Friday, October 17, 2014

The Selloff Is Noise; Do Nothing

  • The market’s price swings are normal and within historic range.
  • Value is unrelated to price, and is rising.
  • Do nothing now, but keep an eye out for deflation risk.

There is nothing happening in the equity market these days that should matter to a buy-and-hold investor. If you’re a day-trader or a chartist, that’s different. But if you have your saving invested in the broad market, nothing is going on and you should do nothing.

The history of the post-Crash bull market is a history of steady price appreciation periodically interrupted by volatility. There have been many selloffs since March 2009, all of which were corrected. There were big selloffs in 2010, 2011, and 2012. This year, we have had slumps in January, April and July. Now we are having another one. The bottom of the January-February slump was 15400 (DJIA), while today’s price (10/15) is ~15,900.

Price fluctuations do not matter for the buy-and-hold investor, because the intrinsic value of a stock is independent of its price. Notwithstanding the EMH, the market’s price often deviates from its value--sometimes for very long periods, such as the fifties when it was underpriced and the sixties when it was overpriced.

Today the market is either fairly valued or is in value territory, depending upon how one evaluates the data. The CAPE says it is overvalued, but it has been saying that since the Crash. If you followed the CAPE, you would have missed the 9000 point run-up in the Dow over the past five years. Today’s high multiples reflect the very low yields on offer in the bond market. Year-to-date, bond yields have declined by one-third from 3% to 2%, while expected equity returns remain around 8%.

The ERP is a much better valuation index than the CAPE, and it continues to flash somewhere between “fairly valued” and “under valued”. At present, Damodaran’s ERP is around 5.5% (and rising), which is roughly the mean value for the post-Crash period. It’s been higher and it’s been lower, but it is not low. It was lower before the Crash, and was 2% in 1999 at the height of the tech bubble. I would worry if the ERP fell to 4% or below.

What is happening in the market now is mainly noise, assuming that the Fed can muster the will to prevent deflation or near-deflation. On that assumption, we are seeing a rising equity premium as the earnings yield rises and bond yields fall. That suggests doing nothing.

The number to watch is PCE inflation which needs to stay where it is (1.5%) or to go higher. Should it fall below 1%, the forces of deflation might become too strong for the Fed to correct, given its feckless leadership and hawkish consensus. The declines in gold, oil and commodity prices are worrying. The ball is squarely in the Fed’s court to take action to prevent deflation. (I discussed this problem in a recent article.)
EMH: the efficient market hypothesis that says that equity prices correctly discount all available information.
CAPE: the cyclically-adjusted price earnings ratio calculated by Robert Shiller at Yale, which uses ten years of inflation-adjusted earnings instead of the trailing 12 months.

ERP: the equity risk premium, which measures the difference between expected equity returns and bond yields. This measure is calculated by Aswath Damodaran at NYU.

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