Rogue Missives -- Is There a Bubble? by Jim Surowiecki

Rogue Missives

ROGUE ARCHIVES

Monday, March 10, 1997

Is There a Bubble?
by Jim Surowiecki (Surowiecki)
The bull market weathered yet another Greenspan-induced storm last week, when the Fed chief allayed the anxieties he had raised the previous week when he openly commented on the possibility that stocks were being overvalued by investors. In testimony before the House Banking Committee on Wednesday, Greenspan suggested that current stock prices were not, in fact, "irrational," given the underlying strengths of the American economy, and that all he had meant to do was ensure that investors understood that it was possible for stocks to drop in price.
"It's pretty obvious that if you look at a normal pricing model for stocks, what you get is a not unreasonable level of prices," Greenspan said, "if the earnings forecasts which the analysts are publishing are accurate."
At the same time, Greenspan cautioned that everything depended on American corporations continuing to produce widening profit margins. He pointed out that compared to 1991, margins were currently quite high, but that in comparison to the 1960s, the last time the American economy enjoyed an extended period of low inflation and growth, margins remained relatively low.
Considering that Greenspan raised interest rates six times in the space of a year in 1994, it makes sense for investors to pay attention to his remarks, since they suggest both something about what the Fed's policy will be in the near term and about the prospects for the American economy in the long term. At the same time, it's not really clear how much time Greenspan put into his original comments about "irrational markets" and "stock market bubbles." So those may just be dismissed as the musings of a naturally cautious man.
On the other hand, Greenspan's concerns do raise a broader question: Is it possible for the stock market in general to be overvalued? In other words, even if we know -- as we seem to from historical comparisons -- that over the long term stocks will bring investors a consistently higher return than other forms of capital, is it possible that the market as a whole is overvalued today, that, in other words, the prices of stocks in general are too high relative to earnings or assets or sales or whatever one considers relevant to evaluating a company's worth?
Now, obviously, if the goal of running a PEG or a simple P/E ratio is to figure whether or not you should buy a stock, then discovering that the market as a whole is overvalued would mean that you should probably not buy and that you should perhaps think about selling. Of course, the problem with this strategy is that it requires remarkable vigilance on the part of investors. Assuming, after all, that in the long run the stock market will continue to rise, you want to make sure that you own stocks in the year 2000. But if you decide not to buy now, or if you sell now, then when do you get back in?
Presumably, you get back in when you run the numbers and discover that the market as a whole is no longer overvalued. But you need a great deal of confidence in your numbers to move in and out like that. All of which suggests that, for the average investor, market-timing may be more interesting as an idle fantasy than as a real strategy.
Still, it might be worth remembering the time that Warren Buffett sold off his investment holdings and returned the proceeds to his investors because he said that there were no undervalued stocks out there. And it might be worth going back to one of the classics of value investing, Benjamin Graham's Security Analysis, and trying to understand Graham's take on the problem of overvaluation.
Graham first published Security Analysis in 1934, in the heart of the Depression and in the wake of the collapse of public faith in the stock market. In that sense, Security Analysis was a thoroughly contrarian work, suggesting as it did that it was possible to distinguish -- in a relatively rational manner -- between undervalued and overvalued stocks, and that careful analysis offered the possibility of guiding an investor safely past the perils of the market.
At the same time, Graham's work was founded on the notion that, in his words, "the processes of the stock market are psychological more than arithmetical." This meant not that one should attempt to understand the psychology of investors, but that the impact of psychology ensured that stocks would be either undervalued or overvalued. In other words, in the short run the market was not efficient. Because investors tend to be driven by either fear or greed (or both), the market price of a stock only rarely meets what Graham terms its fair value. He terms this "the well-known tendency of stock prices as a whole to go to extremes in either direction, as optimism or pessimism holds sway."
But what if optimism is holding sway, not merely over some investors, but over almost all investors? What if fear has disappeared? Does that mean that we need to rethink our ideas of what "fair value" is, or does it mean that the market as a whole may become overvalued, in which case we need to rethink how much cash we have in stocks?
