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Discussion Starter #1
What is Value? How do we assess claims of "asset inflation" when applied to stocks?

A)

According to Benjamin Graham an approximation of value can be calculated by the following formula.

Value = Current (normal) Earnings x (8.5 +2 x annual expected growth rate)

(Reference The Intelligent Investor, page 158)

At a later date the formula was revised by some sharp cookies to account for the interest rate environment. At the time the formula was devised, 30 year bonds were 4.4%, so 4.4%/current bond yields provides a factor to account for present yields. The revised formula is:

V = Current (normal) Earnings x (8.5 +2 x annual expected growth rate) x 4.4/current 30 year bond yields

The formula was tested by using DOW earnings and prices at the time of the 87 crash (correction). The formula gave a value of almost exactly the precise point that the DOW stopped dropping. Stunning.
(The complete article was published in Harvard Business Review around 1990, giver or take a bit).

B)

Considering claims of "asset inflation" in the media the following is a calculation of the current value of the SP&P 500.

Current Bond yield: 3.8
Historical S&P growth rate: 1957 to present. 6.78
current eps est for S&P = 108.73

Value = 108.73 x (8.5 + 2 x 6.78) x 4.4/3.8

= 2777

The current market price of the S&P = 1798

Current price/V = .65

According to the formula, the S&P is priced at 0.65 of of its value. It is under valued. That means, where stocks are concerned, there is no asset inflation.


To me this helps explain the ongoing rise in stocks. We know that institutions are the ones that have the buying and selling power to move stock prices, so it is they who are presently driving up prices. I believe this analysis of Value provided by Graham's formula is an approximation of what the institutions are thinking Value is. They see the S&P as undervalued, so they are driving up prices. Yes, when it ends it will be ugly. But in the meantime, there is money to be made, and we are a long way from the end.
 

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Interesting but neither here nor there. The level of the stock market as a whole (not individual stocks) depends on the money available for investment, and the attractiveness of stocks compared to other investments. For the last 4 years the US government has been deliberately pumping up the financial markets and discouraging fixed income investments by keeping interest rates artificially low. And of course everyone knows what they did to the real estate market. So what else is left? Where is the money going to go?
 

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I thought Graham advocated using normalized earnings (ie, adjusted for business cycle, etc.). This would involve using inflation adjusted earnings over some trailing period, say 10 years.
 

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Discussion Starter #4
I thought Graham advocated using normalized earnings (ie, adjusted for business cycle, etc.). This would involve using inflation adjusted earnings over some trailing period, say 10 years.
The phrase Graham uses with this formula is "current earnings" (see page 158).
 

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Discussion Starter #5
Interesting but neither here nor there. The level of the stock market as a whole (not individual stocks) depends on the money available for investment, and the attractiveness of stocks compared to other investments. For the last 4 years the US government has been deliberately pumping up the financial markets and discouraging fixed income investments by keeping interest rates artificially low. And of course everyone knows what they did to the real estate market. So what else is left? Where is the money going to go?
You are not speaking to the issue of "what is value?" and how does one assess the claim of "asset inflation" when applied to stocks. It is apparently neither here nor there *for you*, but not for everyone. As you know Graham heavily influenced some very successful investors (eg Templeton, Buffett and others). I like to learn from the consistently successful.

Anyway, I'm not sure what your point is in relation to the topic. Are you saying assessment of claims of "asset inflation" isn't important? If some talking head is ranting about "asset inflation" should we, according to you, just swallow that whole with out evaluating the claim? Are you saying there is no such thing as value? Are you saying because of what the government is doing that stocks are inflated beyond their true value? Not really sure what you are offering here.
 

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All of those equations fail to address the issue of money printing by the central bank.

Just graph the Federal Reserve balance sheet against the S&P 500; this isn't a mystery or anything, they correlate nearly perfectly
 

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It's a good question. How to assess claims of asset inflation?

My suggestion: look at the amount of federal and central bank support. Add up the numbers from:

  • QE: federal reserve balance sheet $ amount, readily available
  • ZIRP: factor in the fact that Fed overnight rate is 0.09% as this is a cost of liquidity
  • Federal mortgage support: a few trillion$ in the US and around $800 billion in Canada
  • Other federal guarantees: add up other liabilities and guarantees assumed by US government, attach monetary value
Now add up all these numbers and chart them over time. This certainly should be an input into evaluating asset inflation, since each of those bullet points above acts as a source of financing for asset purchases.

