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Is the Market Fairly Valued? Did the Market Achieve Any Meaningful Bottom Back in March?

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January 03, 2010 – Comments (35)

This is a follow-up post to my last large Fundamental Analysis post The Long View. I explored many topics including valuations in that post. I would like to talk about valuations in a little more detail here.

I can just here it now: "binv, would you just shut up about this! Ever since the 1990s there is just a new valuation paradigm and you should be comparing valuations in this context. As such the market is not overvalued, or is closer to fairly valued in this context"

There have been many arguments made in response to my posts that are materially similar to the statement above.

... AND I DO NOT BUY IT!!!

No sir, not one bit. Because once you strip away the fancy words, the statement above says "This time its different. We are much smarter / cleverer / more sophisticated (pick your adjective) than people were back 50-100 years ago and therefore all the rules have changed".

And I disagree.

Why? ... Because the same emotions that drives overvaluation (greed) and undervaluation (fear) exist exactly the same today just as it has ever since the invention of money.

Exuberance can last a long time, decades in fact. So much so that investors buy their own hubris. Monetary policy can distort signals and show nominal growth in asset classes such as equities and suppress signals in the bond market further distorting the "fairly valued" signals. But this is ultimately a transient event. The "transient" may be so long that investors not looking at the big picture will call it the "new normal". Government manipulation of market forces is a delay tactic. Because the government has no wealth of its own, it only moves around wealth (very inefficiently) within the economy, consuming a large portion of it. And market forces, at the end of the day, will decide the amount of debt the Treasury can sell and what interest rates are. (The caveat being that there is no limit to the amount of debt that the Fed can monetize - including Treasury debt. Which, as long as there is a Fed, is ultimately why the outcome will be inflationary, not deflationary. Deflationary impulses against the backdrop of massive inflation. Most assets you own fall in value and most assets you need to buy/consume rise in value). But the market emotionally high overshoots are met with emotionally low overcorrections. Everything runs in cycles.

And I think this down cycle is far from complete.

I do not expect agreement on this post, nor am I looking for it. Whether you agree with it or not is immaterial. I have an opinion and I am sharing it. Hopefully you find this useful in trying to understand the big picture. If it does (even if you come to the completely opposite conclusion that I do) then this post did its job.

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Required Reading / Sources for this Discussion

-- The Long View
-- Sentiment: P/E, BPSPX, VIX and CPC
- Thoughts on the Dow/Gold Ratio
-- http://www.zealllc.com/2007/longwave3.htm
-- http://www.econ.yale.edu/~shiller/data.htm
-- Regarding Economic Debates and Opinions: The Fallacy of "Purely Objective" Analysis

-------------------------------------------------------------
Main Analysis Point

I will assume you read the links above. These discuss the fundamental case that I make for the current overvaluation of stocks (as a general asset class) relative to the current economic conditions, and how valuations did not, at any point in the crisis since 2000, reach anything approaching a valuation bottom when compared against the historical record.

I discussed valuations using both GAAP and Operating Earnings back in October (Sentiment: P/E, BPSPX, VIX and CPC), and I will take a slightly different approach in this post: I want to examine P/E and Dividend Yields for nominal and real rates using Professor Shiller's data.

But first, to go along with the prologue above, let me reiterate that valuations, especially when viewed in a long term context, are as much a sentiment tool as they are an objective analysis tool.

Let's think about what P/E means. It is the the "payback period" for a stock's current earnings to justify/cover the current share price. Another way to look at it is the *premium* that you place on the stock's ability to generate future earnings. Earnings theoretically grow for growing companies, or they are stable and consistent for well-run companies. But shouldn't a P/E for a particular company or even a sector be a well-known and consistent metric? Why would anybody pay a premium on P/E beyond the historical average P/E?

Because investors are emotional. They fall prey to greed and fear, optimism and pessimism.

Moreover, large scale herd-behavior for optimism and pessimism actually runs in cycles. Read this article, it is a fantastic description of this valuation cycle: http://www.zealllc.com/2007/longwave3.htm. The main upshot of the article is that these long valuation waves take about 32-36 years to run, the last bottom was in 1981, and valuation bottoms do not occur until the broad market (as measured by P/E's on the Dow or the S&P 500, which have very similar P/Es most the time) P/E is between 6-10. Long Term (100 year) average P/E is ~14.

People right now are buying the hype. They buy the upgrades from Wall St. analysts. They buy the "turned the corner" rhetoric from economists. Nobody seems to remember this from the 2007 top or the 2000 top. SENTIMENT and RHETORIC is always extremely optimistic at the top! So they go back to the default "this time its different" mentality, buy the hype and pay the premium on the market with respect to valuation.

On to the data.

All the charts shown in the post are generated from Professor Shiller's data. Here is the relevant excerpt for interpolated and composited data:

This data set consists of monthly stock price, dividends, and earnings data and the consumer price index (to allow conversion to real values), all starting January 1871. The price, dividend, and earnings series are from the same sources as described in Chapter 26 of my earlier book (Market Volatility [Cambridge, MA: MIT Press, 1989]), although now I use monthly data, rather than annual data. Monthly dividend and earnings data are computed from the S&P four-quarter tools for the quarter since 1926, with linear interpolation to monthly figures. Dividend and earnings data before 1926 are from Cowles and associates (Common Stock Indexes, 2nd ed. [Bloomington, Ind.: Principia Press, 1939]), interpolated from annual data. Stock price data are monthly averages of daily closing prices through January 2000, the last month available as this book goes to press. The CPI-U (Consumer Price Index-All Urban Consumers) published by the U.S. Bureau of Labor Statistics begins in 1913; for years before 1913 1 spliced to the CPI Warren and Pearson's price index, by multiplying it by the ratio of the indexes in January 1913. December 1999 and January 2000 values for the CPI-Uare extrapolated. See George F. Warren and Frank A. Pearson, Gold and Prices (New York: John Wiley and Sons, 1935). Data are from their Table 1, pp. 11–14. For the Plots, I have multiplied the inflation-corrected series by a constant so that their value in January 2000 equals their nominal value, i.e., so that all prices are effectively in January 2000 dollars.

