July 31st, 2012
by Andrew Butter
I recently got into trouble for having the temerity to question the divine orthodoxy of CAPE (Cyclically Adjusted Price Earnings ratio, Prof. Robert Shiller), reference Tom Armistead’s excellent article about “The Disciples.”
An indignant disciple berated me for questioning the divine wisdom of my betters and I was told in words of one syllable that CAPE is for predicting real rate of return for a minimum of ten years in the future; so I should kindly keep my snide comments about the recent performance, or lack of, to myself.
Well Tom put up a chart showing that CAPE predicts 10-Year Real Rate of Return (RRR) with an R-Squared of 34%. That means 34% of the “answer” can be explained by CAPE and 66% can’t. And that’s when it’s working optimally; try that for 5 years and you get 18%. So 66% to 82% of “the answer” can’t be explained by CAPE.
Apparently economist valuation experts and their disciples call that a proof!! For me the hard-evidence Jesus walked on water is better than that.
And you wonder why there was a credit crunch?
Looks like the venerable economics profession is now split into two camps, on one side you have the ex-acolytes of Alan Greenspan…the maestro who, late in life, tragically found a flaw in his understanding of the market-place. It is still not clear precisely what the flaw was or even if there was more than one, either way that camp is pretty much discredited as a sad joke.
The other camp is the doomsayers, they predicted DOOM in 2003 and 2004 and 2005 and 2006 and 2007…and in 2008 they were proved right. They are still predicting doom, for example according to CAPE and also Tobin’s Q that other supposedly infallible measure of the value of Wall Street, what they call the fair value of the S&P-500 is 1000 today, which means the market is 30% over-priced…which means there is more doom to come!!
If you believed the second camp you would have been sitting on the sidelines since March 2009 waiting for that index to hit its sweet-spot of 600 (then), before you did anything more adventurous than buy U.S. Treasuries.
Here is Disciple John Hussman’s latest pronouncement:
If we fail to recognize that valuations are richer today than at any point in history, save for the few months before the 1929 crash, and a bubble period that has been rewarded by zero total return for the S&P 500 since 2000.
CRASH, CRASH, CRASH!!!
Zero Hedge; also a disciple, calls the rally from the lows of March 2009 a conspiracy. In April 2009 he surveyed no less than eighty of America’s finest investment managers. According to him, every single one pronounced that the market which had bounced 30% by then, was heading back down, one said it was going down to 325.
…The markets will be 15% to 30% up on today by end 2009 and the medium term trend is also upwards
Bubbleomics was right; the market was up an additional 28% by the end of 2009 and the medium term trend was upwards. But of course that was just a flash in the pan, beginner’s luck…the disciples lined up at the time to tell me that any idiot can win the office lottery once.
Except if you had acted on the six calls put out by that approach between January 2009 and January 2102 you would have turned $100 into $265 just going in and out three-times, not shorting or going long on margin…that’s a 35% per year Real Rate of Return.
Any idiot can win an office lottery once, but six times in a row?
Putting that another way, the chances a chimpanzee with a dart board could have made those six calls, in a row, is about one in four-million, which as every physics-envier knows is the benchmark scientists use to decide if they found a Higgs Boson or not. That is a lot better evidence than the evidence which supports the theory Jesus walked on water, although I’m not saying he didn’t.
In January 2010 Zero Hedge was still talking about a conspiracy. Perhaps next he’s going put out a theory that Elvis’ ghost was the evil hidden hand manipulating the market?
Just so you know, the valuation methodology which provides the basis for the Bubbleomics predictions is not some weirdo formula put together by an autistic geek with bad teeth and an iPad; it’s based on International Valuation Standards.
Those were put together by people who do valuation for a living; many of them still have jobs too!! And the standards are accepted and agreed by all valuation societies in the world of any consequence, including those in both America and France. Imagine that!!!
You can buy a copy for $30; they first came out January 2000 and I have a first edition, although it’s a bit tattered on account of a puppy-dog-guest tried to eat it, he obviously thought it was good-stuff.
I have this sneaking suspicion that the world’s finest economists who prattle on and on about valuation, never even heard of International Valuation Standards, let alone read them. Because (a) their valuation methodologies don’t conform to the standards (b) they seem to get the wrong answer or to belatedly discover a “flaw”, a lot of the time.
Not that I’m the sort of person who likes to tell other people what they should do, but it occurs to me the world might be a safer place if some of the economists, accountants, central bankers and rating agencies who say they understand what’s going on…and how to fix things, invested $30 to buy the standards…and read them.
Why do I care?
Recently I submitted a paper to the prestigious Journal of Economics and Finance with a case study on the valuations of the S&P-500 put out by the various camps between 2009 and 2012. Three months later I got a rejection-slip, a comment from one of my “peers” was:
“If the stock-market blogger Butter is such an oracle, why doesn’t he keep his ideas to himself and make a lot of money?”
