10/19/2014 Why No One Knows What the Market is Really Worth

Sector Model	XLB	1.33%
Large Portfolio	Date	Return	Days
SR	6/2/2014	3.38%	138
CFI	6/9/2014	5.15%	131
RRD	7/21/2014	-1.57%	89
ESI	8/4/2014	-35.78%	75
BSET	8/11/2014	6.45%	68
STRA	8/18/2014	8.95%	61
PBI	8/25/2014	-9.85%	54
CLF	9/2/2014	-42.00%	46
KFY	9/29/2014	0.69%	19
IQNT	10/6/2014	4.59%	12
(Since 5/31/2011)
S&P	Annualized	10.51%
Sector Model	Annualized	23.86%
Large Portfolio	Annualized	20.86%

 

No rotation.

Both the Full Model and the Sector Model have enjoyed a good rally toward the end of the week.  The biggest bounce was in ESI – which is still under water, but not nearly as bad as it was a few days ago.

The Sector Model has now changed to XLB (Materials), after getting a good spike from XLI:

 

 

The great question for now is: what the heck is the market worth?

I don’t know, and I don’t think anyone can truly know.  The reason is QE.

I’ve mentioned this before, but I’ll go into a bit of the math.

When plotting standard deviation channels of historical birth rate data against Shiller’s CAPE ratio, the greatest positive correlation is in the birth rate plus 44 years, and the greatest negative correlation is in the birth rate plus 64 years.

What that means is that people are contributing the most toward their investments in the midst of their working years (and 44 is right in the middle), but that they start drawing from their investments when they retire (hence the negative correlation around age 64).

People in their forties have their basic needs taken care of and start to panic about not having enough for retirement.  People in their sixties don’t know how to budget well and take more than they should before they start selling off assets to live a more manageable lifestyle.

But what IS the true CAPE ratio?  Should it be measured against the Consumer Price Index as Shiller does, or against the M1 measure of money supply as I have argued in this blog?

Here’s Shiller’s CAPE:

 

A CAPE ratio of 24.77 is crash territory.  This is the basis for John Hussman’s continual panic warnings on his own blog.

Now let’s look at an M1 (money supply) adjusted CAPE ratio:

 

A CAPE ratio of 16.57 is rather close to the long term average.

Next, let’s compare that to CAPE projections based on the ratio of 44 to 64 year olds:

 

I’ve terminated these data sets at the end of 2013, because we have not yet reached the end of 2014.

Aside from the titanic spike of “irrational exuberance” in the Dot Com boom, both CAPE ratios spent most of their time near the demographic forecast.  They only break away from each other during QE.

Those with careful eyes can see that the present “bull” market actually peaked in 2010 and never surpassed it.  The market has only gone “up” against the dollar – which has been diluted by QE.

In simplest terms, the market only looks like it is going up because the dollar is falling against it.

So that brings us to the question of “fair value”.  To calculate this, I am taking my demographic progressions against my M1 adjustments to Shiller’s CAPE ratio from 1974 through today:

 

In the broadest terms, the market can go over a decade without crossing its “fair value” designation.  Long term forecasts are not timing tools.  They are merely sanity checks.  However, it is fair to say that the market is not aggressively over “fair value.”  My M1 adjusted CAPE ratio is only 16.57, which is just a tad higher than the 15.06 CAPE forecasted by the 44/64 year old demographic ratio.

So where does that leave us going forward?

Unfortunately, it’s impossible to tell.  Although “fair value” is a little below today’s price on my rosy M1 deflator, it’s NOT so pristine on Shiller’s native CAPE ratio with the CPI deflator.  Using Shiller’s CAPE against the demographics, “fair value” on the S&P index is 1150.

That’s a long way down.

On the other hand, if you use an M1 deflator instead of CPI, you get “fair value” at 1715.  Still lower than today, but not nearly as frightening.

My guess is that inflation will eventually sync back up with money supply, but until that happens, “fair value” is an unknowable figure.  Or rather, “fair value” is an unusable range of 1150 to 1715.

To be equally unhelpful – but more simplistic – the market tends to hover around one standard deviation below the long term price regression during secular bear markets, and around one standard deviation above the long term regression during secular bull markets.

The demographics will keep us in a secular bear until the end of 2018.  Right now the market’s natural range is between 1935 and 1045, with a typical value around 1420.

However you look at it, we should have exhausted the upward potential for a while.

Nevertheless, QE has moved the goal post.  Even these wildly unhelpful ranges could be well removed from the true direction the market will take.  It could be fairly priced now for all we know, demographics be damned.

Good news?

Well, no – because if the market WERE correctly priced in today’s dollars, then everything else isn’t.  Milk, beer, gas, bread, and port wine cheese will all have to run up to catch it.

The last time we’ve seen anything like this was the seventies, after Nixon bought his re-election through massive treasury manipulation.  Although folks like to compare our current President to Carter, they are a bit premature.  We’re just now ending the equivalent of Nixon’s first term.

The next President will have to bridge the gap between Carter and Reagan.

God help us.

Tim