ENLARGE

Notice the pattern? Stocks become a tremendous value when the P/E ratio approaches the Dividend Yield. Fear of equity performance drives valuations to very favorable ratios. Each time this happens, the market puts on a subsequent tremendous bull run. The market becomes eventually becomes overvalued and then needs to pullback and consolidate while the ratios bottom before the next major bull run can commence   

Let's think about why. When times are perceived as good, when investors are (as a herd) optimistic, prices rise and a premium gets placed on growth (P/E goes up and Dividend Yields go down). When times are perceived as bad, investors are pessimistic, prices consolidate or fall and a premium gets placed on safety (P/E goes down and Dividend Yields go up).

And like I am observing above, emotions overshoot in both directions: we get irrational exuberance at the top and abject fear at the bottom.

But why the equality of P/E and Dividend Yield at the bottom (why is this value of about 6-10 P/E and 6-10% dividend yield).

Because this is the ultimate spot for value investors. When the market goes down to a P/E of 6-10, you will have a 100% appreciation on your investment (in terms of earnings) in 6-10 years assuming no earnings growth. That is exceptionally compelling no matter what the investment is. Additionally, a dividend yield of 6-10% means that you will receive cash return on your investment costs that completely pay you back in 10-17 years. Again, this is a ridiculously compelling scenario.

That is what we find at bottoms: absolutely ridiculously compelling investments because the herds emotional state is terrified.

And is that what we found on March 9, 2009? .... NOT EVEN CLOSE.

Earnings were in the toilet but fear was at a peak. So we got a bounced based on oversold technicals and a bearish sentiment extreme. That's all.

The rebuttal (I can just hear it being voiced now): "That is a completely incorrect assessment. The stock market is now based on growth, not dividend yields. This is a result of inflation / monetary policy." (which is the correct assessment on the upward side of the valuation cycle). Or perhaps the rebuttal will be even less well analyzed: "We reached a bottom, the economy is recovering and 666 on the S&P 500 was truly a good value for long term investors".

..... and this explanation is BULLS**T (in this case it is quite literally BS)

Because it assumes "This time it is different". Nothing goes up or down in a straight line. There are secular markets and there are always cyclical countermoves within the secular market. There was a cyclical countermove up (bear market rally) from the bursting of the Tulip Bubble, South Sea Bubble, early stages of the 1929 crash during the Great Depression. The is always some reason to justify why the asset rises despite unfavorable long term valuations while on the way down from a peak. In this case (March 2009 to now) we had massive liquidity injections from the government coupled with favorable currency exchange rates for an inrush of money to place this bounce at the macro level. But both aspects are now changing.

The next chart is using Professor Shiller's Long Term Interest Rate and CPI adjusted P/E and Dividend Yields. Read this for an explanation of what these curves mean.

ENLARGE

Why am I showing you this? For the same reason I showed valuations in this post (Sentiment: P/E, BPSPX, VIX and CPC) using both operating and GAAP earnings. Some people argue that GAAP earnings are not representative, so I showed that even in *operating earnings* terms we did not reach any meaningful bottom.

Same deal here. Some smart aleck might argue that the nominal picture is distorted by inflation, even though I have already shown that inflation arguments for P/E are also invalid, because P/E is "inflation neutral" (Prices are inflated and Earnings are inflated, so P divided by E removes inflation effects). But how Dividend Yield, P/E, and the CPI interact is a bit more complicated. So it is worth showing the slightly more nuanced picture.

But the point is, even in Real terms, there was no meaningful Valuation bottom in March when compared against the historical record

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So What's that Upshot?

From the point of view of the long term value investor there was no meaningful bottom reached in March 2009 with respect to P/E ratios and Dividend Yields when compared to the bottoms of the last 100 years.

Moreover, if you look at the patterns on the charts above, the correction periods of declining valuations were always short in comparison to the previous bull market. This showed that for the last 67 years (1933-2000) we were in a secular bull market and the bearish moves were all countertrend.

This is yet another reason why I reiterate that we are in a secular bear market. This current valuation and price cycle is on the decline and is already 9 years old, and we did not reach the bottom yet. There will be many more years of this bear market to go until we get utter bullish capitulation and absolutely insane "end of the world" valuations (which I firmly believe WILL **NOT** HAPPEN: Thoughts on the Dow/Gold Ratio)

.... But then again, maybe this time it's "different"

35 Comments – Post Your Own

#1) On January 03, 2010 at 7:46 PM, topsecret09 (35.84) wrote:

http://caps.fool.com/Blogs/ViewPost.aspx?bpid=317741&t=01009917921919779399         TS

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#2) On January 03, 2010 at 10:10 PM, brickcityman (< 20) wrote:

As for it being different "this time"  I am generally with you...  Much like rebellious teenagers we all think that the world in which we find ourselves is wholly different than that of our parents generation when in fact the changes are never nearly as pronounced as we would like to think....

 

BUT

 

One cannot ignore changes in the economy and the way in which it functions.  I often wonder if on average our economy has not shifted in non-trivial ways. 

 

The (annoyingly cliche) "information economy" seems to represent a big shift in terms of the capital intensiveness associated with "production".  Furthermore the enhanced fluidity of investment information and the expansion of market participation may well combine to undermine some shift historical precidents.

 

that much said the ying and yang of exhuburance and fear is to me like a sine wave...  Changes in the economy may alter frequency, but amplitude is driven by human emotion which is stubbornly resistant to change.

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#3) On January 03, 2010 at 10:56 PM, binve (< 20) wrote:

topsecret09, Thanks TS!

brickcityman, Thanks! I appreciate your inputs and comments! This is a fantastic comment:

that much said the ying and yang of exhuburance and fear is to me like a sine wave...  Changes in the economy may alter frequency, but amplitude is driven by human emotion which is stubbornly resistant to change.

I couldn't agree more.

I think, based on how you phrased this observation, that you would like these other posts that I have written. If you have not already seen them, please check them out!

First and Second Derivatives of the SPX - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=298547
Recipe for Disaster - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=298451

Thanks!.

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#4) On January 03, 2010 at 11:01 PM, Tastylunch (29.29) wrote:

Binve did you see what I saw in chart 1 specifically about the ratio of the first move down in 1929 in the blue linecompared to now?

the rapid reascent is fairly analogous too...

