Adjusting the Scale of the Selloff to Demonstrate Its Absurdity

Yesterday I discussed the absurdity of the stock market sell off in response to the credit downgrade of the United States by Standard & Poor’s.  This prompted an interesting comment from the What My Intuition Tells Me Now blog’s most loyal reader.  Because of the depth of the thinking behind his comment I feel like it deserves a public showing, along with my response.  My response adjusts the scale of the financial market sell off to demonstrate its absurdity.

Here is the comment in its entirety:

“Hello again Jason,

Forgive me if I misread your analysis, but your reasoning and conclusions appear to be based entirely on the assumption that the S&P downgrade and the market’s overreaction to it were the major reasons for the selling. When calculations yield retarded answers you should first check your math then check your model assumptions.

I can think of a few other plausible reasons for a sell-off that have little to do with the downgrade. Some examples include: (1) continuing fears over the Eurozone crisis; (2) downward revisions made to future U.S. GDP projections (during last week); (3) perceived economic implications of the debt deal; (4) worries about the mounting law-suits against Bank of America over its handling of mortgages and foreclosures; (5) group think, general market mood, and sudden realization that the stock market was overvalued.

I vote for all of the above in some combination. I imagine that for many investors, a weekend was needed to digest the numerous events of last week in order to formulate a determined response. Neither today’s nor Thursday’s sell-offs seem like panics to me; they seem more like a return to sobriety.

P.S. I have noticed that the “Notify me of followup comments via e-mail” option does not work on this blog.”

Here is my response to this careful, intelligent comment, and by natural extension the heart of today’s blog post:

“Hi Stephen.

Thank you for your comment, Stephen – as always, they are appreciated, as is your loyalty to the blog.

Regarding the causes/sources of the “sell off” as described by you: I have to retort a very mild, “well duh!” As you know from reading the blog as aggressively as you do, each of the factors you described as contributing to a 8 August, 2011 sell off have been talked about by me and, in most cases, for multiple years. These factors are not an oversight on my part. I wanted to highlight the absurdity of the selling yesterday relative to the only new piece of actual news: the downgrading of the U.S. government by S&P.

In your comment you ascribe a certain logic to the selling; implicit in this is some sort of assumption that investors are rational actors, or some variation of the “efficient market hypothesis.” I am basing this assertion on your numbers (1) through (4) which all ascribe some sort of logical reasons for the selling of Monday, 8 August. Frankly, I just have never experienced investors, professional, semi-professional, amateur, experienced or inexperienced as being rational, in the aggregate. So of your points the one that makes the most sense to me is “(5) group think, general market mood, and sudden realization that the stock market was overvalued.” Which is why I highlighted in my post the true absurdity of the selling Monday. But let’s adjust the absurdity scale from the amount of additional interest expense to be paid by the United states, that I highlighted in yesterday’s post, to something that should clearly illustrate for you the silliness of the magnitude of the sell off.

Most important in the enumeration of yesterday’s “U.S. S&P Credit Downgrade” post is the ~$722 billion difference in equity value ascribed by investors yesterday relative to the close on 5 August, 2011. That is equivalent to a decline in market cap of approximately 5.0% of 2010 gross domestic product (GDP), or $722.735 billion ÷ $14,418.16 billion. Meanwhile the total lost GDP in the Great Recession was just $353.5 billion, or peak ’08 GDP of $14,291.5 billion – trough ’09 GDP of $13,939.0 billion (source: U.S. Department of Commerce). So yesterday’s sell off destroyed, in wealth, double what was actually lost economic output-wise in the greatest post World War Two economic decline.

What’s more, the cumulative plunge of the S&P 500 now stands at 17.3% dating back to the most recent peak of 7 July, 2011; or 1,119.46 (close 8-8-2011) ÷ 1,353.22 (close of 7-7-2011). That 17.3% plunge represents a loss of market cap of ~$2,134.27 billion, or almost 7x the amount of lost economic flow in the Great Recession.

Regarding the “Notify me of followup comments via e-mail” option – I will look into it.

Keep your comments coming!

