Tuesday, April 12, 2011

Is the Market Overvalued?

Is the Market Overvalued?

Stocks have rocketed from their 2009 lows. Now two prominent market thinkers see two vastly different scenarios playing out. Who is right?

It's a question that is always on investors' minds, but rarely more so than right now: Is the market overvalued?
Bloomberg News
Hit the brakes: Robert Shiller of Yale says stocks are expensive.

Two heavyweights of financial analysis believe they hold the answer. Robert Shiller, the Yale University economist who correctly predicted the bursting of the stock market bubble in 2000 and the housing crash that started in 2006, has data that show stocks are pricey by historical measures.

David Bianco, U.S. stock strategist at Bank of America Merrill Lynch, has been on a campaign to revise the good professor's math. Once he tweaks the calculations, he says, stocks look cheap.

The issue is more than a tempest in an academic teapot. The stock market has roared back from its March 2009 lows, doubling in value on an intraday basis in less than two years. But the last leg of the rally, which began last summer, largely has been driven by the Federal Reserve, whose policy of buying Treasury bonds to inflate asset values across the economy is set to end in June. Investors want to know whether stock prices are too frothy now, or whether they are reasonable estimations of companies' underlying earnings power.

Which side you take—Mr. Shiller's or Mr. Bianco's—depends partly on whether you are more comfortable with the analysis of an academic who works far from Wall Street and whose job is to test theories, or a Wall Street strategist who is paid to track the market closely and bring in business.

Mr. Shiller bases his analysis on a comparison of the value of the Standard & Poor's 500-stock index to its component companies' earnings results over time. Data of this kind don't predict when stocks will start to decline. They just show when stocks are getting expensive compared with their companies' earnings, a sign they could be headed for trouble sooner or later. Mr. Shiller keeps data going back to the late 19th century on his website, at www.econ.yale.edu/~shiller/data.htm.

The innovation of Mr. Shiller's system is that it is designed to avoid distortions from short-term profit swings. Most Wall Street analysts compare stock prices to the previous year's profits or to analysts' predictions of future profits. Mr. Shiller takes an average of corporate profits over the previous 10 years. Long favored by sophisticated investors, that method smoothes out the business cycle, producing a measure of sustainable corporate profit that investors sometimes call normalized profit.

On that basis, Mr. Shiller's method shows the S&P 500 trading at 23 times profits, well above the historical average of 16. It doesn't necessarily mean stocks are about to fall; the S&P 500 went to a record 44 times earnings during the dot-com bubble before collapsing in 2000. But today's level isn't far from the peak of 27.5 hit before stocks fell during the financial crisis of 2007-09. At the 2009 bottom, it went down to 13 before quickly pushing higher again.
Go for it: David Bianco of Bank of America Merrill Lynch says stocks are a bargain.
Alternative Calculations
Mr. Bianco, who is bullish on stocks, says Prof. Shiller's measure is inaccurate, and the Wall Street strategist has taken his criticism public. Over the past year, he has written two reports offering alternative calculations.

Mr. Bianco says he began looking for ways to revise the Shiller numbers last year after a page-one article in The Wall Street Journal on the subject. Clients, he says, started using Mr. Shiller's data to contest his bullish thesis.

Mr. Bianco's massaging shows the S&P 500 trading currently at about 14.5 times his own calculation of 10-year profits, a much more attractive level than Mr. Shiller's 23 times profits.

"Clients call it the Bianco method vs. the Shiller method," Mr. Bianco says. "People call it Wall Street vs. the universities, or the Ivory Tower vs. the Bank of America Tower."

Prof. Shiller says he hadn't paid attention to Mr. Bianco's work until recently, when The Journal inquired. Prof. Shiller reviewed his calculations in light of the criticism and says he likes his math the way he did it.

"The basic analysis I have been presenting is right as is," he said in an email message.

Mr. Bianco doesn't dispute the usefulness of a 10-year average, an idea in line with the thinking of the founders of modern stock analysis, Benjamin Graham and David Dodd. He proposes to change Prof. Shiller's numbers in three ways, however, to remove what he thinks are distortions.