 

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#5) On January 03, 2010 at 11:10 PM, binve (< 20) wrote:

Tastylunch, Hey man! Yep, I agree. There are a lot of similarities technically (actual patterns, Wave counts, retracements, bear market rallies, etc.) and fundamentally (valuations, rhetoric, debt run-up, etc.) between now and 1929. It is not a 1-to-1 comparison and there are quite a few macroeconomic differences, but there are many similarities that most people would rather ignore..

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#6) On January 04, 2010 at 2:00 AM, checklist34 (99.72) wrote:

fwiw, i think this time actually is differnet for dividend yields.  For whatever reason, and I cannot begin to imagine why, share buybacks seem more common on big, massively profitable companies than dividend payouts.  Dell, Csco, and many others come to mind.  If you added $$$ spent on share buybacks what would the yield ont he S&P be?  Were share buybacks as common in, say, the70s?

I have cast a vote on these boards before in favor of dividends and against share buybacks as an efficient means of returning value to shareholders.  Dividends are better, i have postulated.

Additionally we have a couple of once in a lifetime incidents with respect to dividends here.  A) it became in vogue to cut the divi.  Stocks went UP from divi cuts at times, not down.  So severe was the panic and B) basically the whole financial sector slashed its divi as did a great, great many cyclics.  

The similarities seem to be more akin to the 70s than the 30s.  

 

And while I think the wisest argument ever is to argue that the dumbest argument ever is "this time is different", it is worth mentioning the following:

1)  the p/e of the S&P charts that people like to parade around are silly. 

1a) Factor out the massive commodity price bubble of 2008 follwed by the never-before-seen haste with which commodity priced crashed and you have massive losses in cyclicals concentrated in Q4 and Q1.  If aluminum or nat gas were suddenly at all time high prices what would you do?  you'd ramp upoutput.  which would leave you hanging like nobodies business if those prices suddenly tanked.

1b) we saw probably a spike of goodwill write-downs the likes of which the markets have never seen before, also concentrated in Q4/Q1

1c)  AIG alone can substantially swing earnings on the index

1d)  auto industry once in a lifetime cyclical losses.  

1e)  the bizzare perversion of mark to market GAAP accounting.  A company like XL or HIG marks, to market, down the value of an investment and they TAKE A GAAP LOSS.  If the markets recover and that value is marked back up they DO NOT TAKE A GAAP PROFIT.  That is plain dumb and again is enough to swing the p/e of the index substantially

1f)  people aren't insane.  the p/e chart based bearish posts are, however, insane.  if a cyclic company swings to a loss (nearly all cyclic companies did, at once, in Q408/Q109) is the stock now worth nothing?  If a cyclic company has a record quarter (as many did in early 2008) is it now worth 15x these record earnings?  no, and no.  the old addage goes buy a cyclic when its p/e is high and sell it when it falls to single digits.  

add all those up and see what it gets you.  

see my old blogs about valuations at the bottom.  We approached all time lowsfor price/book 20 year lows for price/sales and blahblah blah at themarch bottoms.

 

And, finally, one thing IS different and become ever more different as time goes by.  And that is the dissemination of information.  I, a nobody from nowhere, have access to more information from now to dawn that Ben Graham could have had when he was writing his first book in a month at the library.  

Some information that I have access too includes the probability that the world won't end.  The historical charts of the UK vs the US to counter panic over whether theUS will one day lose its reserve currency status etc.  Historical behavior in the stock market and how crashes lead to rises lead to peaks lead to crashes anda ll of this.

With that information comes a reduced probability of the kind of mega-hyper-cheap valuations in stocks and govt bonds that were seen peaking in the early 80s/late 70s. INFORMATION IS A CHANGE.

And, lastly, the market today lies roughly at historical valuations, i believe, for price/book, price/sales all courtesy of ned davis research and whatever othe sources I quoted in my blog or two from this summer exploring this in detail, look it up, they have lots of recs and lots of replies and easy to find titles.  

lastly, lastly, the current low interest rate environment does have an effect of upward pressure on stock valuations because what are you going to do?  buy 10 year treasuries?  bank CDs?

those record cheap valuations in the early 80s were accompanied by 15% returns on bank CDs.  Big difference.

So while your overall premise is fantastic - this time is never different - its also true that this time IS different in many of the ways above, and many of the considerations above are not just valid but basically obvious if one wants to think openly.  nothing is more silly than that p/e chart of the S&P except the occasional argument that accompanies it saying the S&P should now promptly go to 250 so its valuation is normal.  I realize you did not offer that valuation herein, I confess to not reading your post in extremely thorough detail.

 

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#7) On January 04, 2010 at 2:09 AM, checklist34 (99.72) wrote:

another thing that is differnet are hedge funds controlling billions or trillions of dollars and manipulating or, ahem, "investing in" or "trading in" markets of all kinds.

anybody think oil goes to 150 and down to 35 over what, 6 months, just from market forces?

those greedy little fingers are in everything and messing with everything and, almost without a doubt, the rise of the hedge fund and the massive volatility (not the poor returns, those are justified by the silly valuations at the top of the nasdaq bubble) of the last 10 years are almost without a doubt correlated.

take a bunch of smart people who don't care about much other than profits, give them a trillion dollars, and watch markets bounce around like basketballs?  i'm asking here, not accusing.  

But honestly, aren't all those sly little hedgies probably playing a role in magnifying the volatility in various markets just a bit here?

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#8) On January 04, 2010 at 2:17 AM, checklist34 (99.72) wrote:

apologies if me using words like "silly" and "insane" sounded insulting to anybody, that wasn't the point.  I do feel frustrated by that p/e of the S&P graph from time to time.  My counterpoints to it are outlined above, and many, many other times somewhere or other in these blogs.

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#9) On January 04, 2010 at 2:43 AM, portefeuille (99.60) wrote:

My counterpoints to it are outlined above, and many, many other times somewhere or other in these blogs.

So are mine. Long live the P/B chart by Ned Davis Research!



enlarge

(from this article from 03/08/09, "last Friday" thus was 03/06/09 (!))

The following is from comment #12 here by bigpeach.

----------------------

Generally however, I don't have a problem with looking at P/E as one part of a valuation analysis for a single company. The point portefeuille and I have been making on this site is that applying the same thinking to an index doesn't work. A lot of people seem to be trying to do that these days even though the math doesn't work thanks to limited liability.

