In the Appendix, Exhibits 2–5,17 you’ll find reasonably understandable explanations of four different methodologies for roughly valuing common stocks in the aggregate—and over many decades.
The first compares the total market value of all U.S.-domiciled companies annually with GDP. It has been featured in a number of earlier annual reports. The second, a model originated by Ben Graham and updated by Bob Shiller, traces the 10-year trailing deflated price-earnings ratio from the early 1920s. The third, Tobin’s q-ratio, compares the market value to the replacement value of corporate assets over the same time frame. Finally, a name out of the past, Edson Gould, attempts to use dividend yield as a measure of valuation. Gould’s work is more relevant to the case made below regarding dividends returning to prominence.
These four different ways of looking at the same thing provided not only similar conclusions as to when major market lows occurred but, with reasonable accuracy, how depressed valuations were on those occasions. Common stocks were most out of favor in the early 1920s, the early ’30s, and the early ’80s, the last episode being the only instance of double-digit inflation and interest rates. If the current malaise continues, and those same low valuations are eventually realized, the S&P 500 could decline farther to somewhere between 400 and 550, the Dow Jones industrial average, 4000 to 5500. From year-end prices the further erosion in total market value could range between 30% and 50%.
Exhibit 2: Market Capitalization-to-GDP
One useful measure of aggregate market value is the market capitalization of all publicly traded stocks as a percentage of gross domestic product (GDP). The November 24, 2008, Barron’s article, from which the graphic at right was taken, reveals that the capitalization of the stock market was 59% of GDP. This is below the long-term average of 79% but well above the lows, which, if achieved, would result in a 550 level on the S&P 500.
Exhibit 3: Shiller’s Graham P/E
When calculating price-to-earnings ratios (P/E), most investors divide the stock’s price by last year’s earnings per share (or estimated current-year earnings per share). Legendary investor Ben Graham, however, suggested that P/E ratios be calculated using the average earnings of the last 7–10 years as the denominator. Such a methodology smooths yearly earnings gyrations and gives the investor a better sense of price paid relative to a business’s earning power over a full business cycle.
As of the end of 2008, the market was trading at a “Graham P/E” of 15.5 times earnings, close to the long-term average of 16.3 times earnings. However, if we swing pendulum-like through the average and reach the lows of about 6.5 times as we did in ’21, ’32, and ’82, the S&P would fall to 350–400. Even a more reasonable downside of 9 times equates to a 500–550 level on the S&P 500.
Exhibit 4: Tobin’s Q-ratio
Tobin’s q-ratio, named for economist James Tobin, is conceptually a measure of the market price of a firm’s assets relative to their replacement value (market value of capital/replacement cost of assets). A q ratio greater than 1 means the market is valuing the firm’s assets for more than it costs to replace them. In other words, you can buy a business for less than you can build that business. The converse is true for q ratios below 1. Among the many versions and approximations of Tobin’s q is the equitymarket q—or the market value of publicly traded equities divided by their book value. The chart above shows that as of December, the market was valuing aggregate net assets at about 75 cents on the dollar, which is approximately the long-term average. However, it’s obviously a very volatile measure. In four previous bear markets (’21, ’32, ’49, and ’82) the q ratio dipped below 0.3, which, if revisited, would equate to a 400–450 level on the S&P 500.
Exhibit 5: Gould’s Senti-meter
Famed technician Edson Gould hypothesized that the market’s dividend yield was a reasonable indicator of investor psychology. His theory was that dividend yields less than 3% signified an optimistic bias in investor sentiment and portended a market decline, while a dividend yield greater than 6% foretold the opposite.
According to Mark Ungewitter, vice president and portfolio manager at Charter Trust Company, if dividend payout ratios remain unchanged, a 6% yield would equate to about 500 on the S&P 500.