Graham's answer, interestingly enough, seems to be "Both." In other words, his work seems to lead to the conclusion that we should probably adjust our standards of valuation and think harder about how much of our portfolio we have in stocks.
If it's possible for the market to overvalue individual stocks, that is to say "for favored stocks to sell at unduly high prices," then it's possible for the market to overvalue stocks as a whole, at least in the short term. If all stocks, in that sense, become "favored," then they'll all be trading at unduly high prices, which means you should avoid them.
You should avoid them, of course, if you think that eventually most stocks find their way to their true valuations. If they do, then buying them at unreasonable P/E multipliers makes no sense, even if all the stocks are trading at similar multipliers.
Obviously, not all stocks will be overvalued. It's probably true that bargains will always exist. But the existence of bargains is no guarantee that you'll be able to discover them. Graham himself is skeptical that an investor can escape the impact of the market as a whole. He argues that the value of a given stock cannot be separated from the overall value of the market. Good investors watch their portfolios increase more sharply than the market when the market rises and watch their portfolios decrease less sharply than the market when the market drops. But they cannot evade the market's broader movements. So Graham writes:
"[We do not] deem it possible for many security analysts to show good absolute results from their selective work during a period of substantial decline in the general market.... Intelligent investors should have a smaller proportion of their resources in common stocks, however chosen, at ultra-high levels of the market than at low or normal levels. To implement such a policy -- which runs counter to the instincts of the crowd -- it is necessary for the analyst to form a carefully based view as to whether the market level is or is not excessive."
This, of course, is the reasoning behind the Fool Portfolio measuring itself against the S&P 500. Beating the market is the evidence of successful stock picking. At the same time, what Graham is arguing in this passage is that there are times when the market level is excessive, and at those times investors should think about taking at least some of their money out of stocks.
Accepting, for argument's sake, that the stock market as a whole can be undervalued, the question then becomes: How do you determine if it is? And here Graham offers no single answer, though he does offer some suggestive ideas that are worth considering.
Graham's main tool of analysis in terms of evaluating the market as whole is historical. He uses the past as a way of understanding the future. In the 1962 edition of Security Analysis, for example, he looks all the way back to 1880, and divides the stretch between 1880 and 1960 into four 20-year periods. The mean P/E ratio for the DJIA in the four periods works out to 13.1. Taking into account changing valuation standards, he suggests that a useful multiplier for evaluating the Dow and the S&P as a whole would be 15 times current earnings.
The S&P currently trades at slightly more than 20 times earnings, which is analogous to the valuations the market enjoyed around the time the 1962 edition was published. Graham's point, in fact, was that the market was overvalued in the early 1960s, and that "speculative enthusiasm and excesses" had driven stocks too high.
In the past, Rogue has argued that the conditions confronting American business have changed dramatically over the last ten years, and that the impact of an ever-growing global market, coupled with increased flexibility in the labor force, may mean that a ratcheting up of valuations is justified. Graham, on the other hand, was skeptical about dramatic changes in market structure, recommending that investors "evolve [their] investment principles from a careful appraisal of the facts and the lessons of the last sixty years." But at the same time he insisted that "an understanding of change and the factors of change should appropriately influence investment decisions." And he conceded that "the apparently increased postwar stability in the economy and the improved growth" might justify "some modification in standards of value."
In addition, Graham also argued that it was important to recognize the possibility of "important changes in the underlying structure" of stock valuation. Indeed, the preface to the 1962 edition is explicit about the challenge the bull market of the late 1950s and early 1960s presented to Graham's ideas. While Graham did suggest that the market was overvalued in 1961, he also suggested that "there are sound reasons for anticipating that the stock market will value corporate earnings and dividends more liberally in the future than it did before 1950."
In other words, "fair value" is not a universal concept. A P/E ratio that was appropriate for the late 1930s would be too small for the 1950s, while a P/E ratio that fit the mid-1980s would have been excessive in the mid-1970s. Graham's point is that one key to successful investing is having a set of standards that would allow you to decide what's appropriate, and the best place to find that set of standards is by comparison with the past. Compare, that is, the underlying economic conditions, and compare the changes in the nature of investment, and you should be able to find some answers.