1: Butter is not a stock-market blogger, he does valuations (amongst other things) and in the murky little pond he swims in he is reasonably well regarded, and more important; he has long-standing customers who generally pay their bills.
2: Who says Butter didn’t make money out of his predictions?
3: Butter never said he is an oracle; the only special skills he claims are third-grade arithmetic and the ability to read and comprehend about twenty pages out of the 247 pages of International Valuation Standards.
Why did I bother?
Well I think it would be really nice if all the experts who say they know how to do a valuation but can’t be bothered to read a book about it; could stop losing all their money, particularly the money they borrowed from other people.
Then, hopefully, they wouldn’t feel compelled to put their hands in my pocket so they can bail themselves out. I think if that happened the world would be a better place, so my goal is to do my small part to promote World Peace, Free Love, and better valuations.
And seeing as the world-experts don’t read my blogs…evidently, I thought I would take my message to them. But sadly, they don’t want to listen, they already know the path to the Holy Grail; ah the pain of rejection just tears me up!!
Incidentally when I submitted the paper I had to select from a list of about two-hundred specialties of economics and finance to say what it was about. Intriguingly, there wasn’t a box to tick that said “Valuation”.
And you wonder why there was a credit crunch?
That by the way, was not caused by Alan Greenspan easing after 9/11 as part of his contribution to the Glorious War on Terror (he says that’s why he did it in his book…promise, I’m not kidding), it was caused by sloppy valuation of collateral for loans, period.
Looking to the future…reference the weirdo approach to valuation that relies on the fringe-geeky idea of using International Valuation Standards, which irritatingly, thanks obviously to the hidden-hand of Elvis’s ghost, seems to keep on coming up with the right answer…whilst the disciples keep on coming up with the wrong answer.
The basis of the valuation was a rough & ready income capitalization approach to estimate other than market value. Nominal GDP was used as a proxy for trend-line future value-added and the trend-line 30-Year Treasury yield was used as a proxy for the discount factor to work out Net Present Value.
Is that perfect? No it’s not, nowadays 50% of the profits of companies listed on the S&P-500 are made outside America; in 1929 it wasn’t like that so you have an imperfect time series. But there again there is a reason for that (tax in America and their legal system could play a part), and the driver of value-added is arguably still broadly linked to the health of the US economy.
So it’s not perfect, but the methodology appears to be good enough to be able to spot a bubble and more important to get a rough idea about how big it is, which is something the world-experts seem to be particularly clueless about, one minute they say there are no bubbles, next minute they say they are popping up everywhere, often they are wrong on both counts.
Why don’t I use earnings? Well in a word what companies declare as earnings is the outcome of a negotiation with tax authorities about how to interpret a tax-code that is now twice as long as the Bible; or for indebted companies, negotiations with their banks and/or their creditors often about “stress” and the book value of intangible assets, none of which are necessarily true measures of how much value was gained (or lost) over a year. GDP is at least measured broadly consistently.
The proof of the pudding is does it work?
Well plot that valuation against the actual stock prices going back to 1929 (that’s the limit of data I got), you get a 98.8% R-Squared, that means the model explains 98.8% of the changes over that period, which is a good start.
Sure correlation is not proof of causation but there again no-correlation, or anything below 50%, strongly suggests no causation. That’s why they have the null hypothesis, you are looking at the probability your theory is wrong, you can never prove 100% that it’s right.
That’s why you need to do predictions to test the null hypothesis, at least that’s what you do when you are a scientist: and if you are a scientist, post-ad-hoc doesn’t cut it. You have to predict something, then it has to turn out to be correct, then you have to work out the probability a drunken chimpanzee with a dart board could have done better.
Economists say they are scientists (ha-ha), although I’m not sure if suffering from an incurable dose of contagious physics-envy, counts.
To make predictions about markets, you need to have a handle on two things. First the other than market value (above), which Warren Buffet calls intrinsic value; some people call fundamental value, some call the equilibrium, and some people call fair value, although on the subject of money and value, what’s fair and what’s not, is irrelevant, unless of course you are Ayn Rand (below).
Second, you have to understand that sometimes markets are in disequilibrium. That is when the price differs wildly from the other than market value. When price is more than other than market value that’s a bubble; when it’s less that’s a bust, busts typically follow bubbles.
This is the thing, when markets work efficiently, which is what happens when governments or well-connected crony capitalists, monopolists, socialists, fascists, or communist central planners aren’t manipulating them, on average both sides of every economic transaction win.
Intriguingly, in Atlas Shrugged, Ayn Rand, who even though she died in 1982 before he became Fed Chairman in 1987, allegedly infected Alan Greenspan with a virus that rotted his brain and caused his fatal flaw, whatever it was...the one that “caused the credit crunch”…anyway, in Atlas Shrugged there is an idea that anyone who pays less than the true value of something is as disruptive to the harmony of human existence, as someone who pays too much.
