How does one value the stock market overall? Become a Complete Fool
There are many commonly cited methods: P/E ratio, dividend yield, earnings yield vs. bonds, etc. Well, the first step in deciding on the best method to value the market is to ponder what we should demand of such a method. What would the best one look like?
The following arguments are basically my understanding (which could be flawed) of the book "Valuing Wall Street" by Smithers and Wright (I would HIGHLY recommend this book; it is terrific, and could save many from losing a fortune, which it did for me in March 2000).
First, what do we mean by value? The most practical way to think about it is this: what return should we expect from money invested at this market level? If we should rationally expect a good return, then the market is undervalued. If we should rationally expect poor returns, it is overvalued.
The first thing we should ask from any prospective method is that it be based on sound rationale. The method should make sense as a way to value the overall stock market.
Still, as a critical second criteria, we must insist on a method which can be verified over many, many decades encompassing numerous long cycles of the market. And we should expect that our method has predicted the performance of the market in the past in a statistically significant way, consistently.
Well, the best method to date for valuing the market is the "Q ratio", which is simply the value of the stock market divided by the sum of corporate net worth. As the book very rigorously shows, Q has been shown to have a very important and useful feature: it is mean reverting. Throughout more than a century, it has essentially acted like a huge rubber band: when the value of the market stretches to far--high or low--from its true value, it is always pulled back to Q (well, typically after overshooting the other way). And the further away from true value the market wanders, the stronger is the pull of Q.
The Q ratio has been shown to be a very accurate method to determine the true value of the market. It works in theory and practice. And, as the authors demonstrate, all the other common methods have serious shortcomings. The basic reason Q works is that in an intensely competitive capitalist system, competition forces the value of companies back toward their cost of development (this is for the market as a whole...not individual companies). And, what is important is that this concept was developed decades before it could be substantiated with data, so this is not data mining (Nobel laureate James Tobin first wrote about it in 1969): theory first, then substantiation by data.
So what does Q say about the value of our market? Well, it is approximately 50% overvalued. It is in the same ballpark of overvaluation it was in before the crashes of 1929 and 1973/74. True value for the S&P 500 is about 730. And if history repeated itself, the market will slingshot past Q down to 500 before the rubber band pulls it back. Now I know many will doubt this. But to anyone for whom having a reliable measure of the true, objective value of the stock market matters I would put forth the following challenge: familiarize yourself with the sophisticated rationale for Q, and then see if your method of valuing the market can even come close in being an indicator of value (again, prospective returns from a given market point) through a century of stock market fluctuations. (I think it is appalling that, despite the tremendous power of Q, it was virtually ignored in any common investment media I ever saw...but that's likely because it has been indicating severe market overvaluation for years).
One final note: the value of the overall stock market matters more to some than others. For the investors overall, who by definition own the stock market overall, or for large-index investors, it is extremely important. For an investor such as Buffett, with huge sums of money to invest, it is also very important. For a small, intelligent investor who can find value in individual stocks in a concentrated portfolio, it matters less (for example, even at the peak of the Great Bubble in March 2000, Berkshire Hathaway was trading at a very undervalued price and has since doubled); however, even this small investor will find that one is rarely able to find truly great companies trading at fair (much less mouth-watering) prices during market bubbles...and instead one often has to settle for mediocre companies selling at very low prices.
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How does one value the stock market overall?
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