Flying Donkey

Monday, October 13, 2008

The Oscillating Market: Crash and Boom

The last few weeks have been heck of a roller coaster ride. Just as the stratospheric rise of the stock market in the late 90s and the 2000s was a deviation from fundamentals, I suspect, so is this massive retreat from the markets.

The heady days of the stock boom resulted in irrational valuations in excess of 20 times P/E. Essentially what it means is that investors were either so patient that they were willing to wait 20+ years to realize any profit on their investments or they were expecting markets to grow at an annual rate of 7% annually. The US had a market cap of about $58 trillion at its peak in May 2008. Therefore, it means that the market was expected to add $4.1 trillion to its value in year 1 with a build in growth of 7%. Put it another way, on an average, each publicly listed company was expected to grow by a whopping $241M in Year 1 and increase by 7% perpetually. From a purely quantitative viewpoint, this 7% growth is almost 50% higher than the sustainable growth rate, given the historical retention rates and returns.

We can also look at it from the viewpoint of risk. The market was demanding a spread of only 163 basis points over the risk free yields. Consider this… the average spreads over the last 80 years have been close to 600 basis points. So, the market had been telling us that the risks of investing in the stock market have been reduced by more than 350%. Now, I know that investors have been searching for the zero-beta portfolio, but this is ridiculous…the stock market had effectively given itself a AAA bond rating…I repeat BOND rating.

So, where are we now and where could we be headed. Last week, the average P/E had fallen to 11.42x. This has been a precipitous fall, but if we continue to ignore the fundamentals and rely purely on quantitative strategies, we are nowhere near the bottom. If we look at the current market data regarding risk, growth etc, the models would suggest a fair value of less than 5x P/E. That’s another 50% drop in the indices.

However, another approach is to look at the fundamentals. It includes taking a long term view of the market both prospectively as well as historically. Despite the ups and downs, the market has, on an average, returned more than 9% to the investors and has grown at a rate of over 5.5%. If we continue to believe in the long term viability of the free markets then there is no reason why the markets should not recover. In fact, there is no reason the markets should not recover by more than 20%, which would be indicated by an intrinsic P/E of about 14x. It does not mean that companies above 14x are overvalued or the ones below that are undervalued. It just means that, given the long term growth rates and returns, 14x is the valuation level that is sustainable over the long term.

In the end, the market is the sum total of the fundamentals (people, capital and technology) and the collective expectations of the people. Any mismatch between fundamentals and expectations is not sustainable over the long term. We have had a decade of expectations induced growth, and now we are having a dose of expectations induced decline… a clockwork oscillation of the market pendulum between optimism and pessimism.