Still, this is a difficult task at best, which is why the safest strategy -- even in a market that may be overvalued -- is simply to stay invested with all the cash that you can afford to go without for three to five years. Over that length of time, if you're invested in solid companies, the return on your stocks will almost certainly be superior to that from any other investment vehicle. In that sense, timing the market is not necessary.
On the other hand, there is something eerie about the concept that it's possible to recognize an overvalued market and yet not do anything about it. If, for example, a 10% correction is coming, it would obviously be wonderful to get out before it hits and then get back in just as it turns around. Even if you missed the very top and the very bottom, after all, it still seems as if one could reap sizeable rewards by avoiding the tumble and then bottom-feeding.
The truth is that the problem runs a little deeper than that with regard to today's market, because it's hard to see real problems on the horizon for most American companies. If Greenspan stays off the brakes, rising corporate earnings should continue. And for the market leaders, the future seems almost unimaginably bright. In that sense, why would one not want to invest in DELL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: Dell)") else Response.Write("(Nasdaq: Dell)") end if %> or BOEING <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BA)") else Response.Write("(NYSE: BA)") end if %> or INTEL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>? Are these companies really going to be less valuable five years from now than they are now?
In that sense, it's not only tactically difficult to decide when to take money out of the market, it's also difficult to justify from a valuation point of view. The best American companies will almost certainly be worth more -- from a business perspective -- next year than they are this year, and worth more the year after that. And even if the market has already realized that, it almost certainly will realize that more in the future. The problem, of course, is that it may be a bumpy ride in the meantime.
Benjamin Graham was more hopeful about the possibility of recognizing when something like a market top had been reached and more willing to recommend that investors take money out of stocks when this was the case. But for investors today, the lessons from Graham seem not quite so comforting. The market can be overvalued, he suggests, and in that sense Greenspan was not necessarily wrong. But figuring out when it is, and what to do when it is, is a far more difficult task. The real counsel for the long-term investor ends up being that simple refrain: Pick good companies, and wait. Eventually, everything comes around.

-- Jim Surowiecki (Surowiecki)
(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.

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ROGUE ARCHIVES

Monday, March 10, 1997
Is There a Bubble? by Jim Surowiecki (Surowiecki) The bull market weathered yet another Greenspan-induced storm last week, when the Fed chief allayed the anxieties he had raised the previous week when he openly commented on the possibility that stocks were being overvalued by investors. In testimony before the House Banking Committee on Wednesday, Greenspan suggested that current stock prices were not, in fact, "irrational," given the underlying strengths of the American economy, and that all he had meant to do was ensure that investors understood that it was possible for stocks to drop in price. "It's pretty obvious that if you look at a normal pricing model for stocks, what you get is a not unreasonable level of prices," Greenspan said, "if the earnings forecasts which the analysts are publishing are accurate." At the same time, Greenspan cautioned that everything depended on American corporations continuing to produce widening profit margins. He pointed out that compared to 1991, margins were currently quite high, but that in comparison to the 1960s, the last time the American economy enjoyed an extended period of low inflation and growth, margins remained relatively low. Considering that Greenspan raised interest rates six times in the space of a year in 1994, it makes sense for investors to pay attention to his remarks, since they suggest both something about what the Fed's policy will be in the near term and about the prospects for the American economy in the long term. At the same time, it's not really clear how much time Greenspan put into his original comments about "irrational markets" and "stock market bubbles." So those may just be dismissed as the musings of a naturally cautious man. On the other hand, Greenspan's concerns do raise a broader question: Is it possible for the stock market in general to be overvalued? In other words, even if we know -- as we seem to from historical comparisons -- that over the long term stocks will bring investors a consistently higher return than other forms of capital, is it possible that the market as a whole is overvalued today, that, in other words, the prices of stocks in general are too high relative to earnings or assets or sales or whatever one considers relevant to evaluating a company's worth? Now, obviously, if the goal of running a PEG or a simple P/E ratio is to figure whether or not you should buy a stock, then discovering that the market as a whole is overvalued would mean that you should probably not buy and that you