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Author: bbmd2 Three stars, 500 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 214657  
Subject: 40% Overvalued Date: 10/7/2012 11:47 PM
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If someone believed that the US stock market is 40% overvalued compared to its long term average valuation, then would it be prudent to sell most of your US stocks, and wait for a better entry point? Even if that entry point might be 5-10 years away?

FWIW, Of all the hundreds of stock tips and investing advice Jim gives us, hearing him say stocks are 40% overvalued seems to be the most important.

There is another guy that thinks this way. Prem Watsa. Maybe it is time to "sell it all" and buy a certain Canadian stock.
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Author: knighttof3 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194725 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 12:28 AM
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If someone believed that the US stock market is 40% overvalued compared to its long term average valuation, then would it be prudent to sell most of your US stocks, and wait for a better entry point?

No. Hedging would be prudent. Buy some insurance (index or SPY puts) or sell covered calls for income.
What will you do if you sell all stocks now and the market keeps going up and keeps getting overvalued? When would you jump in?
Jim doesn't have a crystal ball. Even if he is right, the market could stay irrational longer. Trends go a lot longer than most value investors expect them to. Look at gold. Look at treasuries (though that's thanks mostly to Helicopter Ben, there are other fools still buying 10-years at 1.65%).
Today has some parallels to post-World War II era when the Fed kept rates artificially low. How artificial could become clear next year if current year's drought pushes food prices higher and causes inflation. Stocks did well in 60s and they will do well in the 10s.
I will concede that if you HAVE to sell stocks then now may be the time to do it, rather than wait for the market to go even higher. But if you don't have to, then why jump in and out? Sit on your seat (to paraphrase Munger.)

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Author: Technodweeb Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194726 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 8:23 AM
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You may want to look up the Q ratio, or CAPE, or Shiller PE, or debt to GDP. Whatever you want to look up to make the market look expensive, remember two things:

1. In the year 2000 all these ratios were at all time highs. Major highs!

2. In the year year 2000, Berkshire was:
A) Not as cheap as today (1.4-1.5 times book vs 1.24 currently or
less depending on next the next quarterly report.)
B) Wound up more than doubling in price in less than 10 years.

Berkshire to me is a rock solid investment, despite the market being overvalued. At least I think so.

My IV estimate is in the 180K range based on history. Many here do not even want to think about anything over 160K because they use an 8x or 10x multiple on operating earnings on top of BV. Some people use Float and BV together. There is another metric called SALT.

Not that there is anything wrong with conservatism (it can save you a lot of pain sometimes), but I believe that Berkshire's IV deserves the 12x multiple. Conservatism is what Graham would call "margin of safety". Most of those on this board are humble and generous with information, without wanting to over promise anyone anything, and I can't blame them for that. It is better to under promise and over deliver than to have a lot of disappointment. However, I still believe in my heart and mind this company belongs in the 180K range RIGHT NOW based on the prospects in the future, 10-20 years down the road.

The multiple being assigned to the subs right now is stupid silly. I do not believe that it will last much longer, and Berkshire will revalue itself to the upside.

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194727 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 8:26 AM
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If someone believed that the US stock market is 40% overvalued compared
to its long term average valuation, then would it be prudent to sell
most of your US stocks, and wait for a better entry point?
Even if that entry point might be 5-10 years away?


Yes and no.

I believe that the broad US equity market is very overvalued.
But I don't own the broad US market.

If the only thing you could buy were SPY, you'd be right; I'd sit on
cash and wait for a great entry point. But there are always some securities
which are attractively valued, so I own only those to the best of my ability.
The central expected return for cheap firms purchased now can be
quite good even if the broad market is overvalued, and of course this avoids
the problem taht over/undervaluation cycle can last a very long time
and broad valuation levels are therefore crummy predictors in the short run.