First, Mr. Bianco would adjust the way corporate earnings are calculated. Instead of the as-reported profits Mr. Shiller favors, he would use what analysts call operating earnings, which don't count some of the write-offs of the dot-com bust and the financial crisis. That change sharply boosts 10-year average earnings, making price/earnings ratios look less scary.

Second, he would change the historical data to which today's numbers are compared. He prefers to compare today's numbers only to data since 1960 or 1980, a period during which P/E ratios have been higher than in the past, making current levels look less extreme. If long-term data are used, he wouldn't count the decade following 1914, on the grounds that corporate profits were distorted by World War I more than by any other modern event, even the Great Depression. Throwing out that decade also makes past P/E ratios higher, so that today's look better.

Finally, he would adjust earnings figures still higher, based on the fact that companies have been retaining a higher percentage of profits and paying lower dividends for decades. When companies retain and invest more profits, he says, earnings growth is faster and reported earnings don't fully reflect the ability of retained earnings to spur growth. He calls this the Equity Time Value Adjustment, or ETVA.
Bloomberg News
In Bianco's corner: Wharton's Jeremy Siegel.
The debate goes well beyond Mr. Bianco and Prof. Shiller. Prof. Shiller's old friend and sometime critic, Jeremy Siegel of the University of Pennsylvania's Wharton business school, is Mr. Bianco's former professor. Mr. Siegel is siding with his student and against his friend.
Mr. Siegel agrees that earnings should be adjusted for the ETVA, and he also would massage earnings to remove some one-time charges. Earnings recorded at the depth of the financial crisis were highly unusual figures that shouldn't be used now to project future profits and stock values, he says.
"I respect Bob [Shiller] a lot. He is very thoughtful," Prof. Siegel says. "But to keep that once-in-a-75-year event in your data set, to say that is normal earnings, doesn't seem to be realistic."
Bloomberg News
In Shiller's corner: Research Affiliates' Robert Arnott.
Dividends and Earnings
Robert Arnott, whose firm Research Affiliates LLC manages $73 billion from Newport Beach, Calif., has done his own research on one element of the debate: the relationship between dividends and earnings.
He says his work shows it is a fallacy to think that lower dividends lead to faster earnings growth. Lower dividends come when companies are worried about the future or may be spending cash hoards on big acquisitions, which can hold down earnings growth, he says.
"It is peculiar that this thesis keeps coming up year after year when it is so demonstrably wrong," Mr. Arnott says.
Like Mr. Shiller, Mr. Arnott also doesn't trust operating earnings and prefers to use those reported according to generally accepted accounting principles. Such numbers tend to show lower earnings results, but are more accurate, he says.
Mr. Arnott says he uses Shiller-style P/E calculations in his work. The figures helped persuade him to boost his U.S. stock exposure in 2009, when the 10-year P/E was low, and then cut his exposure when the P/E moved higher.
Mr. Bianco says he will have to discuss this with Mr. Arnott. "Rob is one of the best minds in the business," Mr. Bianco says.
Just to show how small the financial world can be, Mr. Arnott also has had run-ins over the years with Prof. Siegel, Mr. Bianco's former professor.
Mr. Siegel and Mr. Shiller, who despite their differences often vacation together, have been debating these issues since they were graduate students together, 40 years ago.
In the summer of 2009, walking on the beach on a barrier island near Atlantic City, N.J., they got so involved in a debate about stock-valuation methods that they briefly wandered away from their wives. They can accuse one another of errors without raising their voices, then thank each other for the critiques and talk about plans for the next vacation.
Mr. Shiller did his own calculation about the impact of declining dividends on earnings growth and concluded that it is marginal at best, not meriting any adjustment. He scoffs at the idea of eliminating the decade after World War I. He says he will think about Prof. Siegel's concern about the big write-offs.
But he is reluctant to make too many adjustments to data that he feels have painted a useful picture up to now.
"I think I should just keep it simple," Mr. Shiller says.
Write to E.S. Browning at jim.browning@wsj.com

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