Frankly I don't understand why everyone wants to try to value "the market." Short of individually valuing every company and summing, I don't know how you would even do such a thing.

----------------------

(emphasis (bold face) partly his, partly mine).

 

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#10) On January 04, 2010 at 3:12 AM, portefeuille (99.60) wrote:

P/B charts for an index are of course almost as silly as P/E ones (see the comment by bigpeach above) ...

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#11) On January 04, 2010 at 3:15 AM, uclayoda87 (29.26) wrote:

One concern that I have when measuring stocks or commodities in US dollars is that the tool used to measure has an uncertain value over the long run, like maybe 10 years.  Even recently, the US dollar index was below 75 and above 78, so do we measure an item when the dollar is at it low point, mid point or high point?  I'm not a historian but from what I have read, it seemed that the value of the US dollar was much more stable when it was on the gold standard, so measuring items in terms of US dollars was probably more valid then.  This would argue that P/E ratios may have been a more reliable and stable tool to measure a company.  If the assumption of a stable US dollar is not currently valid, then are the tools that require measurements in US dollars still valid?

In mathematics a proof by contradiction is done by proposing the opposite of what you want to prove and showing that this leads to a contradiction, which means that your assumption is false.  It may be possible to construct an argument that the P/E ratio is a valid and stable measure and then arrive at two different P/E ratios because of the varying value of the US dollar.  If the P/E ratio in dollars can be shown to have lost its validity, then maybe another method of valuation is needed, such as something based on the value of gold.

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#12) On January 04, 2010 at 6:19 AM, abitare (63.42) wrote:

FYSA-  GW Blog spot:
Is The U.S. Government Buying Stocks?

As I pointed out in December 2008, Nouriel Roubini wrote the month before that the government might buy U.S. stocks:

The Fed (or Treasury) could even go as far as directly intervening in the stock market via direct purchases of equities as a way to boost falling equity prices. Some of such policy actions seem extreme but they were in the playbook that Governor Bernanke described in his 2002 speech on how to avoid deflation.
Given that Roubini was previously a senior adviser to Tim Geithner, he probably knows what he's talking about.

Now, Charles Biderman, CEO of TrimTabs, argues that the government may, in fact, have been buying stocks to prop up the stock market. Given that 25% of the top 50 hedge funds in the world use TrimTabs' research for market timing, it is a credible source.

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#13) On January 04, 2010 at 8:54 AM, russiangambit (29.30) wrote:

In terms of it being diofferent this time - there are two things that are truly different I think, the low interest rates and the money printing. To which degree these two things make it different I am not sure.

We can looks at other countries where these 2 things were present such as Japan, but they didn't have the reserve currency. So interpaly of low interest rates, money printing and reserve currency make this recession quite unique and hard to predict how exactly it will flow.

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#14) On January 04, 2010 at 10:11 AM, binve (< 20) wrote:

checklist34,

Thanks for the comment! I do understand we have a difference of opinion on this issue. So I will just offer a few counterpoints to your counterpoints. And all of my comments will be made in the spirt of this post I wrote: Regarding Economic Debates and Opinions: The Fallacy of "Purely Objective" Analysis - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=305849

i think this time actually is differnet for dividend yields.  For whatever reason, and I cannot begin to imagine why, share buybacks seem more common on big, massively profitable companies than dividend payouts.  Dell, Csco, and many others come to mind.  If you added $$$ spent on share buybacks what would the yield ont he S&P be?  Were share buybacks as common in, say, the70s?

While that is a fair observation on buybacks for the 70s, I do not think it is different this time for dividend yields. We are on the bursting side of the cusp of overvaluation. The previous 40 years say a premium be placed on stock growth (which is a product of the inflationary monetary policies since that time). And we have had an extended period of investor confidence. It's not because politicans and economists are fundamentally smarter than they were previously or that investors are much more disciplined (see Tech Bubble, Housing Bubble, Credit Bubble, etc.) it is that the macroeconomics and monetary policy favored a very long bull run (in nominal terms). But like I was saying in the original post: Exuberance can last a long time, decades in fact. So much so that investors buy their own hubris. Monetary policy can distort signals and show nominal growth in asset classes such as equities and suppress signals in the bond market further distorting the "fairly valued" signals. But this is ultimately a transient event. The "transient" may be so long that investors not looking at the big picture will call it the "new normal". Government manipulation of market forces is a delay tactic. Because the government has no wealth of its own, it only moves around wealth (very inefficiently) within the economy, consuming a large portion of it. And market forces, at the end of the day, will decide the amount of debt the Treasury can sell and what interest rates are. (The caveat being that there is no limit to the amount of debt that the Fed can monetize - including Treasury debt. Which, as long as there is a Fed, is ultimately why the outcome will be inflationary, not deflationary. Deflationary impulses against the backdrop of massive inflation. Most assets you own fall in value and most assets you need to buy/consume rise in value). But the market emotionally high overshoots are met with emotionally low overcorrections. Everything runs in cycles.

My point being that true value investos did not become extinct in the 1960s. I am talking about the bottom feeders. I am definitely a bottom feeder. And proud of it. Unchecked growth in any system (physical or economic) is never healthy, and in nominal asset prices that is what we have had since the 1960s when you step back and look at the big picture. This applies to the valuations underpinning those prices as well.

I am looking for a return to valuations that at least approach those levels before I consider the market a "good value". And because I claim that everything runs in cycles (secular bull and bear markets, valuations, etc.) the overshoot on this next bear cycle, when it finally does bottom, will happen because NOBODY wants stocks. 

I think Dividend Yields will be back in the 6-10% range before this is said and done, and that is the value that I will find attractive.

And while I think the wisest argument ever is to argue that the dumbest argument ever is "this time is different", it is worth mentioning the following:

1)  the p/e of the S&P charts that people like to parade around are silly. 

1a) Factor out the massive commodity price bubble of 2008 follwed by the never-before-seen haste with which commodity priced crashed and you have massive losses in cyclicals concentrated in Q4 and Q1.  If aluminum or nat gas were suddenly at all time high prices what would you do?  you'd ramp upoutput.  which would leave you hanging like nobodies business if those prices suddenly tanked.