But if one were to try this "wait for a good entry point", how do you know
when to get back in? At is happens, a guy in late 1962 was asked
to design a method to identify a good time to enter the market for
the purposes of a long term hold and came up with a simple trigger.
It has worked amazingly well since then. It's called a Coppock signal.
On the surface it looks like purely technical analysis mumbo jumbo, but it's
really just looking for the first upturn after the first really big bear market.
Phrased that way it seems pretty simple and sensible.
There have been only 12 signals since it was invented, most recently
the end of May 2009 when the S&P was at 919.
On average the 2 years following a signal returns about 13.4%/year in real total
return following such a signal versus 7.9%/year for the rest of the two year intervals.
So, I'd buy on the first Coppock signal following the next time the S&P is in triple digits.

Here's a nice figure for you regarding broad valuation levels.
Let's posit that there is some sort of a trend for growth in real
earnings for the S&P. Earnings might grow a little more quickly some
decades than others, but they long run trend rises a maximum of only so much per year.
You will get different trend lines depending on your start and end dates.
The most optimistic possible (steepest) slope is the trend line starting 1985-11-08 and ending today.
That trend line suggests on-trend earnings today for the S&P of $66.60 in today's money.
The average observed earnings yield since 1936 can be considered a
good definition of a "normal" valuation level, being about 7.20%.
So, by this line of reasoning the most optimistic (highest) possible
fair value of the S&P today is 66.6/.072 = 925 for the S&P.
That assumes that earnings will continue to grow at a record breaking pace indefinitely.
With the S&P at 1460 this line of reasoning suggests that the S&P is at least 57% overvalued.
Any other choice of trend line dates will give greater levels of overvaluation.
If you like you could add 20% to that 925 figure for any possible holes
in the reasoning (it's different this time?), but you still get the same general result.

Jim

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194729 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 8:32 AM
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2. In the year year 2000, Berkshire was:
A) Not as cheap as today (1.4-1.5 times book vs 1.24 currently or
less depending on next the next quarterly report.)
B) Wound up more than doubling in price in less than 10 years.


One could make a fairly strong theoretical argument that Berkshire was quite undervalued at that starting point, too.
Had it been fairly valued it would not have returned more than other stocks or the so-called risk free rate!
By the same reasoning, BRK has been undervalued through most of its history.

Jim

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Author: Technodweeb Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194731 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 8:49 AM
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Is that why it usually goes up over the long term horizon?

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194734 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 9:38 AM
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Is that why it usually goes up over the long term horizon?

As with any equity, the longer the time horizon the more your returns will
approximate the change in underlying value of the security and the smaller
the effects of temporary over/undervaluation on the dates of purchase and sale.
The valuation on dates of purchase and sale are extremely important,
but the importance does eventually start to fade.

An example.
I probably overpaid for my original shares, but only by a small amount.
I built my stake in September 2001 at an average cost basis of $64,267.
For a sense of scale that was 1.67 times the most recently reported quarterly book of $38,458.
As long as I sell those shares at a valuation at least that high my long
run return will be at least equal to the change in intrinsic value.
That would be $179,430 today based on price/book. Book/share grew
9.78%/year compounded in those 11 years, versus 2.82%/year total return for SPY.

Unfortunately for me BRK's share price has risen only 6.42%/year since
I bought my shares, an exact doubling in almost exactly 11 years.
That can be thought of as 9.8%/year in value creation and -3.4%/year in multiple compression.
Since I think we can assume the multiple compression is now over, for me
it's a one time drop of -24.5%. So the rate of return from here should
track the value creation and the one time drag from compression will
be a smaller and smaller amount on a per-year-of-share-holding basis.
Again assuming multiples never change from here, at the 20 year mark
the -24.5% drag will have been only -1.4%/year instead of the current -3.4%/year.

Jim

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Author: ssalz Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194735 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 9:48 AM
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I built my stake in September 2001

Interesting. I was already an investor at that time. But when I heard WEB mentionthat they failed to include and exclusion for terrorism into their re-insurance contracts (and therefore could be liable for huge amounts my interpretation) I sold and waited to come back in after Jan 1 2002 when the contracts were re-written. What was it that Yogi said "... predictions are difficult, especially about the future".

