Margins, Multiples, And The Iron Law Of Valuation

Garbage In, Garbage Out.

This well-worn phrase describes how feeding flawed data into a computer guarantees that it will spit out flawed results.

It applies equally to human endeavors: if you attempt to answer a question using bad data, your answer will be wrong, no matter how rigorous your analysis.

That’s why the ability to separate important information from garbage is one of the most useful skills an investor can possess. With statistics like these constantly bombarding us…

“Short Facebook—its price-to-book ratio is 10.8!”

“Load up on Exxon shares—its price/earnings ratio is just 13.3!”

“Don’t even think about buying Blackberry—its short interest is over 20.4%!”

… we need to know which ones to pay attention to, and which ones to ignore.

Today’s guest author, fund manager, and frequent contributor to this missive, John Hussman, is the king of making such distinctions. He often scolds pundits in his weekly market comment series for citing statistics that make for good sound bites, but don’t correlate at all to what they’re trying to prove.

In what follows, John reveals a few lesser-known valuation metrics that actually do have proven track records for predicting where the stock market is going. Read on to learn about them, and what they say about how the stock market will perform over the next several years.

Dan Steinhart
Managing Editor of The Casey Report

The equity market remains valued at nearly double its historical norms on reliable measures of valuation (though numerous unreliablealternatives can be sought if one seeks comfort rather than reliability). The same measures that indicated that the S&P 500 was priced in 2009 to achieve 10-14% annual total returns over the next decade presently indicate estimated 10-year nominal total returns of only about 2.7% annually. That’s up from about 2.3% annually last week, which is about the impact that a 4% market decline would be expected to have on 10-year expected returns.

I should note that sentiment remains wildly bullish (55% bulls to 19% bears, record margin debt, heavy IPO issuance, record “covenant lite” debt issuance), and fear as measured by option volatilities is still quite contained, but “tail risk” as measured by option skew remains elevated. In all, the recent pullback is nowhere near the scale that should be considered material. What’s material is the extent of present market overvaluation, and the continuing breakdown in market internals we’re observing. Remember—most market tops are not a moment but a process. Plunges and spikes of several percent in either direction are typically forgettable and irrelevant in the context of the fluctuations that occur over the complete cycle.

The Iron Law of Valuation is that every security is a claim on an expected stream of future cash flows, and given that expected stream of future cash flows, the current price of the security moves opposite to the expected future return on that security. Particularly at market peaks, investors seem to believe that regardless of the extent of the preceding advance, future returns remain entirely unaffected. The repeated eagerness of investors to extrapolate returns and ignore the Iron Law of Valuation has been the source of the deepest losses in history.

A corollary to the Iron Law of Valuation is that one can only reliably use a “price/X” multiple to value stocks if “X” is a sufficient statistic for the very long-term stream of cash flows that stocks are likely to deliver into the hands of investors for decades to come. Not just next year, not just 10 years from now, but as long as the security is likely to exist. Now, X doesn’t have to be equal to those long-term cash flows—only proportional to them over time (every constant-growth rate valuation model relies on that quality). A good way to test a valuation measure is to check whether variations in the price/X multiple are closely related to actual subsequent returns in the security over a horizon of 7-10 years.