should perhaps think about selling. Of course, the problem with this strategy is that it requires remarkable vigilance on the part of investors. Assuming, after all, that in the long run the stock market will continue to rise, you want to make sure that you own stocks in the year 2000. But if you decide not to buy now, or if you sell now, then when do you get back in? Presumably, you get back in when you run the numbers and discover that the market as a whole is no longer overvalued. But you need a great deal of confidence in your numbers to move in and out like that. All of which suggests that, for the average investor, market-timing may be more interesting as an idle fantasy than as a real strategy. Still, it might be worth remembering the time that Warren Buffett sold off his investment holdings and returned the proceeds to his investors because he said that there were no undervalued stocks out there. And it might be worth going back to one of the classics of value investing, Benjamin Graham's Security Analysis, and trying to understand Graham's take on the problem of overvaluation. Graham first published Security Analysis in 1934, in the heart of the Depression and in the wake of the collapse of public faith in the stock market. In that sense, Security Analysis was a thoroughly contrarian work, suggesting as it did that it was possible to distinguish -- in a relatively rational manner -- between undervalued and overvalued stocks, and that careful analysis offered the possibility of guiding an investor safely past the perils of the market. At the same time, Graham's work was founded on the notion that, in his words, "the processes of the stock market are psychological more than arithmetical." This meant not that one should attempt to understand the psychology of investors, but that the impact of psychology ensured that stocks would be either undervalued or overvalued. In other words, in the short run the market was not efficient. Because investors tend to be driven by either fear or greed (or both), the market price of a stock only rarely meets what Graham terms its fair value. He terms this "the well-known tendency of stock prices as a whole to go to extremes in either direction, as optimism or pessimism holds sway." But what if optimism is holding sway, not merely over some investors, but over almost all investors? What if fear has disappeared? Does that mean that we need to rethink our ideas of what "fair value" is, or does it mean that the market as a whole may become overvalued, in which case we need to rethink how much cash we have in stocks? Graham's answer, interestingly enough, seems to be "Both." In other words, his work seems to lead to the conclusion that we should probably adjust our standards of valuation and think harder about how much of our portfolio we have in stocks. If it's possible for the market to overvalue individual stocks, that is to say "for favored stocks to sell at unduly high prices," then it's possible for the market to overvalue stocks as a whole, at least in the short term. If all stocks, in that sense, become "favored," then they'll all be trading at unduly high prices, which means you should avoid them. You should avoid them, of course, if you think that eventually most stocks find their way to their true valuations. If they do, then buying them at unreasonable P/E multipliers makes no sense, even if all the stocks are trading at similar multipliers. Obviously, not all stocks will be overvalued. It's probably true that bargains will always exist. But the existence of bargains is no guarantee that you'll be able to discover them. Graham himself is skeptical that an investor can escape the impact of the market as a whole. He argues that the value of a given stock cannot be separated from the overall value of the market. Good investors watch their portfolios increase more sharply than the market when the market rises and watch their portfolios decrease less sharply than the market when the market drops. But they cannot evade the market's broader movements. So Graham writes: "[We do not] deem it possible for many security analysts to show good absolute results from their selective work during a period of substantial decline in the general market.... Intelligent investors should have a smaller proportion of their resources in common stocks, however chosen, at ultra-high levels of the market than at low or normal levels. To implement such a policy -- which runs counter to the instincts of the crowd -- it is necessary for the analyst to form a carefully based view as to whether the market level is or is not excessive." This, of course, is the reasoning behind the Fool Portfolio measuring itself against the S&P 500. Beating the market is the evidence of successful stock picking. At the same time, what Graham is arguing in this passage is that there are times when the market level is excessive, and at those times investors should think about taking at least some of their money out of stocks. Accepting, for argument's sake, that the stock market as a whole can be undervalued, the question then becomes: How do you determine if it is? And here Graham offers no single answer, though he does offer some suggestive ideas that are worth considering. Graham's main tool of analysis in terms of evaluating the market as whole is historical. He uses the past as a way of understanding the future. In the 1962 edition of Security Analysis, for example, he looks all the way back to 1880, and divides