The Bottoming Process
The American Stock Markets are trying to find a bottom. This process is usually drawn out over many weeks, but at least a few of the smart guys think there are some interesting signs. Bill Gross cites the “Q” Ratio (above)–the value of the stock market relative to the replacement cost of net assets.
The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, “Q” should mean revert to 1.0. If so, then oh, oh what a “Q”! Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation, as seen in Chart 1.
The other wizard who thinks it may be time to buy selectively is Jeremy Grantham, who has been so right for the last few years about the dangers ahead.
Methodology is telling us that for the first time in 20 years that global equities are reasonably cheap, not spectacularly cheap, they are probably about as cheap as the markets have been expensive 10 out of the last 13 or 14 years, so it’s definitely quite ordinary as cheapness goes, but we have been so long in the overpriced mode in the U.S., I don’t even think it flickered below fair value since 1994, so that feels like a rare opportunity. So it’s a nicely cheap market, but bear in mind that it can be spectacularly cheap if it wants to be.
Neither of these men is willing to say that the bottom has been reached. Gross in fact points out that the world of cheap financing, high leverage and low corporate tax rates may not return for a long time. That in turn may mean the traditional valuations might need some adjustment. But at the end of the day if I can buy Blue Chips like Verizon, Chevron and GE that yield way more than my money market fund and are selling at very low P/E’s, I think it’s a fairly smart bet to allocate some of my money back into stocks.
One last note of optimism from my friend Vince Farrell.
The Fed program to guarantee bank debt is working. Bank of America, Citi, Goldman Sachs, JP Morgan, and Morgan Stanley have sold over $35 billion in short term notes just the past few days. Mortgage rates have fallen sharply with the prospect of the Fed buying mortgage backed paper. The system is starting to slowly unfreeze. There were false starts and Secretary Paulson seems adrift but think of Winston Churchill who said “Americans will always do the right thing- after they have exhausted all other alternatives.”
From Bill Gross’ piece: “Q” ratio [is] the value of the stock market relative to the replacement cost of net assets.
Hrm. One has to believe that net assets are being “properly” priced in order to believe the Q ratio is where it says it is.
I don’t believe that to be the case.
The Treasury department does not seem to want anyone to know what financial assets would go for in the open market. Finance was like ~40% of the S&P profits at peak. Has all that garbage been written down? And that affects sort of other companies that you would never thought had exposure.
In sum, don’t get fooled. These arguments read like a value trap to me. Short term pop that’ll lead to a long term drop.
From Bill Gross’ piece: “Q” ratio [is] the value of the stock market relative to the replacement cost of net assets.
Hrm. One has to believe that net assets are being “properly” priced in order to believe the Q ratio is where it says it is.
I don’t believe that to be the case.
The Treasury department does not seem to want anyone to know what financial assets would go for in the open market. Finance was like ~40% of the S&P profits at peak. Has all that garbage been written down? And that affects sort of other companies that you would never thought had exposure.
In sum, don’t get fooled. These arguments read like a value trap to me. Short term pop that’ll lead to a long term drop.
From Bill Gross’ piece: “Q” ratio [is] the value of the stock market relative to the replacement cost of net assets.
Hrm. One has to believe that net assets are being “properly” priced in order to believe the Q ratio is where it says it is.
I don’t believe that to be the case.
The Treasury department does not seem to want anyone to know what financial assets would go for in the open market. Finance was like ~40% of the S&P profits at peak. Has all that garbage been written down? And that affects sort of other companies that you would never thought had exposure.
In sum, don’t get fooled. These arguments read like a value trap to me. Short term pop that’ll lead to a long term drop.
I still do not understand the logic of your “Q” chart.
I still do not understand the logic of your “Q” chart.
I still do not understand the logic of your “Q” chart.
Stock- It’s simple. The “Q” is just saying you could not recreate all of General Electric worldwide for $180 Billion (G.E.’s market cap). It would be cheaper to buy the stock.
Stock- It’s simple. The “Q” is just saying you could not recreate all of General Electric worldwide for $180 Billion (G.E.’s market cap). It would be cheaper to buy the stock.
I don’t know about this one. What Gross is describing doesn’t seem to fit. It doesn’t fit the chart he provides. It doesn’t fit basic human psychology we all know. It doesn’t fit basic economic theory. And it doesn’t fit what’s happening in the world.
For example, Gross says,
“The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall.”
But the actual logic behind Q is quite different:
1. The majority of stock buyers make buy/sell decisions based entirely on rational, mathematical bases
2. The majority of stock buyers have access to all the needed information on all stocks and companies.
3. The true value of a company is the cost of replacing its physical equipment.
#1 is false as Warren Buffet’s parable of ‘Mister Market’ tells us.
