Price to Book Value Crisis
by John Mauldin
Price to Book Value Crisis
A long time reader sent me some rather startling statistics on
current price to book values of the Wilshire Index, which is
basically the entire US public markets. I have to admit I was
skeptical, so I asked Troy where did he get these numbers? He sent
me back the address of the official Wilshire Index site. You can see
it at
wilshire.com
l .
The entire market cap for the Wilshire Index is $12.7 trillion.
Wilshire calculates that the price to book value ratio is 6.25. That
means the book value for the public American business is just north
of $2 trillion. It follows that the market values these companies 6
times more than there account statements suggest is the real value.
That is a lot of optimism.
Historically, book value runs below 2 in recessions, and I believe
has been below 1 in recessions in the past century.
20% of the market value is in technology and another 20% is in
financial services. 86% is in just a few large cap stocks. How many
of these large companies use fast and loose accounting to over-state
earnings and increase their book values?
Question: How much book value is going to be written off this year in
response to company after company coming "clean" in response to Enron
and Global Crossing? $100 Billion? $250 billion? Double that? More?
Worldcom alone has $50 billion in goodwill on its books, which is
substantially over-stated. How many more companies will write off
billions as Juniper did last year to the tune of $50 billion?
Price to book value ratios could go to nosebleed levels of 7 or 8 or
9 simply because of a new climate of stricter accounting standards.
How can a market rise in a climate where the book values of companies
are falling dramatically and we are in the Muddle Through Economy of
very slow growth? But how much can markets fall when investors keep
hoping for a return of the Booming 90's?
In line with my writings of the past few weeks, Robert Marcin on
theStreet.com did a brilliant essay on how all these valuations are
going to affect investors. I wish I had written it:
"...Do not kid yourself. This Enron crisis is huge. Not because of
the wealth that Enron destroyed, but rather because of the
repercussions it will have on the financial reporting system.
Greenspan and Kudlow contend that stock valuations should improve
because companies will be forced to report honest income statements.
But here's the way I see it: All the "wink-wink" accounting tricks
that most companies use to inflate reported profits will be
gone: "big-bath" and acquisition charges fed back into income;
pension profits; unrecognized option expense; inventory write-offs
fed back into profits; special-purpose-entity profits; off balance
sheet liabilities; recurring and nonrecurring charge-offs; bogus
revenue recognition; and "pro-rata, pro forma, operating profits."
The Future of Valuations
"The financial system will purge itself of these accounting tricks,
and it won't be pretty. There are probably a few more Enrons, Tycos
(TYC:NYSE - news - commentary) and Elans (ELN:NYSE - news -
commentary) out there. More significant for investors, however, will
be the stark admission that many companies have played games with the
numbers to inflate growth rates and stock prices for many years.
"Contrary to Greenspan's and Kudlow's assertions, valuations will
suffer as companies ratchet down growth rates. Risk premiums for
equities will rise in this period of higher uncertainty. Reported
profits will be reduced. Stocks will retreat as honest, but lower,
profits get capitalized at lower valuations."
We entered a long term bear market cycle in 2000 which will
typically last for a decade. There is a great deal of denial at the
beginning of these cycles.
If that were not the case, we would all simply buy S&P 500 puts and
make money hand over fist as the market crashed. But it is not that
simple.
Look at Friday's market action. Boom - out of nowhere the market
rallied big in the last few minutes. There are still lots of true
believers out there who dream that a world of 20% compound growth is
possible.
A lot of dreams were built in the last bubble. A lot of investors
want "just one more ride" and this time, they promise themselves,
they will get out at the top. There is an entire industry of
investment cheerleaders built around separating investors from their
reason, their instincts and their money.
This is the decade of slow and steady. It is the decade of seeking
absolute returns. It is the decade for market timers and nimble
traders and value managers. But like generals who fight the last war,
many investors seem to want a return of the old regime of momentum
and growth investing.
We won't see it return for this market cycle. As study after study
shows, markets always - 100% of the time - return to trend. It can
happen slowly or it can happen fast, but it WILL happen.
What this means is that gross over-valuations put an upper limit on
the rise of the market. There is currently an artificial floor of
investor expectations which prevents a drop of 40% or so back to
trend.
The market will go back to trend. Either prices will drop or
earnings will rise. I have made the case repeatedly that earnings
will rise very slowly. The new Enron era of accounting just makes
that case even stronger, as accounting tricks will become a thing of
the past. |
