Barrons piece on stock mkt valuations models from MSDW's Wien and ISI's Ed Hyman.
(These models are similar to the famous "secret" Federal Reserve model of "correct" level for the stock market).
APRIL 2, 2001
Are We There Yet?
Low bond yields and plunges in stock prices suggest the
market's near a bottom
By Jonathan R. Laing
The stock market proved yet again to be the street of broken dreams last week.
Though a modicum of equanimity appeared to be restored by Friday, that only
came after a gut-wrenching plunge Wednesday that wiped out many of the gains
that the market had managed to string together in the three preceding sessions.
The week thus closed out one of the grimmest quarters in stock-market history,
with the Dow down around 8%, the Standard & Poor's 500 index off 12% and
the Nasdaq more than 25% lower.
Obviously the question on all investors' minds is: When will the pain end? At least
riders on a roller coaster, shrieking as it barrels down a big incline, have the
comfort of seeing the bottom of the dip and the rise ahead of it. Stock investors
have no such luxury.
There's little for investors to hang on to these days. The fundamentalist fraternity
offers little succor. Stocks never seem to be cheap enough for them to buy
without reservation. And the technicians? They're just as clueless. The only
change these days is that they are reading the entrails of eviscerated investors
rather than those of chickens.
And we admit some befuddlement ourselves. But we chanced upon a couple of
charts put together by two of Wall Street's canniest market observers -- Morgan
Stanley Dean Witter's Byron Wien and Ed Hyman of ISI Group -- who appear to
offer some solace to worried stock investors, if not financial recompense for past
losses.
Top chart: When stock prices and bond yields fall, the market usually is due for a
rebound. Bottom chart: Those severe drops in stock prices and bond yields have
rendered equities undervalued by this measure.
Both charts seem to indicate that the bottom in the stock market is nigh, if past
market behavior offers any guide. That said, we should hasten to add that markets
at times have a tendency to do the unprecedented. And one must remember that
hoary market saw about charts -- namely that almost every ship at the bottom of
the ocean had a chart room.
Wien's stock-market valuation chart is of special interest because of its
battle-tested past and rigorously conservative assumptions. The model seeks to
determine an equilibrium level at any point in time where stocks (the S&P 500)
and bonds (now the benchmark 10-year U.S. Treasury) are equally valued by a
rational investor after weighing the different risk profiles of the two investment
alternatives.
Wien's model currently places the fair value of the S&P at 1326 -- some 14%
higher than Friday's close of 1160.34 -- using a dividend-discount model that
assumes a 10-year earnings growth rate for the index of 9.8%, slower growth
thereafter, a 4% increase in operating earnings for the S&P this year to $57 a
share and a bond yield of 4.96%.
In addition, Wien bakes an equity-risk premium of 2% into stocks, on the theory
that fair values for stocks should be clipped some in relation to government bonds
because of stocks' greater uncertainty of return.
During the heyday of the late-'Nineties New-Era bull market, some observers
argued that stocks required no risk premium. After all, don't stocks always
outperform bonds nearly every historical period of more than five years in
duration? Besides, stocks' greater risk is more than compensated for by their
participation in the future profit growth of their underlying enterprises as opposed
to just the fixed returns of bonds. And, finally, the seeming taming of the business
cycle in the 'Nineties appears to make stocks safer. Events these days, however,
seem to be proving most of these notions laughable.
The Wien chart of stock market over- and undervaluation going back to 1980
resembles the EKG of a chihuahua on amphetamines in its extremes. In September
of 1987, just before the 1987 Crash, the model soared to an overvaluation level of
nearly 40% before collapsing to an undervaluation reading of 17.5% just two
months later.
And in December 1999, just a month before the S&P's all-time peak, and three
months before the Nasdaq Crash began, stocks moved to a record high of 55%
overvalued. It was at precisely this point that even Wein's colleagues openly joked
about the irrelevance of Wien and his goofy model. Perhaps the times had passed
the 60-something market strategist by.
But these days the S&P has moved into deep undervalued territory. This reflects
both the precipitous slide in stocks and bond rates since the beginning of the year.
So, are we nearing an important stock market bottom?