1b) we saw probably a spike of goodwill write-downs the likes of which the markets have never seen before, also concentrated in Q4/Q1

1c)  AIG alone can substantially swing earnings on the index

1d)  auto industry once in a lifetime cyclical losses.  

1e)  the bizzare perversion of mark to market GAAP accounting.  A company like XL or HIG marks, to market, down the value of an investment and they TAKE A GAAP LOSS.  If the markets recover and that value is marked back up they DO NOT TAKE A GAAP PROFIT.  That is plain dumb and again is enough to swing the p/e of the index substantially

1f)  people aren't insane.  the p/e chart based bearish posts are, however, insane.  if a cyclic company swings to a loss (nearly all cyclic companies did, at once, in Q408/Q109) is the stock now worth nothing?  If a cyclic company has a record quarter (as many did in early 2008) is it now worth 15x these record earnings?  no, and no.  the old addage goes buy a cyclic when its p/e is high and sell it when it falls to single digits.  

add all those up and see what it gets you.  

see my old blogs about valuations at the bottom.  We approached all time lowsfor price/book 20 year lows for price/sales and blahblah blah at themarch bottoms.

I agree with all these points. In this context, stocks are cheap. But I argue this context does not cover any historical bottom. The last 20 year, even the last 30 years, were still on the uptrend of the last valuation cycle. The mid 1960s from a P/E and Dividend perspective mark the last valuation bottom.

So I think we will have to agree to disagree here

And, lastly, the market today lies roughly at historical valuations, i believe, for price/book, price/sales all courtesy of ned davis research and whatever othe sources I quoted in my blog or two from this summer exploring this in detail, look it up, they have lots of recs and lots of replies and easy to find titles.

The links in your blogs point to reserach going back to the late 70s as far as Price/Book, etc., which as I have stated above is past the last valuation bottom of the 1960s. Do you have anything that takes a longer term view? I think making comparisons against the last 25 years, while useful, does not refute the main point of my post, which is that we have not approached anything that consitutes a valuation bottom when looked at against the historical record (last 100 years)

those record cheap valuations in the early 80s were accompanied by 15% returns on bank CDs.  Big difference.

I have valuations set against interest rate comparisons in my second chart. And the second chart / analysis goes through the same exercise in interest and CPI adjusted terms. And I show that even in these terms a valuation bottom did not occur on March 9

apologies if me using words like "silly" and "insane" sounded insulting to anybody, that wasn't the point. I do feel frustrated by that p/e of the S&P graph from time to time.  My counterpoints to it are outlined above, and many, many other times somewhere or other in these blogs

Fair enough. I am also frustrated by the lack of macroeconomic vision / comprehension that accompanies many blog posts as well, and my frustration often shows.

But to your point: I disagree with your premise that P/E, P/B, etc valuations on the entire index is not particualy useful, or is even invalid.

You can obviously value individual companies, which is the traditional game (and I do that myself), but the S&P 500 is a collection of companies. Moreover, you can long or short the index as a whole (via SPY, etc.) just as if you were buying a company.

My point being that valuing indivuals companies is great, and a time honored and profitable endeavor. And for the last great bull market (1933-2000) you can investors going long and swimming with the tide. The secular environment was condusive to rising asset prices and favorable (and then finally agressive) valuations

But what is the evironment now? Are we in a secular bear market? Is the bear maket from 2000-2009 done? If not, do we expect aggressive valued companies to do well or be punished in a secular bear market?

That is why I go to the trouble to write this posts and analyze in this fashion

a) Because I believe it is valid to do so
b) I believe it is very instructive to look at the historical landscape with respect to price, price patterns, and valuations

And I will reiterate what I said above: I do not expect agreement on this post, nor am I looking for it. Whether you agree with it or not is immaterial. I have an opinion and I am sharing it. Hopefully you find this useful in trying to understand the big picture. If it does (even if you come to the completely opposite conclusion that I do) then this post did its job.

Thanks for a great discussion!!..

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#15) On January 04, 2010 at 10:16 AM, binve (< 20) wrote:

uclayoda87,

Excellent comment! I have discussed before, that when it comes to the dollar (and its movement is obviously tied to monetary policy and inflation), P/E as a valuation metic is historically *very* useful. Since prices are inflated, and earnings are inflated, P/E is "inflation neutral". Which makes it a very usefool tool for long term valuation analysis (which is, like I say, as much a sentiment analysis as it is an objective analysis tool)

I might performe a long term price and valuation analysis using the Dow/Gold ratio. That might give some interesting insight. Thanks!..

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#16) On January 04, 2010 at 10:17 AM, binve (< 20) wrote:

abitare, Thanks..

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#17) On January 04, 2010 at 10:24 AM, binve (< 20) wrote:

russiangambit,

I couldn't agree more, and this is a point which we have discussed a few times on a few other posts.

And like I said above: Exuberance can last a long time, decades in fact. So much so that investors buy their own hubris. Monetary policy can distort signals and show nominal growth in asset classes such as equities and suppress signals in the bond market further distorting the "fairly valued" signals. But this is ultimately a transient event. The "transient" may be so long that investors not looking at the big picture will call it the "new normal". Government manipulation of market forces is a delay tactic. Because the government has no wealth of its own, it only moves around wealth (very inefficiently) within the economy, consuming a large portion of it. And market forces, at the end of the day, will decide the amount of debt the Treasury can sell and what interest rates are. (The caveat being that there is no limit to the amount of debt that the Fed can monetize - including Treasury debt. Which, as long as there is a Fed, is ultimately why the outcome will be inflationary, not deflationary. Deflationary impulses against the backdrop of massive inflation. Most assets you own fall in value and most assets you need to buy/consume rise in value). But the market emotionally high overshoots are met with emotionally low overcorrections. Everything runs in cycles.

As we have discussed before, I think the monetary policies and interventions affect the time it takes for these cycles to play out (they change the "damping coefficent" of the system), and this changes investor sentiment so that we hear terms like "new normal", but I think investor sentiment will eventually swing back toward abject fear and ridiculoulsy low valuations. I am not bullish on stocks now, but at some point in the future, I will be selling gold and buying stocks like there is no tomorrow. When the valuations are ridiculously compelling, which IMO they are nowhere near yet.

Thanks!..