The main difficulty however is that those bullets above work towards financing bonds, stocks, and real estate. I don't know how to separate those out... this money sloshes around.

As a crude first cut however I suggest taking the S&P 500 and dividing by the sum of the above bullets.
 

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This is true! But when you consider that the Fed balance sheet is under direct control of the Fed, i.e. the $85 billion/month they choose to purchase in bonds, I think it strongly suggests that this is the source of the observed effect.
 

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I don't understand the money printing. Can someone explain it to me dumbed down?

My understanding is the government uses debt for purchases and no new money issued.
 

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Considering claims of "asset inflation" in the media the following is a calculation of the current value of the SP&P 500.

Current Bond yield: 3.8
Historical S&P growth rate: 1957 to present. 6.78
current eps est for S&P = 108.73

Value = 108.73 x (8.5 + 2 x 6.78) x 4.4/3.8

= 2777

The current market price of the S&P = 1798

Current price/V = .65
As with all tidy formulas, the quality of the inputs will have a profound effect upon the derived results. For starters, I would question the wisdom of using estimated earnings coupled with a long term growth rate that may not accurately reflect the realities of today's economic environment. While I realize what Graham wrote in the text with respect to earnings, it is likely far more representative of value to use cyclically adjusted earning that are used to calculate CAPE. Expected future growth is not going to be the same as historical as the drivers are different today. I think most would be extremely happy to see GDP grow by a rate of 3% going forward over the long haul in the US. The start date that the OP used is likely more comparable to present day China than it is to present day US in terms of expected GDP growth going forward. Making those adjustments dramatically alters the end result. Taking back growth rate to 3% instantly moves the result back to what is quite close to today's current S&P 500 value. It we substitute the cyclically adjusted earnings of ~$74, then that brings us all the way back to about 1230 or less than half the value the OP has presented.

This isn't about who has the better guess of what represents value, it is simply to illustrate what sorts of differences can result from adjusting inputs to reflect a different set of parameters, either of which can be deemed equally valid. Even small difference in inputs, whether it be growth rates or earnings can have a dramatic impact on the result.
 

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V = Current (normal) Earnings x (8.5 +2 x annual expected growth rate) x 4.4/current 30 year bond yields
Thank you for sharing this. Can this be used to estimate the value of a company as well? I tried it for Google and I am not sure if I am getting the correct figures or if I am using it properly... I am getting a value close to $2,000.
 

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Historical S&P growth rate: 1957 to present. 6.78
If you think that this historic growth rate will continue into the future, you must be smoking whatever Rob Ford likes to smoke. :biggrin: (kidding and no offense)

Historical growth rate was fueled by a set of highly favourable conditions:
- baby boomers demographics
- growing middle class incomes
- relentless consumption by the said baby boomers, financed by debt.

These conditions will not repeat in the future. In fact, one can easily argue that boomers generation borrowed the growth rate from the future generations, by consuming well beyond their means. Witness the mountain of debt they accumulated, both public and private.

Rob Arnott coined a term to describe the current economic conditions: 3D Hurricane. Quote: "Relentless deficits, soaring debt, and deteriorating demographics represent a looming storm for developed markets."

I agree with scomac. We will be extremely lucky to see a 3% growth rate going forward.
 

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Here is my estimate of returns with 3% growth with a S&P market P/E of 20: P/E of 20 gives an earnings yield of 5% plus 3% growth = 8% nominal returns. Although this sounds rosy, it is 3-4% less than the nominal returns over the last 30-50 years. I have also studied Graham and he firmly looked for P/E ratios below 15. Low interest rates do make equities compare favourably, but it's not hard to compare favourably with 1-2% bonds; that doesn't mean you should overpay for stocks. Graham recommended looking for companies that could improve earnings by 33% over a 10 year cycle; this is roughly also in line with 3% a year.

By my calculations, in Graham terms, I would say that the S&P 500 is more expensive than an average valuation, perhaps by about 25%. I would not want to purchase it at an average P/E of 20, especially with an average earnings growth of 3%. Peter Lynch would have a fit. But if the market P/E did drop to 15, I would have no problem adding the S&P 500 with 3% expected earnings growth. I am fairly certain even indexers have noticed this, with outperforming US index funds allowing them to rebalance into other areas.