Dr. Steve

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Author: Technodweeb Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194736 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 11:19 AM
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Thanks for this information. It will be interesting to see how the next 11 years fair for us. $400K-$500K per share would be achievable in my opinion. $600K if things really boom. MidAmerican should have deployed close to 100 Billion by then alone.

""MidAmerican Energy may have an opportunity to deploy as much as $100 billion over the next 10 to 15 years at very reasonable rates." Much of that spending is likely to consist of capital expenditures, but the $100 billion estimate leaves room for strategic deals, and the figure came as one of the biggest surprises to Berkshire watchers at the shareholder meeting.

"That was far north of what I would have previously estimated," says Tom Lewandowski, an analyst with Edward Jones, adding, "Regulated returns are pretty attractive."

http://www.thestreet.com/story/11527440/1/warren-buffetts-el...

These share are cheap.

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Author: ubn Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194742 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 3:38 PM
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S&P is at least 57% overvalued

Lets go with this train of thought

1. S&P is representative of the overall market
2. Generally DOW matches S&P 500 price / value - as per Ben Graham
3. S&P is 60% overvalued
4. S&P is 1450 - so if it were to drop by 40% if would be at 870
5. Not all Dow stocks are overvalued by same amount
6. Therefore some DOW stocks are more overvalued
7. This overvaluation for these "some" DOW stocks has to be more than 60% to compensate for those that are not overvalued (probably more to account for time and the swing in the other direction)

So one should be easily be able to identify about 10 DOW stocks (out of 50) that need to drop by approx 60% to reach fair value ? If you cannot, then the S&P overvaluation logic is inaccurate and flawed.

Note: Because we are saying fair value, so you cannot account for recession and have to assume normal GDP growth (~2-3%)

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Author: razorfangius Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194743 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 4:12 PM
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Note: Because we are saying fair value, so you cannot account for recession and have to assume normal GDP growth (~2-3%)

In other words "assuming that everything stays in the candyland scenario forever, how can you justify the statement that the market seems overvalued?"

But "fair value" is the historical average over the last 90 or so years, which includes wars, rumors of wars, Great Depressions, inflation etc.

If you are okay forecasting no recessions, no wars, no major inflation, and steady 2-3% GDP growth for the next 100 years, then perhaps the market is not overvalued at all. Maybe we've reached a permanently high plateau, lol ...

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Author: tommurphy9 Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194744 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 5:30 PM
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If you are okay forecasting no recessions, no wars, no major inflation, and steady 2-3% GDP growth for the next 100 years, then perhaps the market is not overvalued at all. Maybe we've reached a permanently high plateau, lol ...

I suppose you're referring to this infamous quote:

"Stocks have reached what looks like a permanently high plateau."
-- Irving Fisher, Professor of Economics, Yale University , 1929.

Tom

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Author: tommurphy9 Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194746 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 5:43 PM
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I believe that the broad US equity market is very overvalued.
But I don't own the broad US market.


Still, you've often said that any investor in equities should reasonably expect to suffer a 50% drawdown from time to time. Just taking ownership of Berkshire at its current valuation as an example, this would suggest that BRK is likely to drop to ~40% below its book value somewhere along the line. Is that correct?

Or would the 50% drawdown only be expected when valuations are higher than they are now for Berkshire?

I realize that anything is possible, including instantaneous destruction of all life on the planet by an asteroid, but even the great depression didn't see a 90% drop in the total value of the stock market.

Tom

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Author: ubn Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194748 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 6:44 PM
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If you are okay forecasting no recessions, no wars, no major inflation

Either you are not understanding or trying to be trigger happy selecting a part of the post without context. Read my post again. May be and hopefully it will become clear.

I will spell it out a little bit more.

If you think a DOW component (e.g IBM) is overvalued at $209, then evaluate if the fair value with a 60% drop is $83 is OK. If this makes sense to you then the market is indeed overvalued significantly. In this context assume normal GDP growth (~2-3%) . Now IBM is an example. You can take any of the 50 DOW components.

