The SP500 (SPY) as of Friday’s close of $1466 has risen ~120% from the low of $666.78, reached on March 9, 2009. The past 3 ½ years have been quite literally plastered with many, many calls for a 2nd recession, further stock market erosion, and outright financial collapse, with the advice that only gold, oil, or some other commodity be owned by investors. Meanwhile, Auto & Light Vehicle sales have recovered to between 14mil-15mil SAAR (Seasonally Adjusted Annual Rate), and now miracle of miracles, housing is threatening to enter a strong recovery, in spite of significantly tighter lending standards. Yet, at every turn, the media bring out Nouriel Roubini, Marc Faber, Peter Schiff, and David Rosenberg with overly pessimistic forecasts on issues of which all are aware. Being perpetually “Bullish” or “Bearish” one is always going to be right at least once during an investment cycle!
If one takes a different tack and carefully examines the correlations between economic data and market prices, one comes to the conclusion that broad economic cycles are driven by individuals each adjusting to the economic conditions of the moment, in individual efforts to improve the standard of living for themselves and their families. Broad “Top Down” macro-economic forecasting misses the solutions which each of us develops for our own unique situations. Broad macro-economic analysis misses the vitality of the individual in coming to terms with changed economic circumstances and our ability to modify our behavior, change individual paths, and create individual solutions which “Top Down” analysts cannot forecast. The power of individuals solving problems on the micro-economic scale is what Friedrich Hayek wrote about in The Road to Serfdom. Julian Simon wrote similarly in The Ultimate Resource about how, time after time, humanity threatening forecasts by commonly recognized pundits have never become reality, EVER! Solutions have always been found!
Whenever we have a financial disaster, we talk about not learning from history!
Why do we never discuss our historical ability to recover from financial disasters?? We never talk/learn about this either!!
Human nature is such that we tend much more (psychological studies indicate 2 or 3 times greater focus on negative as opposed to positive outcomes) to focus on the potential for negative outcomes. In my own study, the primary reason for the success of Value Investors is their respect for human ability and their optimism for identifying and implementing solutions to difficult situations. In studying the lives of many Value Investors what is most striking of the two most recognized and most studied Value Investors of the past century, both Warren Buffett and Ben Graham were students of human history. Graham ggraduated from Columbia University, as salutatorian of his class, at the age of 20. Columbia made three offers to teach English, Mathematics, and Philosophy, but took a job on Wall Street eventually starting the Graham-Newman Partnership.
“Buffett Warren Buffett sat for hours in the Columbia University Library reading newspapers—including the ads–from the 1930s to gain a sense of the Great Depression. Jim Rogers, the peripatetic investor, speaks about the value of studying history as an investor in the foreword to “Financial Reckoning Day Fallout” (2009) by William Bonner and Addison Wiggin. Jim Rogers: “The only other way (besides visiting countries around the world yourself) to know what is going on is to study history. When I teach or speak at universities, young people always ask me: “I want to be successful and travel around the world; what should I study?” I always tell them the same thing: “Study history!” And, they always look at me very perplexed and say, “What are you talking about….what about economics, what about marketing?” “If you want to be successful, “I always say, “You’ve got to understand history. You will see how the world is always changing. You will see how a lot of the things we see today have happened before. Believe it or not, the stock market didn’t begin the day you graduated from school. The stock market’s been around for centuries. All markets have! These things have happened before. And will happen again.”
I have been optimistic precisely because of our society’s long, long history of recovery from periodic excesses. This is the lesson most seem to miss when they study markets. The current measure of the SP500 using modern data is shown below in Chart 1: SP500 Index vs. SP500 Earnings Trend Index. I added the term “Intrinsic Value” to the SP500 Earnings Trend Index to identify it more explicitly as the fair value of the SP500 based on Knut Wicksell’s “Natural Rate” concept first formulated in 1898. Based on the historical correlation between the SP500 and its “Intrinsic Value” index, the SP500 at the close on Sept 15th, 2012 of $1466 remains under-valued vs. its “Intrinsic Value” at $1596 by ~9%. But, this does not tell the entire story!
Just as market excesses “rhyme” and repeat so do recoveries. As we have just witnessed the past 20yrs, Hedge Funds with their momentum biased computer-driven investing styles have routinely driven markets to excess the past 2 economic cycles. In 2000 the market peak was some 100% in excess of the Intrinsic Value and in 2007 the excess was ~55%. I expect another excess to occur but it is impossible to predict how far above Intrinsic Value this will occur. While we can measure returns with some accuracy, it is impossible to predict how much people will be willing to pay for them when all finally become convinced that an economic expansion is in full bloom. Market psychology causes prices to rise and fall far depending on how individuals feel at the moment.
The past SP500 lows and highs in Chart 1: SP500 Index vs. SP500 Earnings Trend Index are labeled “A” and “B”, the former for a “market cycle low area” and the latter a “market cycle high area”. Currently, the economic data support the belief that we are roughly half way through the economic cycle. It appears that another 4yrs-5yrs are yet ahead! Housing is just now beginning to be recognized as in a recovery as rail shipments of crushed stone, sand and gravel were sharply higher in August. How “high” the market as we continue economic expansion to maturity cannot be predicted with any accuracy.
Where is the next “B”? If our recent past rhymes with the next “B”, then we could see an excess of a similar magnitude to recent experience, potentially 50%. The Intrinsic Value is rising as inflation falls. Currently the 12mo Trimmed Mean PCE is 1.8% (below) and appears likely to fall towards 1.5% in the next 6mos.-see the latest Dallas Fed data at the bottom of this note and notice the downward trend in PCE. This causes the “natural rate” to fall towards 4.5% from its current 4.85%. Since the SP500 Earnings Trend is “capitalized” by the ‘natural rate”, a lower number for the “natural rate” justifies higher stock prices. IF the markets do hit a 50% excess in 4yrs, THEN the SP500 may be priced in the $2,500-$3,000 range. The potential is high, but will only occur with an overly enthusiastic market psychology which pushes prices to these levels. An improvement in psychology has always occurred with economic expansion, but to explicitly predict this and try to pinpoint a price this far into the future is not something which I think anyone can estimate.
The next market “B” is very likely to come with economic maturity as it has in the past. It is the economic cycle which can be measured and we will have to live with this as a guide. When I am able to discern that the economy is entering its mature phase, then I will recommend we take action to preserve our gains. For now, I estimate considerable gains are yet ahead.