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#18) On January 04, 2010 at 11:38 AM, rexlove (99.43) wrote:

Binve,

I don't see using the P/E to dividend yield chart as a helpful indicator to measuring stock valuations. After all - most companies have been reducing or not even offering dividends for the past 20-30 years. The reduced dividend yield of the S&P 500 is probably more due to this factor than market valuation.

And unless investors place more emphasis on having high yield stocks this is unlikely change. There is only a small percentage of investors looking for high yields nowadays. And only a small percentage of stocks that cater to this group. I'm hoping this would change as I prefer to invest in high yield stocks but the trend is to reduce or eliminate dividends altogether.    

Excellent post and analysis though.   

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#19) On January 04, 2010 at 11:39 AM, rexlove (99.43) wrote:

port -  nice chart. I hadn't seen that one before. 

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#20) On January 04, 2010 at 12:31 PM, binve (< 20) wrote:

rexlove, Thanks for the comment and compliment!

I don't see using the P/E to dividend yield chart as a helpful indicator to measuring stock valuations. After all - most companies have been reducing or not even offering dividends for the past 20-30 years. The reduced dividend yield of the S&P 500 is probably more due to this factor than market valuation.

I agree this is the current trend, but I think that trend is going to change. The point of my charts above, and indeed the whole premise of this post, is that there have been several cycles over the past 100 year where the first half of the cycle is marked by increasing P/E ratios and decreasing dividend yields and the second half of the cycle is just the opposite.

My point is that there is not a "new normal" of perpetually increasing P/E ratios (essentially a "this time its different" argument). We are on the declining part of the valuation cycle and we have not yet reached the bottom

If the S&P 500 goes to 2000 and Dividend Yields go to effectively 0% before we make a new low, please consider my analysis wrong and we will have proof that things are different this time.

But I consider historical valuation techniques to be effective until they are proven otherwise and nothing has been demonstrated to my satisifaction that a meaningful bottom was made in terms of either price or valuation on March 9, 2009.

And unless investors place more emphasis on having high yield stocks this is unlikely change. There is only a small percentage of investors looking for high yields nowadays. And only a small percentage of stocks that cater to this group. I'm hoping this would change as I prefer to invest in high yield stocks but the trend is to reduce or eliminate dividends altogether.

That is a point I was trying to make in this post:

Notice the pattern? Stocks become a tremendous value when the P/E ratio approaches the Dividend Yield. Fear of equity performance drives valuations to very favorable ratios. Each time this happens, the market puts on a subsequent tremendous bull run. The market becomes eventually becomes overvalued and then needs to pullback and consolidate while the ratios bottom before the next major bull run can commence   

Let's think about why. When times are perceived as good, when investors are (as a herd) optimistic, prices rise and a premium gets placed on growth (P/E goes up and Dividend Yields go down). When times are perceived as bad, investors are pessimistic, prices consolidate or fall and a premium gets placed on safety (P/E goes down and Dividend Yields go up).

And like I am observing above, emotions overshoot in both directions: we get irrational exuberance at the top and abject fear at the bottom.

But why the equality of P/E and Dividend Yield at the bottom (why is this value of about 6-10 P/E and 6-10% dividend yield).

Because this is the ultimate spot for value investors. When the market goes down to a P/E of 6-10, you will have a 100% appreciation on your investment (in terms of earnings) in 6-10 years assuming no earnings growth. That is exceptionally compelling no matter what the investment is. Additionally, a dividend yield of 6-10% means that you will receive cash return on your investment costs that completely pay you back in 10-17 years. Again, this is a ridiculously compelling scenario.

We are coming off a time of exuberance that has lasted for decades. Dividends are slashed and emphasis is being placed on growth. Because even today, investors as a herd are still confident and optimistic

Fear will drive the herd to seek safety, and I think dividends will come back en vogue. I think in the coming couple of years, increasing divided ratios will become the trend again vs. decreasing and the yields will increase from not only increasing dividend amounts, but falling prices as well. Both phenomenon will increase yields and will be part of a flight to safety / risk aversion mentality that has been conspicuously absent the last 30 years.

My $0.02..

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#21) On January 04, 2010 at 1:40 PM, rexlove (99.43) wrote:

I'm starting to believe a market PE of 6-10 is a thing of history. Investors have the ability to look back at the market history of the past 100 years and know that a buying opportunity will never come along because investors will come along and buy such a pullback before it reaches such low valuations. 6-10 PE is very undervalued and something we just wont see unless we have a Great Depression #2.. You may be waiting a very long time before you see that again. 

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#22) On January 04, 2010 at 1:41 PM, outoffocus (22.91) wrote:

Great post Binve and Happy New Year,

I agree wholeheartedly.  To put it in other words, you can just sweep all the dirt under a rug and say your house is clean.  Sooner or later those lumps will become noticable and the smell will be unbearable.  Something you said sparked a comment from me but then I forgot it a few minutes later. I think it had something to do with borrowing fueling the rise in asset prices, the pending rise in interest rates, and the retirement of baby boomers removing liquidity from the markets.  Ah well, you get my drift.

Actually I was just telling someone today that this is the best time to pay down debt.  Interest rates are at record lows so your savings arent earning anything but your debt isn't charging much.  So the best thing now to do is pay down debt so when interest rates go up you are earning more interest than you're paying. I think before we get too heavy into investing in commodities and whatnot, we should first work on paying down debt (all debt, not just "bad" debt).  Therefore if we experience even stronger stagflation, (for those of you who don't know, we are already in a stagflationary period.  If you don't believe me, ask yourself why oil is over $80 a barrel in the winter), we would be better able to handle it with less debt weighing down our finances. 

Either way, good post again.

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#23) On January 04, 2010 at 1:47 PM, ocsurf (< 20) wrote:

I agree binve...I keep thinking 'MARKET MANIPULATION'...I believe it has to bottom in order to have a healthy bull run.

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#24) On January 04, 2010 at 1:50 PM, binve (< 20) wrote:

rexlove,

I'm starting to believe a market PE of 6-10 is a thing of history.

Fair enough. We have discussed this before and I know we don't agree. Like I said in the post, I am not looking for agreement, nor was I expecting much. Just sharing my opinions.

6-10 PE is very undervalued and something we just wont see unless we have a Great Depression #2.. You may be waiting a very long time before you see that again.