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Author: razorfangius Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194750 of 214657
Subject: Re: 40% Overvalued Date: 10/8/2012 8:01 PM
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If you think a DOW component (e.g IBM) is overvalued at $209, then evaluate if the fair value with a 60% drop is $83 is OK. If this makes sense to you then the market is indeed overvalued significantly. In this context assume normal GDP growth (~2-3%) . Now IBM is an example. You can take any of the 50 DOW components.

Yeah, but there are already ways to evaluate if the market is overvalued:

1. Total market/GNP (this one endorsed by Buffett).
2. Ten year P/E.
3. Q

Curiously, all these methods seem to be in agreement!

You are saying "toss those time-tested statistical methods and just do a gut feel check on IBM". Why?

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Author: EsM30 Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194760 of 214657
Subject: Re: 40% Overvalued Date: 10/9/2012 9:25 AM
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Yeah, but there are already ways to evaluate if the market is overvalued:

1. Total market/GNP (this one endorsed by Buffett).
2. Ten year P/E.
3. Q

Curiously, all these methods seem to be in agreement!

You are saying "toss those time-tested statistical methods and just do a gut feel check on IBM". Why?


I think he makes a good point actually. If everything is telling you that the general market is overvalued by nearly 60%, yet you think certain large stocks are undervalued, then you should make sure you can identify other stocks that are obviously overvalued. Otherwise, maybe your logic for your stocks being undervalued is flawed. It's not about discarding the existing methods of identifying overall market overvaluation.

"If you've been in the game 30 minutes and you don't know who the patsy is,you're the patsy." I'd just like to be sure I'm not the patsy.

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Author: rationalwalk Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194767 of 214657
Subject: Re: 40% Overvalued Date: 10/9/2012 10:17 AM
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If the only thing you could buy were SPY, you'd be right; I'd sit on
cash and wait for a great entry point.


This is unfortunately a major issue facing the vast majority of passive investors who intelligently choose to index rather than to pick stocks without investing the required time and work. Obviously, these people could choose an active strategy and delegate management to someone with a proven track record ... however, it is also not easy to pick a successful manager.

Would it be insane for a passive investor to allocate a large percentage of US equity exposure to Berkshire? In some ways, it might be if the individual doesn't have sufficient personal understanding of Berkshire to avoid panic in a bear market and is unwilling to learn about the business. But for someone who wants a relatively passive strategy and is willing to invest maybe 10-20 hours per year following Berkshire, this could be a superior approach. I really don't think it takes much more than 10-20 hours per year to keep up with Berkshire at a level sufficient to be intellectually armed against panic selling during a bear market.

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Author: razorfangius Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194768 of 214657
Subject: Re: 40% Overvalued Date: 10/9/2012 10:17 AM
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I think he makes a good point actually. If everything is telling you that the general market is overvalued by nearly 60%, yet you think certain large stocks are undervalued, then you should make sure you can identify other stocks that are obviously overvalued. Otherwise, maybe your logic for your stocks being undervalued is flawed. It's not about discarding the existing methods of identifying overall market overvaluation.

If that was the point (which I did not get), then fine. But it's clear the issue is use of DCF analysis. It turns stock market valuation into a guessing game. "IBM is undervalued because I punched in 15% growth for 10 years, which I think is reasonable, but XOM is overvalued because I punched in -2% growth for 10 years, which I also think is reasonable." Okay.

DCF makes the valuation whatever your heart desires. Buffett says it's an easy game if you have the right temperament. I think there's a big catch in that "if", because it looks like the number of people with the "right temperament" can be counted on one hand.

There's a reason why most Buffett followers:

1. Buy Berkshire
2. Buy whatever Buffett buys (13-Fs)
3. Buy things that resemble Berkshire (LUK, MKL, FRFHF, L, etc.)

They're not being stupid or lazy, they're acknowledging they don't have the right temperament and solving the problem, using one of the solutions that's available.

