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Appendix

A macro framework Clarium’s Q1 2009 quarterly letter, The Wonderful Wizard of Oz, argues that the “Goldilocks” era of
for valuing the low inflation and stable credit creation likely ended in 2008 for the foreseeable future. Suppose this
S&P 500 thesis is true. How could investors use this assessment to value an asset class such as equities? Stock
markets have depreciated substantially since the financial crisis began in August 2007. Stocks were
objectively expensive then. Have stocks now priced in all the bad news and reached fair value? Are
stocks now cheap? Could stocks still be overvalued?

We present a framework for valuing the S&P 500 by combining two analyses. The first analysis
is based on a process proposed by Benjamin Graham and David Dodd in their classic 1934 book,
Security Analysis and subsequently developed further by Robert Shiller in his 2000 book, Irrational
Exuberance.We calculate the 10-year trailing inflation adjusted P/E ratio1 for the index on a monthly
basis from 1916 through 2008 and compute its average value over that 92 year history. The second
analysis determines whether a given year is classified as “positive liquidity” or “negative liquidity.”
Positive liquidity years are characterized by stable prices coupled with meaningful credit expansion
and/or money supply growth, while negative liquidity years are characterized by severe inflation,
deflation or substantial credit contraction2.

Fig. A1 S&P 500 – 10 year Trailing P/E Ratio

50
S&P 500 – 10yr Trailing P/E

40

30

20

10

0
Positive liquidity cycles (lasting more than 2 years)

1928 1948 1968 1988 2008

Conceptually, one would expect the stock market to receive a higher valuation in an era of positive
liquidity than in an era of negative liquidity. And indeed, this is exactly what we see.

1This P/E ratio is computed as follows. The price (P) is the inflation-adjusted average price of
the S&P 500 for a given month. The earnings (E) is the simple average of the inflation-adjusted
earnings over the previous 10 years. The data is from Robert Shiller: http://www.econ.yale.
edu/~shiller/data.htm. All adjustments for inflation are based on the level of the CPI in March
2009.

2 The precise quantitative definition is as follows. In a positive liquidity year the average of
the growth over the prior year of the money supply and private debt is greater than 2%, and
the CPI is between -2% and 5%. A negative liquidity year is one that is not a positive liquidity
year. Money supply is defined as M2 from 1960 – 2008; from 1916 – 1959 the definition follows
Milton Friedman and Anna Schwartz, A Monetary History of the United States, table A-1, column
9. Private debt is taken from the Fed Flow of Funds from 1946 – 2008; from 1916 – 1945 the
source is the US Department of Commerce.
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• The average valuation overall is a P/E ratio of 16.3. Applying this valuation to the calculated
earnings of the S&P 500 for December 2008 implies a value of about 945.
• The average valuation in a positive liquidity regime is a P/E ratio of 19.1. Applying this
valuation to the calculated earnings of the S&P 500 for December 2008 implies a value of
about 1,105.
• The average valuation in a negative liquidity regime is a P/E ratio of 11.1. Applying this
valuation to the calculated earnings of the S&P 500 for December 2008 implies a value of
about 640.

A more detailed look shows that stock market valuations vary quite a lot around the average in both
positive and negative liquidity cycles3.

Fig. A2

TYPE OF PE START PE END


PERIOD TROUGH PE PEAK PE AVERAGE PE
LIQUIDITY CYCLE OF CYCLE OF CYCLE

1916-1922 NEGATIVE 12.5 8.0 4.8 12.5 7.4

1923-1929 POSITIVE 8.0 22.0 7.3 32.6 14.7

1930-1933 NEGATIVE 22.0 12.3 5.6 25.8 14.0

1934-1937 POSTIVE 12.3 13.0 10.4 22.2 15.7

1938-1951 NEGATIVE 13.0 12.1 8.5 16.8 12.2

1952-1968 POSITIVE 12.1 22.3 11.1 24.1 18.2

1969-1982 NEGATIVE 22.3 8.5 6.6 22.3 12.3

1983-2008 POSITIVE 8.5 15.3 8.5 44.2 22.8

Note how stock market valuations tend to overshoot on both the upside and downside.Valuations
start a negative liquidity cycle significantly higher and trough significantly lower than the average
throughout; the same is true in reverse for positive liquidity cycles. If one applies a typical trough
valuation to the calculated earnings of the S&P 500 for December 2008, it implies a value of
roughly 370. No doubt the eternal struggle between fear and greed partly explains this pattern, and
of course by definition one does best to buy at the cheapest price. But there are also fundamental
reasons for this behavior. The rate of credit growth or contraction and the degree of price stability
profoundly affect profit growth and the cost of capital. Determining whether one is in a positive or
negative liquidity cycle and estimating the length of that cycle are critical valuation inputs, and the
change in valuation throughout the cycle reflects the evolution of those estimates.

One should note that a deflationary negative liquidity cycle is even more dangerous than an
inflationary negative liquidity cycle. In a deflationary cycle, falling prices cause (both real and
nominal) earnings to fall, and this happens in conjunction with compressing valuations. Cash is
therefore a superior asset to stocks. In an inflationary cycle, rising prices cause (nominal) earnings
to rise, which partially offsets the effect of compressing valuations. Here one may still do better to
own stocks than to hold cash, particularly if one avoids the initial valuation compression.

3 Only major liquidity cycles are shown in the table and the graph.  A time period is classified
as a major liquidity cycle based on more than two years of either positive or negative liquidity as
quantitatively defined.  There are several shorter time periods where the quantitative definition
of the liquidity cycle contradicts the classification used for major liquidity cycles (1939-1940,
1944-1945, 1949-1950, 1971-1972 are shown as negative liquidity in the table and the graph,
but are quantitatively classified as positive liquidity, while 1990 is shown as positive liquidity in
the table and the graph, but is quantitatively classified as negative liquidity). 
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Finally, it is important to stress that this framework is only descriptive and not predictive. One
has to make an independent prediction about whether the next several years will be a positive or
negative liquidity cycle to know which historical P/E ratios to use. Nevertheless, this framework
may be a powerful way to supplement traditional valuation metrics in making an asset allocation
decision. After twenty-five years of a positive liquidity cycle, investors who have been lulled into
believing that the macro makes no difference to valuation may pay a high price.

patrick wolff, cfa


Managing Director
Clarium Capital Management LLC

RICHARD SCHLIPF
Associate
Clarium Capital Management LLC

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