April 4, 2019
As the legendary money manager Peter Lynch used to say, “If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted ten minutes.” No one can predict the economy, the markets, or the direction of currencies. Only a charlatan would pretend to. Yet if you click on your financial news most days, that’s all anyone is trying to do. Pundits rarely invoke the wisdom of Socrates: “I know that I know nothing.”
In fact, the only thing known to any of us is value, defined as quality assets selling at a reasonable price. The alternative to value is noise, which is literally everything else—from the newspaper to politics to pop-up ads from so-called gurus to brokerage reports from investment banks (with their attendant conflicts of interest) to cocktail-party tips.
So how do we define value? Value is often best described by the earnings yield, namely the amount that any company (or group of companies) could pay out in earnings annually to its shareholders relative to its market value.
If the Dow is at 26,000, is it overpriced? Before you answer that question, let’s turn to a real estate analogy. Is a $2 million apartment purchased for investment purposes overpriced? If you answered “I don’t have enough information,” you’re right. If I tell you the apartment has 1,000 square feet and therefore sells at $2,000/square foot, that tells you a little more. And if I tell you the apartment could be rented out for $10,000/month, that tells you much more. Now we know the earnings yield. $120,000 divided by $2 million = 6%. And, finally, we have some measure by which to assess value.
So when I asked about the Dow at 26,000, you now know there wasn’t enough information. From the apartment example, we can see that we’re missing the denominator: the cash flows that underpin the price. With a stock or an index, we also need to know the earnings yield. If company XYZ has $100 in annual earnings, and has a market capitalization of $1,000, the earnings yield is 10% ($100 divided by $1,000 = 10%). Across all 30 companies, earnings on the Dow were $1,445 over the trailing 12 months. Therefore, at 26,000, the Dow is trading at 18 times earnings (26,000 divided by 1,445 = 18). If we flip that fraction, we get the earnings yield, a true measure of value: 1 divided by 18 = 5.6%.
In contrast, the earnings yield on emerging market stocks is now approximately 8.3%, a full 48% above the earnings yield on the Dow. You are effectively getting paid 48% more to hold emerging market stocks instead of US stocks. The value is there; the noise shouldn’t matter.
Best wishes for the coming quarter.