As we’ve noted frequently over the past couple of months, the stock market has finally fallen back to its long-term valuation average. Of course, after bubbles like the one we just had, stocks often fall far beyond their long-term average, into severely undervalued territory.
Jeremy Grantham and others think the S&P 500 will likely fall to 600 or so (vs. today’s 900) before bottoming. This would represent another 35% downside from here.
Another guru, an expert in “Tobin’s Q” valuation (a measure of replacement cost), thinks the S&P 500 will bottom at 400. (See chart below, which maps the S&P 500 on Q and cyclically adjusted earnings).
That’s a horrible thought.
Just as bad, the guru, Russell Napier, thinks the market could take until 2014 to get there. And don’t laugh. His logic is perfectly reasonable.
Bloomberg: The [Q] ratio, developed in 1969 by Nobel Prize-winning economist James Tobin, shows the Standard & Poor’s 500 Index is still too expensive relative to the cost of replacing assets, said [Russell] Napier. While the 39 per cent drop in the index this year pushed equity prices below replacement cost, history suggests the ratio must sink further as deflation sets in, he said. The S&P may plunge another 55 per cent to 400 by 2014, Napier said.
“The Q has come down to its average, however it’s not always stopped at the average,” said Napier, Institutional Investor’s top-ranked Asia strategist from 1997-1999. “It has tended to go significantly below that in long bear markets…”
Napier, who teaches at Edinburgh Business School… based his S&P 500 forecast on the Q ratio for U.S. equities as well as the 10-year cyclically adjusted price-to-earnings ratio, another measure of long-term value…
The Q ratio on U.S. equities has dropped to 0.7 from a peak of 2.9 in 1999, and reaching 0.3 has always signaled the end of a bear market, said Napier, 44, the author of “Anatomy of the Bear,” a study of how business cycles change course. The Q ratio for U.S. equities has fluctuated between 0.3 and 3 in the past 130 years.
When the gauge is more than one, it indicates the market is overvaluing company assets, while a Q ratio of less than one signifies shares are undervalued because it is cheaper to buy companies than to build them from the ground up.
At the end of the four largest U.S. bear markets in 1921, 1932, 1949 and 1982, the Q ratio fell to 0.3 or lower, and history is likely to repeat, said Napier. From the 1982 trough, the S&P 500 grew more than 14-fold to the middle of 2000, when Napier says the last bull market ended.
“Bear markets always end for exactly the same reason, and that is the market begins to price in deflation,” he said. “Equities will be incredibly cheap.”
Just as interesting: Napier thinks that we’ll get a major bear-market rally lasting two years or more before we resume our decline. This, too, would be in keeping with previous bear markets, which have taken their own sweet time (see Japan).
Before the trough in 2014, investors are likely to see a so- called bear market rally for the next two years as central bank actions delay the onset of deflation, Napier said…
Federal Reserve Chairman Ben S. Bernanke’s indication that he will use “quantitative easing” to prevent deflation points to a stock market rally that may last for the next two years, Napier said. With quantitative easing, a tool pioneered by the Bank of Japan, central banks can stimulate inflation by printing money and flooding the market with cash in order to encourage consumers to spend.
The government’s efforts will eventually fail as ballooning government debt devalues the dollar, causes investors to flee U.S. assets and takes the S&P 500 to its eventual bottom in 2014, Napier said…