The other solution is to toss DCFs, go back to Graham, and use more objective yardsticks.

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Author: rationalwalk Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194769 of 214657
Subject: Re: 40% Overvalued Date: 10/9/2012 10:21 AM
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I really don't think it takes much more than 10-20 hours per year to keep up with Berkshire at a level sufficient to be intellectually armed against panic selling during a bear market.

Perhaps this statement should be qualified by assuming a baseline understanding of Berkshire and a survey of the insurance industry. "Boot Camp" could include a Berkshire annual meeting plus reading a few key books (Intelligent Investor, compilation of Buffett's letters, Poor Charlie's Almanack, etc). So maybe an investment of 100 hours? I think an investment of +-100 hours initially plus 10-20 hours/year of "maintenance" (annual report, 10-Qs, 13-Fs, following WSJ/Barron's mentions of BRK) is a cheap way to be intellectually armed enough to own Berkshire vs. a passive index like SPY.

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194770 of 214657
Subject: Re: 40% Overvalued Date: 10/9/2012 10:57 AM
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I think he makes a good point actually. If everything is telling you
that the general market is overvalued by nearly 60%, yet you think
certain large stocks are undervalued, then you should make sure you can
identify other stocks that are obviously overvalued.
Otherwise, maybe your logic for your stocks being undervalued is flawed.
It's not about discarding the existing methods of identifying overall market overvaluation.


The poster is correct: if everything is overvalued, then it's a
necessity that there be lots of individual big things be overvalued.
The problem is that most things seem reasonably valued, and we can't see the overvaluation.
I think the fault lies with our vision though, not the result.
It's hard to imagine revenues and profits of big firms going down, but they will.
There is always another recession coming, and the current fiscal thrust
can't be continued at this pace forever. It's also hard for us to imagine stocks
trading at their historic average multiples because they have been overvalued
for a large number of the last 20 years and few people are able to imagine
anything older than that being relevant to a definition of "normal".

A better way to go about it might be to start with the top-down conclusion.
All the firms are (in aggregate) going to have lower earnings for at least part of the next
few years simply because we're very close to a cyclical peak and things go up and down.
If this year were neither unusually good nor unusually bad, the aggregate
earnings right now would be a fair bit lower, say 25% lower give or take.
Time will heal that wound because real trend earnings rise over time, but only very slowly.
A bigger issue is that one should probably assume the multiple of
on-trend earnings in 10 years will be the long run average multiple,
which is a heck of a lot lower than today's multiples.

So, perhaps what one should do is start with the position that all US
firms are going to be trading at (say) 3/4 of today's levels in real
terms in 3-5 years and then try to identify which firms will fall less
and which will fall more such that the end average result is still
plausible based on any estimate of on-trend sustainable real earnings
and long run average multiples that you care to use.
(the notion of 3/4 the price in 3-5 years is rather arbitrary; we might
simply see flat or very low net returns for a much longer period)
IBM may really be cheap now because it's one that is less overvalued
based on its likely future earnings than others are, but that means
there has to be another big firm that's more overvalued than average.

If we each pick our own estimate of the cyclically adjusted real
earnings and estimate of the long run average multiple of earnings, this
approach should be pretty unassailable: if we still find it hard to
find the likely underperformers, we'll know it's our imagination and
biases rather than any flaw in the reasoning.
Again, I highly recommend playing with tab 3 column J in the Excel file here http://www.econ.yale.edu/~shiller/data.htm
A graph of the log of real earnings should have a trend line that's not too far from straight.
Print a graph of the log real earnings and use a pencil to sketch your own trend line estimate.
In what year does the line you just drew cross above today's level?
You might end up with a graph like this stonewellfunds.com/TrendE_1931-2012.jpg
That one suggests today's current real earnings of around $89 will be
the on-trend sustainable level only in late 2024, 12 years from now.
Try different central trend lines that look plausible and see what answer you get.

