Dow 5,000 Redux
William H. Gross
Here I go again! Gosh it was only six years ago that I cemented my place in stock market history by predicting that the Dow would fall from 8,500 to 5,000, instead of going up to 14,000 where it peaked in October of 2007. Well, I could use the standard set of excuses: 1) No one else saw it coming, 2) I was misinterpreted, and taken out of context, 3) I was tired, overworked, and had family problems, or 4) I had just come out of rehab. But these days what really works is a full confession. I mean, like, uh, it was totally my fault and I take full responsibility. The fact is I was only off by 9,000 points. That’s my story, and I’m stickin’ to it.
Well, fools rush in. This time though I’m definitely older and maybe a little bit wiser. No magic number, nor a specific target date from the Swami of the Dow. This one will be more conceptual, but still present a “take” that you can criticize or damn with faint praise. And no, despite the title, it doesn’t imply that the stock market is headed to 5,000 and that I was always right or just a little bit early. It only suggests that I’m readdressing the critical topic of equity valuation – that mysterious fragile flower where price is part perception, part valuation, and part hope or lack thereof. Press on, Swami.
Let me first announce a fundamental premise with which I think all rational investors would agree: I believe in stocks for the long run – but only if purchased at the right price. That statement packs a real punch. It says that capitalism is and will remain a going concern, that risk-taking – over the long run – will be rewarded, but only from a starting price that correctly anticipates the economy’s growth and its share of after-tax corporate profits within it. Acknowledging the above, let’s look at a few basic standards of valuation that historically have stood the test of time, to see if at least the price is right.
One of them is what is known as the “Q” ratio, or the value of the stock market relative to the replacement cost of net assets. The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, “Q” should mean revert to 1.0. If so, then oh, oh what a “Q”! Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation, as seen in Chart 1.
Another long-term standard of valuation comes from the good ol‘ P/E ratio, where earnings per share, or E, is compared as a function of P, or price. Chart 2, going all the way back to 1871, shows the same relatively massive undervaluation, not only in the U.S. but elsewhere. This has been a global bear market. Yet here one should be careful. The sage of rationality, Yale’s Robert Shiller, cautions us to look at earnings on an historical 10-year moving average to remove adverse or fortuitous cyclicality. When measured on this basis, P/E’s are cheap but less so, slightly below their mean average for the past century.
Professor Shiller may be on to something, although even his 10-year approach may not be enough to adjust for our future economy and its functioning within the context of a delevering as opposed to a levering financial system. Recent Investment Outlooks and indeed, discussions in PIMCO’s Investment Committee and Secular Forums for the past several years have pointed to the necessity to view current changes as not only non-cyclical, but non-secular. They are, in fact, likely to be transgenerational. We will not go back to what we have known and gotten used to. It’s like comparing Newton and Einstein: both were right but their rules governed entirely different domains. We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money. Welcome to a new universe stock market investors! In this rather “sheepish” as opposed to “brave” new world, here are some considerations that may affect Q ratios, P/E’s, and ultimately stock prices for years to come:
My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner. Dow 5,000? We don’t have to go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well. One only has to recognize that roughly 20% of bank capital is now owned by the U.S. government and that a near proportionate share of profits will flow in that direction as well. Better to own corporate bonds than corporate stocks, but that’s a story for another Investment Outlook.
William H. GrossManaging Director
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