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The Iron Law of Valuation

The discipline which holds that stocks and the market in aggregate have a fair value based on past, current, and estimates of future earnings. This method is calculated through exhaustive mathematical analysis and statistical back-testing.  Through this methodology, a current fair value can be derived.  The Iron Law of Valuation is that, while actual prices will fluxuate, the inevitable pull of fair value will win over the long run. This analysis compares the current price to what is historically normal and can further demonstrate the degree of the difference; whether this market is under or overvalued.

Furthermore, by assuming, what has been true will continue to be true and comparing the current price to an expected future fair value, the probability of an expected future average annual return can be derived. Therefore, history gives a fair value: an average, a mean, a best fit. In addition, because stocks are no more than the present value of future earnings, these earnings can be anticipated, then assigned a current value discounted at some function of the Federal Reserve’s ‘neutral policy’ interest rate. It becomes a simple matter to determine whether the current price of the stock market is above or below fair value; whether it is under or overpriced.

Right now, the current price of the stock market is higher than this discipline would expect. But reality often turns theories about the appropriate value of the stock market into junk. Recent history is full of instances where the stock market continued to make substantial gains long after these theories stated otherwise. No one better documents this divergence than Laszlo Birinyi, and he is still bullish.

However, I believe knowing fair value is very important. The Iron Law of Valuation is like gravity.  Over the long term, it wins.


It has recently been argued by a leading economist that the Federal Reserve’s great financial experiment of buying massive amounts of bonds (QE), dramatically dropping interest rates (ZIRP), and flooding the system with newly created money was not about bailing out the big banks, it was about Main Street jobs. That, in order to restart the economy the Fed’s began a policy of targeting not just bonds prices, but stock prices as well.

Too many people taking on too much debt caused the 2008 financial crash. Debt they could not pay back. After 20 years, the economy topped out and went bang. In the aftermath, Americans were choking on debt and unable/unwilling to continue spending at binge rates. Economists call this a Liquidity Trap. Dropping interest rates did not encourage us to borrow more and spend. Someone who already ate too much is not interested in free hamburgers.

The argument continues that it is not the level of debt, but rather the amount of debt relative to equity that matters. A $300,000 mortgage on a house worth $250,000 is not good. However, the same mortgage on a $500,000 is another story. Price influences behavior. A homeowner with $200,000 equity in their house behaves differently than a homeowner that is underwater….they spend. Furthermore, corporations are run by people, so by lifting their equity (their stock price), they would also behave differently. Expansion plans would be undertaken, plants built, orders made, and finally, people hired. Therefore, by boosting the stock market, middle class jobs are created.

In this way, the level of the stock market became a policy tool of our Federal Reserve. Their plan to escape this Liquidity Trap was to lower interest rates, flood the system with money, and thus run the stock market to change the “mood” of the economy. The plan is to boost asset prices, revive the economy’s animal spirits, which then will start creating jobs.

So, here we are. The Fed has fully implemented its Grand Experiment of Zero Interest Rate Policy and Quantitative Easing (QE). They are now one of the largest holders on U.S. Treasury bonds. Their policy of driving stock prices higher worked. The market is up. However, the economy has yet shown little response. Consumer expenditure has remained weak.

The “fair value” of proper asset prices so important to capitalist systems was no match for the determined will of the central planners of our government. The price of the stock market is now a policy tool of the Federal Reserve and freed from the Iron Law of Valuation, freed from fundamentals of the underlying economy.

So, there it is. Government policy intentionally rallied the stock market to kick-start our anemic economy. Now it is time to see if it worked.

This brings me to last quarter’s positive GNP report:

Gross domestic product, the broadest measure of goods and services produced in the U.S., grew at an annual rate of 4.6% in the second quarter.


Small Caps Continue to Dance Around the Long Term Trend

With all the discussion of the Fed, the referendum vote in Scotland, the S&P 500 hitting new highs and the IPO for Alibaba, some investors may have lost track of the small caps. They haven’t been so fortunate. Here’s a good article that helps to put this trend into perspective and why it hasn’t seen returns like the S&P 500:

SocGen Warns Small Caps Are Headed For a Big Correction


Why The Big Mac Index May Affect Your Decision to Travel Abroad

At first it sounds silly; use the cost of McDonald’s Big Mac to gauge purchasing power in different countries. What first started as a humorous approach to addressing the pricing discrepancies between countries for similar goods, has been taken more and more seriously by economists.

See for yourself which countries have the cheapest Big Mac, an indication that your dollars will go further.

Anecdotal evidence based on my experiences abroad is inline with these findings. I felt like I was getting more value in certain countries – After travelling through parts of Turkey, I discovered that I spent much, much less than I budgeted. While a trip to Europe ended with a blown budget.

Before my next trip, I will use the Big Mac Index to help create my travel budget.

Doom-and-Gloomers Have It Wrong

The stock market didn’t crash.

The economy didn’t collapse.

The government didn’t default.

The Euro didn’t fail.

The inflation rate didn’t turn into hyperinflation.


And yet, every time we turn on the TV, all we see are more dark clouds looming in the distance, which only gives investors more reason to sit on the sidelines.