Jim

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194771 of 214657
Subject: Re: 40% Overvalued Date: 10/9/2012 11:14 AM
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This is unfortunately a major issue facing the vast majority of
passive investors who intelligently choose to index rather than to pick
stocks without investing the required time and work. Obviously, these
people could choose an active strategy and delegate management to
someone with a proven track record ... however, it is also not easy to
pick a successful manager.
Would it be insane for a passive investor to allocate a large percentage of US equity exposure to Berkshire?


I don't think that's a bad idea.
But then, if I didn't think it was a good idea I wouldn't be here typing this.

There are lots of ways to have a reasonable chance of beating the odds,
in particular of trying to minimize the impact of very low expected
forward returns from here for the broad US market based on CAPE-type analyses.

For example, if you're worried that the broad market is overvalued
because it's above its long run average multiple of around 13.5 times
trend earnings, don't buy any companies which are individually trading
above 13.5 times your own estimate of their cyclically adjusted trend earnings.
You could be wrong by a fair bit and still duck the problem you're trying to duck.

Failing that, pure quant approaches aren't so dumb.

There is also (I mention it for the sake completeness) market timing.
You can't predict the market reliably, but you can definitely separate
the times into more and less likely to be bad.

For those who are really going to be in index funds, sitting on cash
till things are really cheap is probably a good idea.

Jim

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Author: StubbleJumper Three stars, 500 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194774 of 214657
Subject: Re: 40% Overvalued Date: 10/9/2012 1:15 PM
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If someone believed that the US stock market is 40% overvalued compared to its long term average valuation, then would it be prudent to sell most of your US stocks, and wait for a better entry point? Even if that entry point might be 5-10 years away?

FWIW, Of all the hundreds of stock tips and investing advice Jim gives us, hearing him say stocks are 40% overvalued seems to be the most important.

There is another guy that thinks this way. Prem Watsa. Maybe it is time to "sell it all" and buy a certain Canadian stock.



Well, the challenge with selling high and re-buying low is that 1) you need to do something with the proceeds and 2) there are many possible ways for an over-valued market to correct itself.

For first challenge, presumably you are speaking of dumping equities to hold high quality bonds. However, at current rates, it's hard to believe that bonds will be anything other than certificates of confiscation (ie, 1% or 2% nominal interest rate will probably be a negative real return after income tax and inflation).

For the second challenge, you are probably implicitly assuming that the equity market will correct through a draw down, or perhaps even a crash. However, that's not the only possibility. It is also possible that the market could go sideways for 7 years, which would give you a 2-ish dividend, but at the end of the 7 years the broad market would be roughly fair value. Or perhaps the broad market will INCREASE 2% per year for the next 15 years, meaning you'd get the 2-ish% dividend plus a small capital gain, and at the end of 15 years the broad market would be roughly fair value.

The strategy of selling equities to buy bonds is a real winner if the market correction is rapid and severe. But it could be a real loser if this thing drags sideways for a lengthy period.


SJ

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Author: ubn Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194789 of 214657
Subject: Re: 40% Overvalued Date: 10/9/2012 11:15 PM
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So one should be easily be able to identify about 10 DOW stocks (out of 50) that need to drop by approx 60% to reach fair value ?

Here is the data for DOW 30 and PE

PE if you exclude AA is 16.8 * AA has a very high PE so skewing the data
PE for 30 companies is 20.8
PE if you exclue AA, T and VZ is 14.5

I cannot find any company that need to fall by 60% to reach fair value. Needless to say, no one will call IBM way overvalued given that WEB was a buyer at $170+.