Jason”

I am guessing that you will agree with me that by looking at the lost wealth in the last month of financial market declines (~$2 trillion) relative to total GDP (~$14 trillion) helps to highlight the sheer madness of recent financial market selling.  There is just no way to rationally justify the magnitude of the sell off relative to the news flow.  Instead, in my opinion, you have to consider the irrational, as the blog commenter and I both did.

Most importantly, when stock markets are irrational is usually when the greatest mis-pricing, and typically consequent greatest opportunity, exists.  So let’s look to see if the financial markets look rationally priced here.  Put another way, is there opportunity to buy right here?

As of yesterday’s close, the S&P500 stood at a 19.32 P/E ratio.  That equates to an earnings yield of 5.18%; or 1 ÷ 19.32 P/E.  This is a yield over the 10-year U.S. Treasury Note’s yield of 2.363% of 2.817%.  This is equivalent to the “equity risk premium” that I alluded to in yesterday’s post.

Historically the equity risk premium has been about 4.5%.  If we were to take that 4.5% equity risk premium as gospel we would get a preferred earnings yield of: 4.5% equity risk premium + 2.363% 10-year Treasury Note yield = 6.863%.  If we invert that (1 ÷ 6.863% earnings yield) to get a fair value P/E ratio for the market then we get 14.57x, or a fair value level of the S&P 500 of 844.23.  That’s a further drop of 275.23 points, or another 24.6% decline from here.  Clearly, by this measure the stock market looks overvalued.

In the blog comment the poster states: “Neither [Monday’s] nor [last] Thursday’s sell-offs seem like panics to me; they seem more like a return to sobriety.”  Might I parenthetically point out that most folks who are addicted to a substance to the point of masochism do require a panic in order to become sober?

Be that as it may, perhaps he is right about the financial markets still being overvalued.  After all, in this environment it is obvious that investors are indeed nervous about equities and they will require higher rates of return to re-enter the fray.  But I guess I would ask rhetorically, how does the U.S. government being downgraded so dramatically affect the value of U.S. businesses themselves?  If we had the answer to that then we would be close to unraveling the mystery.

But let’s go back to that argument that the financial markets must fall much further from here because it strongly rests on the assumption that 4.5% is the amount of additional return investors require above a “risk free rate” of return (i.e. U.S. Treasury Notes).  Data show that investors have not required this kind of equity risk premium in the modern investing era.

In fact, the equity risk premium has averaged, on a monthly basis, the following (sources: www.multpl.com and What My Intuition Tells Me Now blog):

Past 1 year:       1.87%

Past 5 years:    1.15%

Past 10 years: 0.32%

Past 15 years: -0.78%

Past 20 years: -1.06%

Past 25 years: -1.27%

Past 30 years: -1.19%

Past 35 years: -0.87%

Past 40 years: -0.68%

Past 50 years: -0.57%

In fact, the last time the equity risk premium averaged 4.5% for a fifty year period is the fifty years beginning September 1919 and ending August 1969.  That standard 4.5% equity risk premium figure has been bandied about for many decades.  Yet there are many periods, dating back to January 1881 where the equity risk premium is much lower, and much higher than 4.5%.  By the way, the average monthly equity risk premium dating back to January 1881 is 2.4%, and not the proverbial 4.5%.

Let’s take a look at the average monthly S&P 500 P/E ratio for the last fifty years (source: www.multpl.com and What My Intuition Tells Me Now blog):

Past 1 year:       22.39

Past 5 years:    21.87

Past 10 years: 23.86

Past 15 years: 28.04

Past 20 years: 26.37

Past 25 years: 24.29

Past 30 years: 21.86

Past 35 years: 20.09

Past 40 years: 19.28

Past 50 years: 19.47

In other words, the current 19.32x P/E of the S&P 500 looks inexpensive relative to the modern economic era, frankly.

During moments like now where there is tremendous volatility the danger always is to ascribe to a current situation the same characteristics as a previous situation – in that attribution is obscurity and misunderstanding, at the margin.  This is another way of saying that the current crisis requires diligence, intelligence, wisdom, and super importantly, open discourse.

Jason

[This post has been edited to change the word “Bond” to “Note” which is the more proper term when referring to the 10-Year U.S. Treasury debt.  This post has also been edited due to a calculation error that slightly affected the Equity Risk Premium data initially quoted.]