Quite possibly. And all of the ultrabulls on the site can come by and call me a dumba$$ for not jumping on the "once in a lifetime" opportunity at 666. I did, but I played it as a bounce only, not as a glorious value investing spot. So if the market leaves without me, so be it. I don't perceive the market as low risk and so I did not invest accordingly.

If my thesis is wrong I will revise my strategy and reasses. My point is that nothing has yet invalidated my thesis. Others may disagree and call me a fool (and that may be true), but I am simply calling it like I see it.

outoffocus, Thanks!! Happy New Year!!

To put it in other words, you can just sweep all the dirt under a rug and say your house is clean.  Sooner or later those lumps will become noticable and the smell will be unbearable.

LOL! Awesome :) I love it :)

Actually I was just telling someone today that this is the best time to pay down debt.  Interest rates are at record lows so your savings arent earning anything but your debt isn't charging much.  So the best thing now to do is pay down debt so when interest rates go up you are earning more interest than you're paying. I think before we get too heavy into investing in commodities and whatnot, we should first work on paying down debt (all debt, not just "bad" debt).  Therefore if we experience even stronger stagflation, (for those of you who don't know, we are already in a stagflationary period.  If you don't believe me, ask yourself why oil is over $80 a barrel in the winter), we would be better able to handle it with less debt weighing down our finances.

Fantastic observations and assessment! I compltely agree!!

Thanks for the comment!..

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#25) On January 04, 2010 at 1:57 PM, binve (< 20) wrote:

ocsurf, Thanks! The only thing I can say is: ditto ... :)

At some point in the future I will be long stocks in a big way. And not because I think the economy is collapsing utterly, but because we have a lot of excesses that need to be purged.

People seem to think that when I write these posts I am saying "the US economy is terminally ill and we will spiral down and burst into flames!!". That is not the case. I am saying "The US economy needs an enema". Not a pleasant description but an apt one. Too much garbage stuck in the system and just a little flush to help get it out.

I do not think the world is ending, I do think we will recover and I think the subsquent bull run after the necessary purging will be unbelieveable. I want to be bullish when the herd is calling for the end of the world, not while the herd is nominating Bernanke as Man of the Year. I am bullish long term because the world will *NOT* end, and I am just trying to maintain purchasing power while I wait for big picture valuations to become more favorable.

Thanks!.

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#26) On January 04, 2010 at 4:13 PM, ocsurf (< 20) wrote:

"The US economy needs an enema". Not a pleasant description but an apt one. Too much garbage stuck in the system and just a little flush to help get it out.

Our government needs the enema and the garbage in the system is our politicians in Washington :)

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#27) On January 04, 2010 at 5:54 PM, Option1307 (29.76) wrote:

Bvine, sweet post man!

Whether people agree with you or not, I don't think anyone can doubt your conviction. While it is good to keep an open mind to other possibilities (i think u do), it is often much harder to hold your ground under attack after attack. I great quality to have in investing, you deserve a beer for that!

Sometimes I think the disagrement with your posts arises simply b/c you have a different timeframe than most other Fools here. You are essentially looking at the last 100+ yrs. and trying to pin down averages and what is "normal" Most others are not looking at things from such a wide standpoint. They are playing he shorter term trends (be it 1-2 yrs. or 5-10 yrs.)

So in essence, both camps could be technically correct. Say we are in a secular bear market, that doesn't mean the "final drop" back down to valuations that you are comfortable with is going to occur anytime soon. We might continue experiencing a mini bull market for anyother 1-2-3-5 yrs. Who knows. But some people would be right in saying we are in a new bull market. While in the end, we could regain our senses and return to more attractable valuations, where you'd "be right".

It really depends on one's time frame. I know you try and be clear about yours, but I think much of the dissagreement stems from this fact.

I agree with much of what you say. I think we have some serious fundamental issues that have not been addressed within our economy, government, society, basically everything. Eventually I believe these will ultimately bringus bac down to reality. Until these are corrected, I will be cautious. However, I think we all need to realize that we have no idea when this might/will occur. It honestly could happen tomorrow, or in 50 yrs.

Irrational thinking is a very powerful force and can continue for longer than you think.

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#28) On January 04, 2010 at 6:27 PM, binve (< 20) wrote:

Option1307,

Thanks! I appreciate that!!

Whether people agree with you or not, I don't think anyone can doubt your conviction. While it is good to keep an open mind to other possibilities (i think u do), it is often much harder to hold your ground under attack after attack. I great quality to have in investing, you deserve a beer for that!

LOL! Thanks man :) I'll take a nice hoppy Pale Ale :)

Sometimes I think the disagrement with your posts arises simply b/c you have a different timeframe than most other Fools here. You are essentially looking at the last 100+ yrs. and trying to pin down averages and what is "normal" Most others are not looking at things from such a wide standpoint. They are playing he shorter term trends (be it 1-2 yrs. or 5-10 yrs.)

Yep, this is definitely part of it. This is the reason for my large macroeconomic and historical valuation posts. Because I hear a lot of "new normal" rhetoric, when I believe the the current valuation cycle is not even complete. It is longer and more exaggerated than the previous ones. Which is why understanding the macroeconomics, especially monetary policy helps you to see this cycle in context and why it is more drawn out. But I believe we will have a complete cycle.

And at the very least, investors need to step back and take a look at the big picture. So while it is possible that this time it is different, that should *never* be your going in position (IMO). Assume that previous cycles and valuation levels are valid until definitively proven otherwise.

I have seen too many people jump on the recovery bandwagon, or the "deal of a lifetime" bandwagon. And I remain skeptical. And I just wanted to share the reasons why I remain skeptical. That's it. I am not trying to convince anybody, and if absolutely nobody agreed with what I am saying I would be perfectly fine with it. And am just offering my opinion and I am sharing my thought processes and analysis as to why I come to that opinion. That is what I hope people find useful. Not the outcome, but rather the process.