#2 is also dubious, despite all efforts by regulators to make the markets transparent.
#3 contradicts one of the basic tenets of Microeconomics 101, which states that a company is worth more as a ‘going concern’ than the sum of its physical plants and equipment. There is supposed to be a value in the brand and reputation of a company, as well as in the combined experience and skills of its employees working as a team.
Gross goes on to say:
“In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical.”
The chart he gives us indicates that this is false since 1950 – for the great majority of time over these 50+ years, Q has been well below 1. Does this mean capitalism does not work, even in a relatively frictionless stock market? If Q were ‘mean reverting’ then it would bounce around at or near 1.0. Instead it spends a solid 43 years below 1.0 through markets good and bad, through the great postwar boom years, the frenetic 60s, as well as the malaisical late 70s, the go-go Reagan years when North Slope and North Sea oil basins made oil ultra-cheap, on through the years when GHW Bush was president, in war and recession. Q then leaps above 1.0 for 10 straight years before plunging again.
Then Gross says,
“Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation”
This isn’t what his chart says. Indeed, it looks like an entire fifth of this time period, 1975-1985, Q was laboring below today’s level.
The conclusion Gross draws are also a bit off-kilter:
“We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money.”
I would put this very differently: the world we are moving into is one in which global population will be shrinking, not increasing, as we but up against the limits to growth. Arable soil, drinkable water, fish supplies, oil, coal, fertilizer, are all just about at their limits. And the world is a lot more polluted than it was 100 years ago. Then there is global warming and the wrench that climate change is going to inflict upon all the survivors.
There is also another generational shift, as boomers stop investing their surplus pay and go into retirement. This reverses one of the chief impetuses to the bull markets of the past 30 years.
Gross seems to make the common Wall Streeter’s mistake in thinking that the map (economic theories, government fiscal policy, charts and numbers) is the same as the territory (the real world where we all live and breathe and make real things we really use).
I don’t know about this one. What Gross is describing doesn’t seem to fit. It doesn’t fit the chart he provides. It doesn’t fit basic human psychology we all know. It doesn’t fit basic economic theory. And it doesn’t fit what’s happening in the world.
For example, Gross says,
“The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall.”
But the actual logic behind Q is quite different:
1. The majority of stock buyers make buy/sell decisions based entirely on rational, mathematical bases
2. The majority of stock buyers have access to all the needed information on all stocks and companies.
3. The true value of a company is the cost of replacing its physical equipment.
#1 is false as Warren Buffet’s parable of ‘Mister Market’ tells us.
#2 is also dubious, despite all efforts by regulators to make the markets transparent.
#3 contradicts one of the basic tenets of Microeconomics 101, which states that a company is worth more as a ‘going concern’ than the sum of its physical plants and equipment. There is supposed to be a value in the brand and reputation of a company, as well as in the combined experience and skills of its employees working as a team.
Gross goes on to say:
“In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical.”
The chart he gives us indicates that this is false since 1950 – for the great majority of time over these 50+ years, Q has been well below 1. Does this mean capitalism does not work, even in a relatively frictionless stock market? If Q were ‘mean reverting’ then it would bounce around at or near 1.0. Instead it spends a solid 43 years below 1.0 through markets good and bad, through the great postwar boom years, the frenetic 60s, as well as the malaisical late 70s, the go-go Reagan years when North Slope and North Sea oil basins made oil ultra-cheap, on through the years when GHW Bush was president, in war and recession. Q then leaps above 1.0 for 10 straight years before plunging again.
Then Gross says,
“Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation”
This isn’t what his chart says. Indeed, it looks like an entire fifth of this time period, 1975-1985, Q was laboring below today’s level.
The conclusion Gross draws are also a bit off-kilter:
“We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people’s money.”
I would put this very differently: the world we are moving into is one in which global population will be shrinking, not increasing, as we but up against the limits to growth. Arable soil, drinkable water, fish supplies, oil, coal, fertilizer, are all just about at their limits. And the world is a lot more polluted than it was 100 years ago. Then there is global warming and the wrench that climate change is going to inflict upon all the survivors.
There is also another generational shift, as boomers stop investing their surplus pay and go into retirement. This reverses one of the chief impetuses to the bull markets of the past 30 years.
Gross seems to make the common Wall Streeter’s mistake in thinking that the map (economic theories, government fiscal policy, charts and numbers) is the same as the territory (the real world where we all live and breathe and make real things we really use).
“Q” is also one indirect measure of whether humanity will get beyond the present expression of the “death meme” that some cynics (me?) think is part of its collective DNA — the group equivalent of apoptosis.
