Deflation and Stock Market Valuation

Here's an interesting article about the spectre of deflation which bond markets are anticipating (inflation-indexed bonds are priced with the assumption that there will be deflation over the next 5 years).

In 2003, as the article points out, there was a deflation scare which caused the Fed to cut interest rates down to 1% and helped fuel the housing bubble. To paraphrase one banker who posted on an investing forum, "Under normal conditions, you go to work at 9 am and cautiously lend money until 5 pm. In 2003, all the 'good' loans for the day were made by 12 pm. This left everyone 5 hours to have a party and make crappy loans (and huge profits) with really cheap money."

30-year treasuries are now yielding a mere 4.4%. Short sale opportunity anyone? The only problem is proper timing. I KNOW they are overvalued, perhaps drastically so because most investors are afraid. This is irrationality in action. The only question is, WHEN will confidence return to the bond markets (so that yields can rise again and you can make money on a short sale)? And will the return of confidence be gradual or sudden?

Also, I am grappling with the question of whether the stock market is currently 'undervalued' or whether it is now finally returning to fair value after a decade of decadent capital gains. I have seen blog posts and heard people say both. I suppose it depends on the way you compute P/E. This article answers the question rather nicely. As does the graph below, showing cyclical P/E ratios just returning to average after years of overvaluation. Cyclical P/E ratios are computed using the price of the stock over the average of the earnings over the last 10 years.


As the article says however, "The news has to come with the caveat that markets are prone to overshoot and become too cheap after prolonged periods when they have been too expensive. Hence, both these measures are consistent with stocks falling much lower before they find a bottom, even though they are currently fairly priced."

Will the market fall ever further after the recent boom period? If one believes that economies which experience a tremendous amount of unsustainable activity must compensate by enduring periods of slowdown below potential growth to compensate and that these economic booms and busts are reflected in stock prices (translated in technical terms as the negative serial correlation of real stock market returns) , then it looks like we may still have a long way to fall.

Here is a prescient report by Andrew Smithers written in February 2007. His thinking on economics, finance and market valuation is quite pragmatic and many of his predictions have already come true. He writes:

"The average return over the past 10 to 30 years has been over 8%, compared with 6.9% over the past 135 years. Investors in the US stock market must expect very poor returns over the medium-term, such as the next 5 to 10 years."

Check THIS one out:

"The gap between the valuations given by CAPE and q indicate, at first sight, that financials are much more overvalued than nonfinancials. We check, by an alternative approach to cyclical adjustment, the overvaluation indicated by CAPE. This confirms the estimate of overvaluation. On the other hand, our look at the details of net worth data for non-financials leads us to suspect that these have become increasingly overstated in recent years."

He concludes:

"The US stock market is probably overvalued by around 77%, as indicated by CAPE, and thus needs to fall to around 800 on the S&P 500 index to reach fair value."

Keep in mind, this was written BEFORE THE FINANCIAL CRISIS. The S&P 500 as of today is at 873. Which means there is still quite a way down to go, especially if you take overshooting into account.