the stretch between 1880 and 1960 into four 20-year periods. The mean P/E ratio for the DJIA in the four periods works out to 13.1. Taking into account changing valuation standards, he suggests that a useful multiplier for evaluating the Dow and the S&P as a whole would be 15 times current earnings. The S&P currently trades at slightly more than 20 times earnings, which is analogous to the valuations the market enjoyed around the time the 1962 edition was published. Graham's point, in fact, was that the market was overvalued in the early 1960s, and that "speculative enthusiasm and excesses" had driven stocks too high. In the past, Rogue has argued that the conditions confronting American business have changed dramatically over the last ten years, and that the impact of an ever-growing global market, coupled with increased flexibility in the labor force, may mean that a ratcheting up of valuations is justified. Graham, on the other hand, was skeptical about dramatic changes in market structure, recommending that investors "evolve [their] investment principles from a careful appraisal of the facts and the lessons of the last sixty years." But at the same time he insisted that "an understanding of change and the factors of change should appropriately influence investment decisions." And he conceded that "the apparently increased postwar stability in the economy and the improved growth" might justify "some modification in standards of value." In addition, Graham also argued that it was important to recognize the possibility of "important changes in the underlying structure" of stock valuation. Indeed, the preface to the 1962 edition is explicit about the challenge the bull market of the late 1950s and early 1960s presented to Graham's ideas. While Graham did suggest that the market was overvalued in 1961, he also suggested that "there are sound reasons for anticipating that the stock market will value corporate earnings and dividends more liberally in the future than it did before 1950." In other words, "fair value" is not a universal concept. A P/E ratio that was appropriate for the late 1930s would be too small for the 1950s, while a P/E ratio that fit the mid-1980s would have been excessive in the mid-1970s. Graham's point is that one key to successful investing is having a set of standards that would allow you to decide what's appropriate, and the best place to find that set of standards is by comparison with the past. Compare, that is, the underlying economic conditions, and compare the changes in the nature of investment, and you should be able to find some answers. Still, this is a difficult task at best, which is why the safest strategy -- even in a market that may be overvalued -- is simply to stay invested with all the cash that you can afford to go without for three to five years. Over that length of time, if you're invested in solid companies, the return on your stocks will almost certainly be superior to that from any other investment vehicle. In that sense, timing the market is not necessary. On the other hand, there is something eerie about the concept that it's possible to recognize an overvalued market and yet not do anything about it. If, for example, a 10% correction is coming, it would obviously be wonderful to get out before it hits and then get back in just as it turns around. Even if you missed the very top and the very bottom, after all, it still seems as if one could reap sizeable rewards by avoiding the tumble and then bottom-feeding. The truth is that the problem runs a little deeper than that with regard to today's market, because it's hard to see real problems on the horizon for most American companies. If Greenspan stays off the brakes, rising corporate earnings should continue. And for the market leaders, the future seems almost unimaginably bright. In that sense, why would one not want to invest in DELL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: Dell)") else Response.Write("(Nasdaq: Dell)") end if %> or BOEING <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BA)") else Response.Write("(NYSE: BA)") end if %> or INTEL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %>? Are these companies really going to be less valuable five years from now than they are now? In that sense, it's not only tactically difficult to decide when to take money out of the market, it's also difficult to justify from a valuation point of view. The best American companies will almost certainly be worth more -- from a business perspective -- next year than they are this year, and worth more the year after that. And even if the market has already realized that, it almost certainly will realize that more in the future. The problem, of course, is that it may be a bumpy ride in the meantime. Benjamin Graham was more hopeful about the possibility of recognizing when something like a market top had been reached and more willing to recommend that investors take money out of stocks when this was the case. But for investors today, the lessons from Graham seem not quite so comforting. The market can be overvalued, he suggests, and in that sense Greenspan was not necessarily wrong. But figuring out when it is, and what to do when it is, is a far more difficult task. The real counsel for the long-term investor ends up being that simple refrain: Pick good companies, and wait. Eventually, everything comes around. -- Jim Surowiecki (Surowiecki) (c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.