Same idea, when both sides of transaction do not benefit equally, in the end everyone loses, although sadly Rand had no advice on how to do a valuation, but otherwise, her philosophy on that subject was sound, even though her views on racism were slightly to the right of Hitler, different race of course.
When markets are inefficient, as in when they are in disequilibrium, for every winner there is a looser.
For every unfortunate who paid $1 million for a house in 2007, and then watched in horror as the price they could sell it for went down to $500,000; there was a “winner” who bought the house for $500,000 in say 2002 and sold it on for $1 million. Net-net, no economic value was created, its zero-sum.
Like a pebble thrown in a pond, disequilibrium creates waves, but that does not raise the level of the pond, and like waves, the extent of “up” above the level of repose, is mirrored in the extent of “down”, because money, like water, is incompressible.
So if you know where the line of the other than market value goes, then you can figure how big the bubble was and how long it lasted; and you know that the bust has to mirror that…so then you can make predictions.
The story so far according to Plodding Stock-blogger Butter:
1: In 1996 a bubble started to grow, in my view that could easily have been completely caused by the success of Microsoft. Because then all the wannabe’s put that story in their business plans projecting untold riches in the future like Facebook put Google in their business plan…with less success…and they all went to IPO.
2: In 2000 there was a judgment against Microsoft for anti-competitive behavior and their stock tanked because of that. Then the stocks of all the wannabe’s tanked, and then all the other stocks which had been pulled up by the euphoria which said potential for future value-added is nothing to do with value, all that counts is vision…well they tanked. The bubble popped.
3: But it didn’t pop completely, thanks to Alan Greenspan who helped engineer the transfer of the idea of money for nothing into the housing market, which “cured” the pain, but not the disease; aided and abetted by the genius of securitization which took over the helm (and provided the liquidity), so he thought he was steering the ship, blissfully unaware that the shadow banks had disconnected the steering mechanism.
4: Then, inevitably, what Ludwig von Mises called the mal-investments, had to clear. In disequilibrium, for every winner, there has to be a looser.
5: The bubble crest [C] was about 100% over other than market value (i.e. double)… so according to Bubbleomics and The General Theory of the Pebble in the Pond, the minimum [M] had to be half the equilibrium [E].
Putting that into the language of the physics enviers, that says E2 = MC.
Sounds familiar? There is another General Theory a bit like that one; could there be something divine going on here? And I’m not talking about that Keynes guy.
Either way that’s how Plodding Stock-blogger Butter, who’s only knowledge of the New York Stock Exchange back then, was that it is in New York, managed to figure out (in January 2009) that the market would turn when the S&P-500 hit 675, which it did.
But then, once the pop had been fully expressed, what Mises called “the slow process of recovery”, starts, which is how come Plodding Stock-blogger Butter managed to figure out that the index would then go up in a pretty straight line to 1200 before it reversed…which is what happened.
Zero Hedge and The Disciples say that the bounce was thanks to market manipulation by the Fed and no one could have anticipated that. Perhaps that’s true.
If so, that means Plodding Stock-blogger Butter is not just a pretty face quite good at arithmetic, but NO!!! He is possessed with divine psychic powers and he can read the minds of people in New York and Washington from 10,000 miles away, which beats walking on water any day, and there is hard-evidence too!!!
Take your pick, personally I’m comfortable with both those descriptions, and if you want to become a disciple, send me money, all you got, and I will think about whether it’s enough to buy you a ticket to the Holy Grail, just please don’t call me an oracle.
With regard to the future…Mm, that’s tough, because guru-oracles risk blotting their copy-book if they get it wrong, just once. Sometimes it’s better to just rest on your laurels, take Nouriel Roubini for example, he predicted the credit crunch (for the wrong reasons), and for a while he could command the same appearance fees as that nasty little sociopath Tony Blair used to charge for opening supermarkets in China; but then he made the mistake of making stock-market predictions, and he lost all his credibility.
All I can say is that according to the way I do arithmetic, the S&P-500 is headed up towards the other than market value, and since it is less than that now the growth of the price will be more than the growth of the fundamentals, until it reaches there, in about three or four years time.
With regard to the prospects for other than market value, my guess is as good (or bad) as anyone’s.
There are two drivers in my model, nominal GDP is pretty predictable +/- some small percentage. The world will not end (that’s a prediction). America has a lot wrong with it but it has a lot going for it too, and it’s recovering from a mega bubble, so in general the only way is up, although sometimes it’s a case of two-steps up and one step down. Base-case I think 3% to 5% nominal is a pretty safe bet, what part of that is inflation is irrelevant for the model.
