How to value markets
The FT today published a letter from Stuart Fowler with the title ‘Do away with the noise to hear the signal better’. This was in response to a letter on 26th March from Christo Leventis pointing out flaws in the use of forward price/earnings ratios to measure the valuation of an equity market. Stuart extends these flaws to all valuation measures that rely on accounting earnings, however intuitive the general approach. The letter introduces the concept of a Market Value Ratio based purely on the deviation from trend of a cumulative index of real total returns. This is the approach used by Fowler Drew in its quantitative portfolio-management process since its formation ten years ago.
We show below the letter together with a chart of the ratios, as measured and calibrated by us, for the US, UK, Europe (ex UK) and Japan. The current values contrast with the message from fundamental accounting-based measures that the US market, among others, is overvalued.
Christo Levantis (Letters 26th March) rightly points out that the forward/PE shares with Cape the characteristic of ‘smoothing the denominator of the ratio’. So, if noise in the denominator (volatile accounting profit) is interfering with the signal about valuation, why not get rid of fundamental accounting inputs altogether?
Inflation is common to both numerator and denominator in each ratio so if we drop accounting profit we need to focus on deflated equity price to find our signal. However, if we assume the signal results from some systematic equity-return process, as a function of an adaptive capitalist system, the numerator is better defined as deflated total return, with dividends reinvested.
A ratio of cumulative, logarithmic, real total return against its own long-term regression trend offers a noise-free estimate of valuation for a market index (itself a Darwinian construct). Together with assumptions about the strength and time dependency of reversion to trend, the ratio will also provide an objective estimate of horizon-specific, future, real returns and variances for that index. When fundamental denominators are distorted, the ratio will provide better estimates and when they are not the estimates will be no worse.
Current ratios of market value suggest that no major developed market is significantly different from normal except Japan which is still undervalued. The implication is that the coincidence of international accounting changes and the credit crisis is still distorting fundamental inputs.”