But just because the S&P 500 has a P/E of 20 doesn't mean all US stocks are bad investments. Warren Buffet/Berkshire Hathaway bought $1B of Exxon Mobil shares in Q3..with a P/E of 10, I think it's a smart move.
 

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Why load up on S&P 500 when most international markets are better valued? Both EEM and EAFE are at CAPE ratios in the 16-17 range vs 24 for SP500.
 

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Discussion Starter #16
Thank you for sharing this. Can this be used to estimate the value of a company as well? I tried it for Google and I am not sure if I am getting the correct figures or if I am using it properly... I am getting a value close to $2,000.
Yes, it can be used for individual securities. Can you post the figures you used? It would be excellent to play around with this.
The formula is a tool, and like any tool it is only as good as the person using it, which is not a criticism of you. Rather it is to encourage you to use it, keep a record of your results. After a lot of use, you may see how it can help you determine if we are in a time of "irrational exuberance", or not.

Back in 1999 and 2000, I used it on QQQ, which was trading at over 100 for a while. The formula gave a value of 30. QQQ eventually bottomed out in the 20's. To me, that ratified the value of the formula for me. Had it not been reasonably accurate, I would have tossed it out of my toolbox. I mainly used it on indexes to get an idea of where the overall value of the market is. Due to the results I got with QQQ, I used it again in 2008 - 9 on the S&P to help me determine a buy time.

I realize some people will be suspicious and critical of the formula, but that is actually good, provided that they are sincere and reasonable. Sincere and reasonable critique is always valuable. Perfectionists won't be happy at all with it even though Graham clearly stated it is an *approximation* for the layman.
 

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Discussion Starter #17
I don't understand the money printing. Can someone explain it to me dumbed down?

My understanding is the government uses debt for purchases and no new money issued.
This is a difficult subject. The first thing you need to know about the government "printing money" is it is a metaphor. They are not literally talking about printing currency. They are talking about "increasing the money supply" by various means. The theory is that the increased money supply will contribute to increased economic activity. The unwanted side effect is sometimes, but not necessarily, inflation. Google "How does the government increase the money supply" and you should get an overview of how the government "prints money".
 

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Discussion Starter #18 (Edited)
It's a good question. How to assess claims of asset inflation?

My suggestion: look at the amount of federal and central bank support. Add up the numbers from:

  • QE: federal reserve balance sheet $ amount, readily available
  • ZIRP: factor in the fact that Fed overnight rate is 0.09% as this is a cost of liquidity
  • Federal mortgage support: a few trillion$ in the US and around $800 billion in Canada
  • Other federal guarantees: add up other liabilities and guarantees assumed by US government, attach monetary value
Now add up all these numbers and chart them over time. This certainly should be an input into evaluating asset inflation, since each of those bullet points above acts as a source of financing for asset purchases.

The main difficulty however is that those bullets above work towards financing bonds, stocks, and real estate. I don't know how to separate those out... this money sloshes around.

As a crude first cut however I suggest taking the S&P 500 and dividing by the sum of the above bullets.
james, I kind of like you and once you make one or two adjustments in your thinking and analysis, you will become really wealthy. And I don't find your repetitive perspective exhausting.

Lets compare and contrast two methods of evaluating "asset inflation". For the moment lets put stock values aside, then come back to stocks. Suppose I am thinking of buying a used car, and I want to know if the asking price is "inflated", or in other words, is the price too high? So I kick the tires, take it for a test drive, take it to my trusted mechanic for an inspection, find out what other sellers are asking for the same model, try and find out what this model actually sold for recently. In short, I study the asset itself, and the current market for that asset. Similarly with stocks; I study the asset itself to determine if it is worth it. However, you seem to be proposing to study something other than the asset itself in order to determine the value of the asset. The stuff you want to study, eg QE, ZIRP and so on is not totally irrelevant, but it is too general and indirect. It won't give you a dollar value of a 2005 Ford 150 in 2013, and it won't give you a dollar value of a stock or a stock index.