The big imponderable is the yield on “risk-free” assets. The problem there is the supply has been seriously impaired; five years ago you could buy some variation of a synthetic collateralized debt obligation, or a structured note underpinned by the sovereign state of Greece, which carried pretty AAA stamps on their rumps. Now, presumably, a 30-Year U.S. Treasury isn’t even AAA, and you can’t sell a synthetic collateralized debt obligation to anyone, not even to a Norwegian sovereign wealth fund…except of course the Fed and the ECB who will pay you face, if you got connections.
“Ah” you say “who wants to buy risk free anyway?”
Well there are buyers, particularly pension funds and insurance companies which are obligated by law to hold a proportion of their portfolio in “investment-grade assets”. The fact that’s a pretty silly law, and demonstrates how government edict can distort markets, and was one of the main drivers for the shadow banks to manufacture all those investment-grade toxic assets, which was central to the whole problem, and as remarked earlier, provided the liquidity for the housing bubble...doesn’t change the fact that it’s still the law. So those guys have two options, buy U.S. Treasuries at zilch yield, or park the money in cash in a bank they have good reason to suspect is only still alive thanks to government edict. I suppose an option might be to keep the cash under the bed?
Risking getting labeled as Bungling Bond-picker Butter complete with a BBB rating, my view is that U.S. Treasuries are a bubble, caused by all the usual suspects, namely government incompetence and interfering in markets; and the correct yield on a 10-Year right now is 3% or thereabouts.
Incidentally BBB said that in early 2010 when all the world’s finest expert economists and their disciples were predicting hyper-inflation, and Nassim Taleb pronounced that even an idiot chimpanzee could figure out that was the time to short U.S. Treasuries to death.
Incidentally, they were wrong, BBB was right; and for my next trick I’m going to walk on water.
So I reckon as a base case we are looking at 3% to 4% on the 30-Year over the next few years, mainly because I don’t see anything that’s likely to pop the bond bubble on the horizon.
The most likely candidates for that are either changing the laws on what pension funds and insurance companies can invest their money in (letting them decide that themselves might be a good idea), but that would mean they would stampede out of Treasury’s and Bunds so governments would have to pay a whole lot more in interest to roll their debt over…so that’s unlikely to happen. The other possibility is the resurrection of securitization business, hopefully with proper valuations of the underlying assets this time around, but that’s not happening.
The line “A” is what the model says will happen to the other than market value (where the index is headed) for 3% nominal GDP growth and 3% yield on the 30-Year.
The line “B” is what it says for 5% nominal GDP growth and 4% yield on the 30-Year.
Either way, to this plodding stock-market bungler, who as remarked earlier, doesn’t know anything about the New York Stock Exchange, except that it’s somewhere in New York, that looks like a buy.
What happens after that is a disturbing prospect, in a sense line A will be a sort of bubble, caused by and dependent on artificially super-low yields on risk-free debt. Which is potentially how bubbles get transmitted, just like the Dot.com bubble got transmitted to the housing bubble, which got transmitted to the bond-bubble…and next that bubble will get transmitted back to stocks. The good news is that the best time to get into a bubble is at the start, all you got to do is get out in time which is the tricky part, and even someone who can walk on water has a problem figuring that one out.
What a sensible government or central bank “ought” to do would be to pop the bond bubble before it causes too much damage, and to end the cycle of insanity. And the best way for them to do that would be, as always, to get out of the darn kitchen.
The problem is they won’t do that because (a) they can’t recognize it’s a bubble (b) if they did, as remarked earlier, they would not be able to afford to roll over their debt and (c) and this is the most important reason, it wouldn’t be popular. The reality of what Lord Hailsham called the Dilemma of Democracy back in 1978, is that democracy feeds on election-candy. Sadly long-term candy causes disease and bubbles all over your body, that can only be got rid of, by austerity.
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About the Author
Andrew Butter started off in construction in UAE and Saudi Arabia; after the invasion of Kuwait opened Dryland Consultants in partnership with an economist doing primary and secondary research and building econometric models, clients included Bechtel, Unilever, BP, Honda, Emirates Airlines, and Dubai Government.
Split up with partner in 1995 and re-started the firm as ABMC mainly doing strategy, business plans, and valuations of businesses and commercial real estate, initially as a subcontractor for Cushman & Wakefield and later for Moore Stephens. Set up a capability to manage real estate development in Dubai and Abu Dhabi in 2000, typically advised / directed from bare-land to tendering the main construction contract.
Put the unit on ice in 2007 in anticipation of the popping of the Dubai bubble,defensive investment strategies relating to the credit crunch; spent most of 2008 trying to figure out how bubbles work, writing a book called BubbleOmics. Andrew has an MA Cambridge University (Natural Science), and Diploma (Fine Art) Leeds Art College.