Probably, Wien said in a telephone interview with Barron's between ski races in a
Pro-Am event. In the past, stocks have tended to make a final low at
undervaluation levels of between 10% and 20%. That was the case in 1987, 1994
and 1995.
Only in 1980 did the model's stock undervaluation level reach lower levels, hitting
30.9% in June of that year.
Still, Wien offers some cautionary statements to temper the bullish implications of
his model. He warns that the stock market became so grossly overvalued in 1999
and early 2000 that the danger of a symmetrical move to the downside may exist
this time around. "I'm also worried that we haven't seen unambiguous signs of
capitulation, with mutual funds dumping blocks of stock to meet heavy investor
redemptions," he averred. "But I do think it's too late for investors to sell, but not
too early for them to buy stocks."
Later that day, Wien called back to slightly amend his statement. "Just say that it's
not too early for investors to buy some stock," he elaborated.
The second chart, from Ed Hyman's ISI Group, illustrates the yin and yang
relationship between stock and bond market performance. Under ordinary
circumstances, a sharp rally in bonds -- i.e., a precipitous slide in bond yields -- is
good for stock prices.
After all, plummeting yields tend to make stocks more attractive to investors
looking for enhanced returns. And the Treasury market arguably already has
reflected all the rate-cutting the Federal Reserve is apt to do with the 10-year note
below 5%, where Greenspan & Co. still is pegging the overnight federal funds
rate, making fixed-income investments relatively less attractive. Lower interest
rates also bolster economic activity by reducing borrowing costs for businesses
and consumers alike, and by fattening profit margins.
But most interesting are periods in which the performance of these two key
markets wildly diverges. The past six months has witnessed such a period. The
chart attempts to capture this phenomenon by adding together the year-over-year
percentage change in the price performance of the S&P and the year-over-year
percentage change in the 10-year Treasury yield.
The latest reading, a negative 46.3%,
shows the largest divergence in the
two markets in some 40 years of data.
That outlier negative reading was the
result of a big bond-market rally than
sent yields tumbling, and the sharp
decline in the S&P.
The chart imparts several messages.
First, such gross divergence between
a falling stock market and soaring
bond market tends to signal periods of
extreme stress in the economy. Notice
the four previous lows on the chart
during the 1974 and 1982 recessions,
the 1987 stock market crash and the 1998 Russian ruble- and Long-Term Capital
panic.
But of more relevance to investors, invariably stocks markedly outperform bonds
in the year after periods of major divergence like the current one. Add to this the
fact that stocks have posted back-to-back years of negative total returns only
once since 1920 (that was in 1973-1974 during an inflationary recession, the
worst of all economic worlds), and investors ought to feel pretty good about the
stock market's prospects in the months ahead.
For last year was a year of negative returns for almost all of the stock market's
major measures. And the past lows in the ISI divergence chart -- 1974, 1982,
1987 and 1998 -- turned out to be sensational buy points for the stock market.
Going to Extremes
Yet Karina Mayer, a managing director of ISI, offers several caveats about the
chart. She stresses that no one knows how long the current period of market
divergence will last or how extreme it could become. The drop in the current
reading has already fallen into record territory and threatens to fall right off the
chart as currently calibrated.
Mayer theorizes that the current stock-market downturn may prove to be more
prolonged and intractable than most other post-World War II bear markets. For
this downcycle is being driven by a glut of productive capacity and resulting steep
decline in capital spending rather than the typical inventory excesses of past
contractions. It's far quicker and easier to work off inventory gluts than excess
capacity.
Likewise, she and ISI worry that this bear market could have a far more corrosive
impact on consumer confidence than past bear markets. Household ownership of
stocks is so much greater today than ever before. "We here at ISI definitely
believe in the wealth effect and the fact that stock market losses could have a
major effect on U.S. consumption," she observes.
Of course, one must remember that falling interest rates don't always revivify
stock prices or even economies, for that matter. The Japanese economy and stock
market, after all, have been in an 11-year funk, despite interest rates that have at
times dropped to zero percent or just above.
Not to worry, says Mayer. Japan's problems have arisen, in part, from its citizens'
unwillingness to consume. That has never been a problem with the American
consumer.
Let's hope so. For the sake of the stock market if nothing else.
Copyright © 2001 Dow Jones & Company, Inc. All Rights Reserved. |
