Wednesday, November 26, 2008
Martin Wolf in the Financial Times tells us, "Why fairly valued stock markets are an opportunity." With the above graph, he looks at the long run fluctuations in Tobin's Q and cyclically adjusted P/E ratios. He gets the former from Andrew Smithers. The latter comes from Robert Shiller.
To my eye, it appears that long run market trends are associated with inflation regime shifts: the World War I inflation, the resumption of the gold standard, Bretton Woods, the Great Inflation of the 1970s beginning in the mid 1960s, the Vocker retrenchment, and the Greenspan punchbowl (i.e., "We do not prick bubbles and we live in fear of the demon deflation." The traditional role of the Fed was to take away the punchbowl just when the party got interesting.)
The valuations in the 1940s and 1950s may be understated, particularly for Tobin's Q. The government accelerated the recognition of much capital investment as part of the war effort in World War II. some economists believe this led to an underestimation of the capital stock and perhaps also an understatement of reported earnings and equity.
How sanguine should we be? Wolf concludes, "investors with long time horizons (the relatively young, or institutions) are, for the first time in almost two decades, confronting attractive, although not sensationally attractive, market valuations. ... nevertheless, formidable pressures for further falls in valuations, as leveraged players continue to be forced to offload assets at bargain prices."