at times of insane overvaluation (like those we experienced from January 1996 through September 2008). An investor contributing $1,000 to his 401(k) account each month in 2000 was directing $350 each month to an asset class likely to pay a long-term return of 6.5 percent real and $650 to an asset class (cotton-candy nothingness) representing precisely zip long-term value. Yak!
The theoretical implication is that Eugene Fama was both kinda sorta right and kinda sorta wrong with his famous (infamous?) Efficient Market Theory. The market really is the best guide to what stocks are worth; we really should not be trying to outguess it. But we have been reading the market wrong since the days when Fama first put forward his theory. To Fama and his followers the nominal price and the market price are the same thing. To Valuation-Informed Indexers, the market-generated P/E10 value is every bit as important an information bit as the market-generated nominal price. To report only one (it is common practice today to say that the Dow is priced at whatever the nominal Dow price is) is misleading.
The obvious question is — Why is the stock market not like other markets? When you are trying to determine the market price of a car or a house or a banana, you look at the price being charged in the market. It’s a simple, one-step process. What is it about the stock market that requires us to go to two steps to identify what the market thinks the true price is at a given time?
To understand this, you need to consider for a moment how it is that a market works its magic of determining the proper price assigned to any asset sold within it. Say that we are trying to determine the proper value of a used car. The seller starts out asking a price of $20,000. The buyer starts out willing to pay a price of $10,000. They both engage in some give and take, the car sells for $15,000, and we call this the market price. How is it that the market figures out that both the seller and the buyer are initially slanting things a bit and that the true value of the car is a number somewhere in the middle of the two opening bids?
The market does this by forcing both the seller and the buyer at some point to be serious. A penalty is imposed on sellers who will not lower their opening bids — they don’t complete many sales. And a penalty is imposed on buyers who insist on living in fantasylands — they lose out on opportunities to obtain the cars they want. Markets work by forcing the two parties engaged in a transaction to at some point become serious in their pricing demands or else to pay a penalty for failing to do so.
The stock market does not do this.
When we say that the Dow is worth 12,000, we don’t do that because every owner of every share in the companies comprising the Dow agreed to sell his shares at a price that led to that number being the value for the Dow. The price for each company’s stock is the price at which a single transaction was completed. If Apple is selling today at $30, every Apple shareholder is treating each of his shares as being worth $30. But each shareholder has not engaged in a transaction in which the shares were sold at that price. The numbers being used are not the numbers that would apply if we forced the Reality Principle to be applied in a sale of each shareholder’s shares.
What would happen if all Apple shareholders tried to sell their shares on the same day? The price would collapse. Then, when the price got so low that other buyers were enticed to rush in an obtain Apple assets on the cheap, it would stop collapsing. The result of a sale of all the shares is that the owners and buyers of all the shares would get serious in their pricing demands and the market would reveal to us something pretty darn close to the true value of those shares.
The Reality Principle never has a chance to assert itself in the process by which we assign a value to the Dow each day. The numbers that the market is being said to generate are not transaction-generated numbers. They are silly numbers, fantasy numbers, numbers that cannot fairly be said to reflect reality or to be “efficient” in any meaningful sense.
Is it impossible then to know the market value of the Dow?
No, it’s not impossible. To do this, we need to perform an additional step. We need to find out not only what the market says about what the silly price is but also what the market says is the adjustment to the silly price needed to know the real price.
That’s what P/E10 does. P/E10 tells us the extent to which the nominal price reflects overvaluation or undervaluation, the extent to which investors are playing games because they are not being forced just yet to be serious about pricing.
Fama was onto something huge when he developed the Efficient Market Theory. The theory is almost valid. He just tragically left out a link in the logic chain. The stock market functions unlike any other market. You cannot use the nominal market price as something real because it is not the product of a negotiation process for all the shares outstanding at a given time. You also need to consider the playing-around factor, the extent to which investors of the day have elected to make themselves feel good (or bad) about their financial circumstances by assigning a temporary price to stocks higher (or lower) than the one that would apply if the number were determined by making reference to real financial transactions.
Fama made a mistake and then Malkiel copied his mistake and then Bogle copied the mistakes of Malkiel and Fama. We are today as a result in a big mess. The idea of rationalizing the investing project was a wonderful one. But when you get a foundational point wrong,the analytical errors must be corrected or else all of the strategic recommendations developed from following the implications of the invalid foundational point will be in error.
There is no one stock allocation that is at all times right for any investor. The value proposition of stocks is an ever-changing thing; it changes depending on the extent to which investors engage in playing-around behavior in their pricing demands. We will achieve a huge advance in our understanding of all investment strategy questions when we accept the need to make valuation adjustments to all market-generated numbers used in stock analyses.