Irrational thinking is a very powerful force and can continue for longer than you think

I couldn't agree more, and is the reason why I wrote this paragraph above:

Exuberance can last a long time, decades in fact. So much so that investors buy their own hubris. Monetary policy can distort signals and show nominal growth in asset classes such as equities and suppress signals in the bond market further distorting the "fairly valued" signals. But this is ultimately a transient event. The "transient" may be so long that investors not looking at the big picture will call it the "new normal". Government manipulation of market forces is a delay tactic. Because the government has no wealth of its own, it only moves around wealth (very inefficiently) within the economy, consuming a large portion of it. And market forces, at the end of the day, will decide the amount of debt the Treasury can sell and what interest rates are. (The caveat being that there is no limit to the amount of debt that the Fed can monetize - including Treasury debt. Which, as long as there is a Fed, is ultimately why the outcome will be inflationary, not deflationary. Deflationary impulses against the backdrop of massive inflation. Most assets you own fall in value and most assets you need to buy/consume rise in value). But the market emotionally high overshoots are met with emotionally low overcorrections. Everything runs in cycles..

These Cycles last a very long time and are getting longer (distorted by monetary policy). I don't blame most investors for not being able to perceive the cycle as we are in it. We have seasonal cycles which are very well understood. But cycles that last years / decades are hard to discern.

This is why I think examining the historical record is especially useful and why I am baffled when these comparisons are dismissed out of hand.

Thanks for the comment!!.

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#29) On January 04, 2010 at 6:50 PM, topsecret09 (35.84) wrote:

   Well,we got back what we lost last week....  Are Average Investors Getting Too Optimistic About Stocks?
CNBC.com

Wall Street's first test of the new year and decade could well be whether investors are following each other over a cliff.      http://www.cnbc.com/id/34688573 

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#30) On January 04, 2010 at 7:27 PM, uclayoda87 (29.26) wrote:

If a company was measured in gold today and it sold products in gold later, then the P/E ratio in gold would be a valid long term comparison.  But if you measure a company today in dollars, which is say $1,100 per oz of gold and you have earnings a year from now where the dollar is say $1,200 per oz of gold, then the P/E ratio as measured in dollars would not match up with the P/E ratio as measured in gold.

As I noted before, this was probably not a big problem when the historical data was collected (when the dollar was on the gold standard), but is it truly valid now, when the P/E ratio can vary 10% or more just with the fluctuation of the dollar.  The question then becomes how stable of a P/E ratio is needed for a comparison to be valid, maybe 10% variability is still OK?  I don't know.

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#31) On January 05, 2010 at 1:46 PM, hhasia (65.89) wrote:

HI Binve

I will label this Lessons from Hong Kong:

In 2002/2003 the HK govt was in the throws of real deflation and a deficit ( RARE ) . Home owners had negative equity and the hole was getting bigger. Solution:  Expanded the money supply and took an active role in the the equities market. The govt had never invested in the market until this time.  They compliled a portfolio of blue chip stocks and listed it.  With the open commitment of the Govt, market sentiment and equities improved. Then over the 2005,6,7 period the govt began to unwind the portfolio and bank a healthy profit to add to the Govt's working budget.  As well, in 2007 the Govt took a direct 6% stake in the Hong Kong Exchange. The vested interest reflects the impact of more and more mainland companies going public in HK, and the HK gov't exposure to mainland interest is viewed favoraby in Beijing.

It is the secrecy  of the FED's involvement in the market that has the figures in the table skewed. If they had taken the open and direct approach as HK did, plus a broadbased public listing, not just S&P futures purchases: then folks would understand the true picture.

The flow of $ is reversed in the HK example. It pumps money into the treasury not by selling debt, but realizing profits from equities. On top of that, ALL transactions are taxed here. The govt takes a cut of all market activity. There is NO capital gains tax. Personal income tax is capped at 17.5%.

This system encourages savings.

So while I appreciate the analysis of the US markets, it looks to me like the intervention playbook. Accordingly the prior periods of pullback /bull runs do not apply. This is new to the USA, but not to us here in Asia. 

Just .02 the next shock will be external in origin. As well, expect earthquakes and hurricanes to wreek havoc and push folks over the edge.

 

HHASIA

 

 

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#32) On January 05, 2010 at 8:14 PM, binve (< 20) wrote:

topsecret09, Yes indeed!

uclayoda87, That is an interesting idea man, I will ponder that for a bit.

hhasia, Those are some excellent observations. Thank You!..

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#33) On January 05, 2010 at 11:10 PM, russiangambit (29.30) wrote:

hhasia, I wish US govrenment did the same thing because it makes sense. But they can't do it because they have to continue pretending that free market still exists in the US.

So, instead they just give the money  away to the banks to speculate with and forgo all the potential upside and just hope the banks will do the right thing with the money.

Another possibility is that they actually do invest in the equity markets and simply hide it. The temptation to do that would be very strong. And certinly many people noticed unusual things in the futures markets in May - July timeframe. But hiding it is just plain wrong for many reasons.

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#34) On January 06, 2010 at 11:40 AM, hrc777 (< 20) wrote:

First off, I can see your position that valuations never reached a low enough valuation.  Problem is, I dont think they will, at least not soon enough to make it investable.

Let me throw this at you- As everyone knows, there is a massive float of $US all around the globe.  Its a huge pile that many really dont know what to do with.  Yes they can and perhaps must buy treasuries to play with their currency, and yes they can, do, and will buy gold.  But there is one other place they dump their unwanted dollars where it wont just be someone elses problem- and that is the USA where fancy paper is still well regarded.  They can buy real estate, and do and they can buy stocks.  As the global glut of dollars increases and the places to put it decrease, the possibility of increased purchases of US equities increases.

We may well be in a very long term bear market, but the March lows could hold for years. 

Is your long term THAT long term?  hrc

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#35) On January 06, 2010 at 12:52 PM, binve (< 20) wrote:

hrc777,

Thanks for the comment.

Your scenario is not unkown to me. There are always multiple effects occurring on the stock market and economy. Some will agree with a particular thesis and some won't. There is *never* a slam dunk case, bullish or bearish.

So as an analyst you need to weight factors as best you can. And I think the weight of the bearish factors outweighs liquidity pumping of this rally.

For my take on the bearish case, see here:

The Long View
http://caps.fool.com/Blogs/ViewPost.aspx?bpid=314202

Also, I discuss liquidity and Quatitive Easing as well as assigning risk to the various scenarios, bullish bearish and in-between, in this post

The Long View - Q&A
http://caps.fool.com/Blogs/ViewPost.aspx?bpid=314893

Thanks!..

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