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of all guest columns written by Dennis C. Butler, CFA
There is a point in a rocket's trajectory called "brennschluss" (German for "end of burning") at which the motor cuts off, but the missile's momentum carries it further upward before it begins its descent. It would seem that the stock market has reached its own kind of brennschluss, while a powerful thrust of speculation has created the momentum to carry it onward and upward.
And onward and upward it was on Wall Street. Our financial markets did not stop to look back after the declines of March and April and have since broken one record after another. Whether or not the aggregate value of American businesses has increased by 20% in the last six months is a question few seem to be pondering at the moment. As long as stock prices go up, who cares?
We do like to think about things like the value of businesses, and its rate of change. Over time, this value is reflected in the stock market; what makes life interesting for investors is the fact that the translation of what we might term a business's "intrinsic" or economic value into market value is an inexact process, subject to fluctuations brought about by the flawed filter of collective human judgement. Incongruities between the two values create opportunities for investment.
Ultimately, the value of corporations is based upon their earning power, and the stock market is a reasonably accurate gauge of that power over time, at least in terms of magnitude. The enormous market value of stocks today, compared with that of decades past, is indicative of the country's great increase in wealth, as reflected in higher corporate earnings. In fact, the rates of growth in earnings and stock prices parallel each other over very long periods, at around 7-7.5%. Stock prices at any given moment also reflect expectations of future economic activity/earning power. This is where the human judgement factor enters, the source of the incongruities alluded to above. Due to the unusually strong appreciation in market values during the last three years, it is certainly fair to ask whether things have been carried too far and market values have outdistanced underlying intrinsic worth. Indeed, there has been a great deal of discussion recently over whether current prices are justifiable.
There appear to us to be three major groups of participants in this debate. The first includes those who take a traditional and conservative view of market valuations, basing their judgements on past relationships between the markets and business activity. They tend to view the current situation with alarm, since traditional valuation measures, such as dividend yields and P/E ratios, are skewed toward the extreme end of overvaluation. A middle group, perhaps best exemplified by Wall Street analysts, is oriented to the present and focuses on near-term trends. This group views high valuations as being justified by the current low levels of inflation and interest rates, benign government policies and so on, all of which, it is assumed, will continue for the immediate future. The third group includes some prominent academicians and market seers who argue that we are experiencing an entirely unprecedented economic situation, with opportunities that cannot be compared to the past. Economic globalization, the opening of countries to foreign investment, worldwide communications and capital flows, and retirement money create an environment that not only justifies the strong increases in global equity prices we have already seen, but also even higher prices -- and valuations -- in the future.
To us the Wall Street group's argument seems the least impressive. It is just too facile to suggest that we can take comfort in the fact that currently favorable conditions justify higher security prices. "As long as the FED doesn't raise rates," "As long as inflation remains under control" are hedges one often hears attached to Wall Street forecasts. Presumably, the forecasters think they will be smart enough to detect a change in trends before everyone else so they can get out of the market in time to avoid the falling prices that will inevitably result when expectations are deflated. This does not seem very helpful to anyone trying to make sense of what is going on in the markets or of current risk levels.
Our own views tend to coincide with the traditional group. After all, past experience is all we really have to provide the context by which to evaluate the present, and the record of past financial folly has provided good lessons for those wise enough to learn them. Knowledge of those lessons, and of past market parameters, permits one to protect against an unknowable future.
However, we admit to being somewhat intrigued by the more radical notion that we are seeing something truly unique in financial history. Although we have little use for the ravings of the more excitable element -- the market "gurus" looking for 12,000 or 15,000 for the Dow Jones Industrial Average -- the more careful academic analysts add value to the debate by cogently arguing, correctly in our view, that there is nothing cyclical that we can be certain of. Perhaps we really are in an unprecedented period that will foster growth for many years to come. We remain highly skeptical of such views (after all, certain academicians did proclaim the "new era" of the 1920s), but they serve to remind us that these market upswings can and do go on for very long periods of time, much longer than would be considered probable based on historical experience.
What use one makes of these ruminations depends, of course, upon one's approach to investing and the importance one attaches to "big picture" sorts of analyses. Those seeking to speculate on the movements in security prices would obviously find useful the views of those seeking to determine whether the environment will continue to support vigorous market gains, especially if they are well-known opinion leaders. Our own preference for buying undervalued securities implies a type of analysis that has little use for these market viewpoints, so, from a practical standpoint, we pay little attention to them. However, there is value in being aware of such views simply because they tend to become reflected in the market's pricing mechanism itself. At inflection points, when these views change, such disruption can occur that the price/value incongruities we mentioned above take place, creating investment opportunities for us.
One of the things that fascinates us is the extent to which people are unaware of the character of their own times. In the investment world the lack of this perspective is particularly dangerous because speculation so often parades in the guise of investment, especially in bull markets. So, we close this issue with some random factoids designed to illustrate the financial tone of our times and the great wealth by which those who happen to live in this country are surrounded. In one way or another, these phenomena are also reflected in the market's pricing mechanism and, in turn, are influenced by market psychology.
Anecdotal evidence suggests that Boston's Beacon Hill district is experiencing a real estate market boom the likes of which have never been seen. Some property prices have increased 50% in the space of several months ... Rents in neighboring Cambridge are climbing by about 10% per year ... The market for office buildings, thought by some analysts just a few years ago to be suffering from a potentially decades-long slump, has returned to vigor ... Remote communities in Vermont are home to gourmet "country stores" -- and real estate offices ... Cell phones...Cigar bars ... Money in politics ... There is talk among stock market forecasters of 10,000 or 15,000 on the Dow Jones Industrial Average. At least one market analyst has broached the idea of a 50-year bull market ... The Wall Street Journal reports that many so-called "401(K) millionaires" (those whose retirement accounts have ballooned in value along with the bull market) are making "lifestyle adjustments" -- retiring early, buying sports cars, going on cruises ... Small investors marvel at how easy it is to make money in the stock market.
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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation,
investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in
Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Telephone: 617.441.9695
Email: [email protected]
URL: http://www.businessforum.com/cscc.html
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