For instance, instead of a 2002 Ford, I am thinking of buying shares of Potash Corp, I use a similar method, namely, I study the asset itself. I study Potash Corp. Studying QE, ZIRP, and so on, although not totally irrelevant, won't give me a proposed price/value of Potash shares that I can compare to the asking price. But the formula will. So let me ask you, given your analysis of QE, ZIRP and so on, What is the current value of Potash shares? I'm guessing you won't have a proposed specific price to offer, because you are not studying the asset itself, but rather some general economic conditions that all stocks are in.

So my critique of your method is, it is too general. It is similar to saying all 2002 Ford 150's are the same value in 2013 regardless of the specific condition of a specific model. Using the formula for stocks is like kicking the tires, getting a mechanical inspection. Using the formula is part of the process of getting down to nuts and bolts. Your method is relevant, but too general. Your method is only part of a more complete analysis.

Too, after I read the article (in Harvard Business Review) using the formula to analyze the 87 crash (correction) I applied the formula to QQQ when the market price was over 100. The formula said the value was 30. Some two years later, QQQ bottomed out in the 20's.
Back in 2000 there were cries of "irrational exuberance". It seemed to be true, but it was general. What the formula did was get more specific. The formula proposed a specific value ie 30, that one could compare to the market price, ie 100.

Presently we have some talking heads talking "asset inflation". I think they are incorrect. I believe asset prices have to be much much higher before they are irrationally inflated and the formula is only one of a few tools that tells me that.

After the 87 crash, I was terrified, but I wasn't going to quit. I felt I needed more knowledge. On my quest for knowledge I read "Blood in the Streets". On the cover it said "The book that predicted the crash of '87". Why is that on the cover? Its marketing. Its to sell books. Its to get one to believe that since the authors predicted the last crash, they *must* be right next time, and if you don't buy the book you will lose out. Also on the cover it says, "If the Great Depression of 1990 doesn't frighten you, then try Blood in the Streets". Why is that on the cover? Its to sell books. Its to get one to buy into the premise even before reading it. Its to get one to believe there is a depression coming, and if you don't read the book, all is lost, because you won't know how to protect yourself from the coming plagues. Notwithstanding the fact that the authors predicted the crash of '87, they were totally wrong about the "coming years of havoc" in the 1990's. It isn't impossible the authors laughed all the way to the bank with cash from book sales, and then retired to a tropical paradise. Presently we have a Nobel prize winning economist who predicted the US real estate crash. Is he selling books? Is he preaching doom and gloom? Is he laughing all the way to the bank with cash from book sales, inflated professor's salary, and inflated pension credits? Will he retire in a tropical paradise after scaring Dick Newbie, and his partner Jane Naive away from buying low and selling high? To me, the chronically critical prophets of doom are using fear for profit, *their profit*, not Dick Newbies profit. And once Dick Newbie figures that out, he shouldn't be angry at the prophets of doom, he should start using fear for *his* profit. How? Buy at the time of maximum pessimism. Sell into optimism.

I'm not trying to rain on the parade of the latest guru who predicted the last crash. I'm trying to get people to critically evaluate the latest guru, and give people the tools to evaluate for themselves. Right now there are many people who are in fear of stocks, and they are in fear because they choose to be overly influenced by the prophets of economic doom. They allow, as I did in '87, to let the prophets of doom define the box they think in.

So james4beech, what would happen if you thought outside the box of the prophets of doom knowing that if you didn't like it, you could always go back to the doom box? What would stop you from thinking outside the doom box, just for a while, just to give it a test drive, knowing that if you didn't like it, you could always go back to the doom box? It occurred to me that if one is to get outside the doom box, there has to be an alternative toolbox to try out, other wise the alternative is just a vacuum. So the formula offered, is one from a different toolbox. If you dismiss it simply because it isn't in your present toolbox, you are not critically assessing it.


Anyway james, I think you are going to make it. You are a smart, hard working thinking individual, and I believe you are going to develop your toolbox, and break free of the naysayers, the chronically critical, and they guy who predicted the last crash.
 

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Appreciate the response. I believe I am at the start of the learning curve so kindly bear with me and my stupid questions/responses.

I looked at the figures again, and did few adjustments... number I am getting now is $1692.

I used 42.47 as the EPS for the last 12 months ending Sept 30, 2013, 16.26% as the growth for the next 5 years and 4.53% as the yield on corporate bonds (AAA). Source: Yahoo Finance!

Your thoughts?
 
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