If you have even a little experience with GAAP, you know that figuring out what it would cost to replace the assets of a corporatioin, even a small one, offers many a chance for creative accounting. But as long as everyone uses the same rules (both the “legal” and logical and metric types) it looks like a good tool.
Anybody buying GE stock these days?
“Q” is also one indirect measure of whether humanity will get beyond the present expression of the “death meme” that some cynics (me?) think is part of its collective DNA — the group equivalent of apoptosis.
If you have even a little experience with GAAP, you know that figuring out what it would cost to replace the assets of a corporatioin, even a small one, offers many a chance for creative accounting. But as long as everyone uses the same rules (both the “legal” and logical and metric types) it looks like a good tool.
Anybody buying GE stock these days?
“Q” is also one indirect measure of whether humanity will get beyond the present expression of the “death meme” that some cynics (me?) think is part of its collective DNA — the group equivalent of apoptosis.
If you have even a little experience with GAAP, you know that figuring out what it would cost to replace the assets of a corporatioin, even a small one, offers many a chance for creative accounting. But as long as everyone uses the same rules (both the “legal” and logical and metric types) it looks like a good tool.
Anybody buying GE stock these days?
The baseline ratio shown at 1.0 assumes that the underlying value of the firms production (ie the use of the assets) is maintained.
The current situation is affecting on the meaning of “business as usual” based on easy credit, so to the extent there are doubts about this (see GM, Ford, Chrysler), there will be a discount to replacement value in the assets.
Eyeballing the chart suggests a long term mean level of 0.6 (40% discount) over the 50+ years. If this recession is a crisis of confidence or a systemic breakdown, rather than just reversion to the mean, then there may be a way to go.
The baseline ratio shown at 1.0 assumes that the underlying value of the firms production (ie the use of the assets) is maintained.
The current situation is affecting on the meaning of “business as usual” based on easy credit, so to the extent there are doubts about this (see GM, Ford, Chrysler), there will be a discount to replacement value in the assets.
Eyeballing the chart suggests a long term mean level of 0.6 (40% discount) over the 50+ years. If this recession is a crisis of confidence or a systemic breakdown, rather than just reversion to the mean, then there may be a way to go.
Whoa, give me a minute to digest this…..”liars figure, and figures lie” comes to mind. As far as GE, they’ve been around for 100 years with a reputation and capital assets that could be decades old and dollars were young. How can we estimate a Q replacement company and allow for inflation/value at todays market cap. I’m not convinced even though Bill Gross and Jon Taplin are professional smart guys.
P.S. Hey JT….Why would anyone buy GE when they could buy Google????
Whoa, give me a minute to digest this…..”liars figure, and figures lie” comes to mind. As far as GE, they’ve been around for 100 years with a reputation and capital assets that could be decades old and dollars were young. How can we estimate a Q replacement company and allow for inflation/value at todays market cap. I’m not convinced even though Bill Gross and Jon Taplin are professional smart guys.
P.S. Hey JT….Why would anyone buy GE when they could buy Google????
Davaudian-You buy GE because it pays you a 6% dividend and you have considerable up side in a recovery. Google Pays no dividend and it would have to go to $600 again to get the kind of lift you could get from $19 GE. Besides, GE makes Wind Turbines, Solar power equipment, clean jet engines and locomotives, etc. Well positioned for the Green New Deal.
Don’t get me wrong, I think Google is a good company, I’m just looking for better return with a solid dividend in a really funky market.
Davaudian-You buy GE because it pays you a 6% dividend and you have considerable up side in a recovery. Google Pays no dividend and it would have to go to $600 again to get the kind of lift you could get from $19 GE. Besides, GE makes Wind Turbines, Solar power equipment, clean jet engines and locomotives, etc. Well positioned for the Green New Deal.
Don’t get me wrong, I think Google is a good company, I’m just looking for better return with a solid dividend in a really funky market.
Jon, you’re right about the dividend. If you use the rule of 72, that means 12 years to double your money. Google can double at $550 in , hell I don’t know, but less than 12. I thought about some GE, but I’ll wait till it’s under $10.
Jon, you’re right about the dividend. If you use the rule of 72, that means 12 years to double your money. Google can double at $550 in , hell I don’t know, but less than 12. I thought about some GE, but I’ll wait till it’s under $10.
Jon, you’re right about the dividend. If you use the rule of 72, that means 12 years to double your money. Google can double at $550 in , hell I don’t know, but less than 12. I thought about some GE, but I’ll wait till it’s under $10.
GE made fifty cents of every dollar from GE Capital. I would not describe its dividend as “rock solid”.
GE made fifty cents of every dollar from GE Capital. I would not describe its dividend as “rock solid”.
GE chart since these comments
GE slashes quarterly dividend by two-thirds
GE chart since these comments
GE slashes quarterly dividend by two-thirds