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Stock Market Valuation Made Easy

Stock Market Valuation Made Easy

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Published by Wade Dokken

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Published by: Wade Dokken on Dec 17, 2010
Copyright:Attribution Non-commercial


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On December 31, 1964the Dow closed at 874.2. Seventeen Years later on December 31, 1981 theDow closed at 875. Over that time period theGDPof the US grew by 370%, the sales of theFortune 500 more than sextupled, and the Dow inched up a mere fraction of a point.How is it possible that the economy could expand by such a large degree when the Dow grew by only one tenth of a percent? This is the question that Warren Buffettposed in a1999 interview inFortune magazineon the nature of the current market. The simple answer is that the  value of the economy grew but the price investors were willing to pay for a share of the future of that economy did not. So the actual question is what caused investors to have such a low  valuation of the economy despite its huge growth. It is important to remember the simple, oftenforgotten, idea behindinvestmentwhich Buffett defines as, ³laying out money today to receivemore money tomorrow.´ In effect the value of an investment is the expected return and a declinein investor valuation signals a decline inexpected returns. Thus, the answer to the question putforth by Buffet can be found by looking at the value of expected returns.The career of Wade Dokken began at a historic low valuation in the market, and everyone whosecareer had an early 1980¶s beginning has experienced an unprecedented market run. We formed WealthVest Marketing to market guaranteed annuities, index annuities, and income annuities² because we believe that we may be in another period²not unlike the 1964-1982 period---and aperiod unknown to almost all current financial service professionals. So, this is a story of stock market valuation²and over-valuation.Every asset has some level of uncertainty attached to itsfuture value. This uncertainty isquantified by risk which effectively lowers the future value of an asset. Investors need to comparethis risk between multiple assets and, as a result, for any meaningful comparisons to be madethere has to be some kind of standard of risk to be compared to. This comes in the form of what iscalled therisk free ratewhich is derived from the interest rates on long termgovernment bonds, an asset with effectively no risk. This is the baseline value to which all investments are ultimately compared to. Even minor changes in these interest rates can have huge effects on market valuation. Buffett underlines the far reaching nature of these rates by saying, ³Ineconomics,interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts
of the world, the tiniest change in rates, changes the value of every financial assetOverall, therisk free rate is the first thing an investor looks at when trying to determine how much he shouldpay for even one dollar in the future.This graph is a perfect example of how changing interest rates can have a huge impact on themarkets. As the risk free rate rises it lowers the value of other assets because of the inherent risk associated with them. It comes down to the idea that if two assets have identicalrates of returnbut differing levels of risk, then the asset with lower risk will always be more valuable. Inthe case of an asset with effectively zero risk, a small increase in the interest rate can significantly depreciate even the value of assets with much higher rates of return. Conversely, a drop in therisk free rate can significantly inflate the value of an asset (in my opinion this is the dominant risk today²and why we are structuring innovative index annuities, which fundamentally reduceinherentinvestment risk ). This is the first part of the explanation as to why the stock marketpreformed so poorly in the period from the mid 60¶s to the early 80¶s. Interest rates steadilincreased threefold from 1964 to 1981 where they finally peaked at 15.32%, a level which is almostunfathomable today. This served to suppress the relative value of assets during this perioddespite significant gains in the economy.profits by such a degree and given the high interest rates of the period, inflation is at the top of thelist of culprits.
  An easy way to look at inflation is to look at the average price of consumer goods in US cities. Therate of change of these prices over time is analogous to theinflation rate. The graph above clearly shows how inflation rates steadily increased during the period of 1964 to 1981, peaking around1980. Comparing this to the previous graph, the effect of higher inflation rates becomesapparent. The peak in corporate profits in 1964 corresponds to the low in inflation rates. Movingforward to 1981, inflation rates increased and corporate profits decreased. Businesses grew, salesincreased and still investors suffered because the value of their returns were being discounted by record high inflation rates.This is the second major piece in the puzzle of trying to reconstruct why the stock market did sopoorly during this period. Investors were faced with sub-par profits that were being driven toeven lower levels due to high interest rates. From this they predicted a dim future for theeconomy and consequently valued the Dow at the same level as 1964 despite huge gains in theeconomy. The result of this is an economy where businesses grew and investor valuationsshrank. It is also a perfect example of how incredible investment opportunities are created out of periods of widespread pessimism among investors. High inflation and the resulting high interestrates had lowered investor valuations across the board. The entireUS economy had just gone onsale and, for the investor who was willing to look, there were sound companies to be had forclearance prices.³The arithmetic here is deceptively simple. If a company's earnings will increase 15% this year,and if the P-E ratio remains unchanged, then presto! The ³investment´ shows a 15 percentperformance, plus the smalldividend. If the P-E ratio advances²as it did for Avon in almost every  year--the performance becomes that much better. These results are entirely independent of theprice levels at which these issues are bought. Of course, in thisfantasia, the institutions werepulling themselves up by their own bootstraps--something not hard to do in Wall Street, butimpossible to maintain forever.´

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