Note: We are trying to find companies that are highly highly overvalued (not slightly overvalued) - something that should jump out

Stock PE
-------------
AA 132
AXP 13.65
BA 12.21
BAC 12.12
CAT 9.48
CSCO 12.62
CVX 8.74
DD 13.37
DIS 17.03
GE 19.62
HD 21.91
HPQ NA
IBM 15.11
INTC 9.3
JNJ 21.73
JPM 9.19
KO 10.25
MCD 17.3
MMM 15.36
MRK 21.08
MSFT 14.64
PFE 18.97
PG 18.79
T 49
TRV 12.47
UNH 11.64
UTX 16.21
VZ 45.7
WMT 15.63
XOM 9.71

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Author: Technodweeb Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194790 of 214657
Subject: Re: 40% Overvalued Date: 10/9/2012 11:40 PM
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My wife just bought some Intel around $22. It is stupid cheap in my opinion and for it to drop 60% and hen yield 10% would be outright assaninity.

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 194800 of 214657
Subject: Re: 40% Overvalued Date: 10/10/2012 9:53 AM
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I cannot find any company that needs to fall by 60% to reach fair value.

That would indeed be a big fall!
(not sure where the 60% figure came from...I'd certainly want to be
prepared for a fall that big or bigger, and I more or less expect it,
but equities will be cheaper than average when that happens).

But in any case, my pointing out that the market is clearly overvalued
is based mainly on the observation that current earnings are near a cyclical highs,
so the table of current P/E ratios tells you very little about valuations.
The point is only slightly that multiples are too high, the bigger issue is that earnings are unsustainably high.
A much more interesting thing would be to look at the ratio of price to
10 or 15 year average of EPS for a bunch of individual firms.

On average over time the EY15 for the broad US market averages about 6.12% (time weighted since 1945),
so the average big company is "fairly" valued at that level.
Convert each of the prior 15 years' EPS into current-day dollars, average those, divide by current price.
For Verizon you get 6.76% which is cheaper than the long run average based on E15,
no problem with that one, but of course their real earnings have been falling steadily for a decade which might be a sensible reason for cheapness.
For PG you get EY15 of 4.27%, 45% more expensive than the long run average for the broad market 6.18%.
It would appear that this one is closer to being typical of the broad market.

Unfortunately, and "average" valuation hides a multiplicity of sins,
as there are always some firms that are [deservedly] cheap and others worth a premium.
You'll get some oddities in the Dow, so it would have to be done with
quite a few big firms before you got a clear idea.
Walmart was unusually undervalued for quite a while, Pfizer had
a huge windfall earnings bubble from Lipitor, Intel just crashed, etc.
The firms in the Dow 30 are not randomly chosen, but rather selected
for their dominance, to they tend to be a little more highly priced
on average than the broad market and probably deserve that.

In any case, if you want to try this yourself with any firms, here are
the multipliers for old EPS to convert them into today's dollars.
end of...
1996 1.453
1997 1.427
1998 1.405
1999 1.369
2000 1.323
2001 1.299
2002 1.271
2003 1.249
2004 1.206
2005 1.166
2006 1.143
2007 1.096
2008 1.085
2009 1.065
2010 1.053
2011 1.019
To get E15 you'd average 1997 through 2011 or 1998 through estimated 2012, au choix.

Broad US real earnings based on E15 rose at a rate of 3.02%/year 1945-1970,
by a rate of only 0.51%/year 1971 through 1995 (!), and 3.25%/year 1996 to date.
The overall rate of real growth of E15 in since 1945 has been 2.17%/year,
a pinch above the very long run rate of just under 2%.
Let's assume that the recent period growth of 3.25% since 1996 is sustained indefinitely, a most optimistic assumption.
Since the long run average E15 earnings yield is 6.18% and the S&P is at 1435,
Thus E15 would have to be at $87.87 in today's dollars for the S&P to be
fairly valued (long run average historical multiple) at today's prices.
That reasoning is very solid with only an extremely small error range.
But E15 is only $61.77 right now, and at 3.25%/year it won't reach
$87.87 (in today's money) till April 2024 extending the 1995-to-date trend.
So, either the market has to fall 30%, or has to be flat for 12 years
while trend earnings catch up with today's prices, or some mix of the two.
That conclusion uses what I believe is an unustainably high estimate of real trend earnings growth.
Also I believe E15 (an imperfect metric) is itself a pinch high right now.

Jim

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