Evaluating Value
What’s a fair price for a share of stock? In theory, it’s easy to define. The fairest price lies at the intersection of the company’s supply and demand curves. The market price at any given moment reveals exactly where that point is. The averaged prices of all stocks in an index, appropriately weighted, tell us the same for market benchmarks.
In practice, the calculation is not so simple, because it is human beings who make the decisions – if not themselves then by telling their computers how to decide. Humans don’t always make rational choices. The stock market is the scene of a never-ending debate over who is the most rational actor.
My good friend Steve Blumenthal of CMG and I wrote a joint letter earlier this year called “Stock Market Valuations and Hamburgers.” Four months later, that letter is even more relevant. So are charts that my friends at Skenderberg Alternative Investments shared in their latest monthly review. (It’s free, by the way, and you should definitely ask to join their list. Just be aware, they seem to have a permanently bearish view, or at least they have recently. They are a fascinating source of all things bearish each month.)
We begin with this Bank of America chart. Look how many hours the average worker has to work in order to buy a notional share of the S&P 500. Amazing. Kudos to the B of A analyst who worked this data up.
You can see how valuations that are measured in this way skyrocketed in the 1990s bull market, then plunged in the following bear market and recession. They climbed again ahead of the 2008 crash yet could not reach their late-1990s peak – but now they have.
Equity capital is now at a historical high (going back to 1964) relative to labor. Two factors could tug the line down to a more normal level: sharply higher wages or sharply lower stock prices. Of course, I guess prices could go sideways for a few decades as wages rise. But on the probability scale I put that outcome pretty close to zero.
The S&P 500 is just one index, of course. There are many others. In fact, choosing an index is now even harder than choosing a stock is.
The upper line is staggering: Since 1995, the number of listed stocks has fallen 42%? What market force could be causing that? Actually, I can think of several. The financialization of the markets since 1995, making it cheaper to buy your competitors than to actually invest in equipment to compete, has produced a constant stream of mergers. This is not creative destruction. It has not resulted in new jobs and greater competition. It is, rather, a result of the central banks of the world messing with the free market and of businessmen optimizing the value of their earnings and cash. When cash is cheap, buy your competitors.
Another clear culprit is regulatory overreach, making it harder for small companies to go public. I am closely aligned with a few private companies. They could easily go public at nine-figure valuations, but the thought of being public companies is simply abhorrent to their management. It’s a been-there, done-that, have-the-scars-on-my-back-and-don’t-want-to-go-there-anymore attitude. Serving on the boards of two small public companies (mostly as a learning experience, because they do suck time) has inoculated me against fantasies of going public. When Uber and Air BNB and a host of their fellow unicorns do not go public and thereby allow the general market to participate in their growth, something is clearly wrong with the system. Congress should step in and take control of their regulatory creations, but it appears they can’t even do the simple stuff like healthcare and tax reform.
In any case, just in the last year the number of indexes crossed above the number of stocks – and is pointed higher still. The increasing popularity of index-based ETFs is driving this trend, but at some point momentum has to slow. But I don’t think that is going to happen soon, because the money that is being made by successful ETFs is such a lure that anybody with the distribution process thinks he or she can do it. Duplicating somebody else’s ETF? Not a problem; it’s all in your distribution chain. And the market is eating the index ETFs up.