Capco Institute Blog

In a few months we will be remembering the 10th anniversary of the stock market crash of 2000. Most of the people involved in finance have probably forgotten what caused it and how much wealth actually disappeared as a result. Bonuses have been going up at the major financial institutions exponentially since then and things could not be any better. In fact, even the current economic collapse couldn’t really completely ruin the party.

Of course, outside of these institutions there are thousands of academics who are pouring over the data to see what caused the crisis so that they can warn future generations of investors, who actually never read those studies, what they need to do to avoid a similar occurrence. Ironically, they all know that future crises will happen, except that since their causes are not exactly the same they would be unable to predict them yet again.

The reason that the 10th anniversary is important is because we are slowly approaching the period it took for the stock markets to recover from the crash of 1929. In fact, if we also take account of NASDAQ, we are probably a decade or so away from fully recuperating all our losses. For example, while the Dow seems to be quite healthy, at 10,236 today, and many are very optimistic about its future, it is still lower than where it was in November 1999, at 11,497. Of course, NASDAQ still has a long way to go from today’s 2221 to reach its high of over 5000 in March 2000. One should ask why such a major loss of capital caused a depression almost 90 years ago, but we actually lived through an economic boom since the crash of 2000.

However, the main issue is not that indices still have a way to go to reach their highs of 10 years ago, it is that, as Feiger and Shojai (2003) had predicted, pricing models will never behave as models expect them to, or as they had behaved in the past. For example, they suggested that unlike what the proponents of Rational Belief Hypothesis (such as Stanford’s Mordecai Kurz and Maurizio Motolese) believe, P/E ratios will not revert back to their long-run averages of between 7 and 12, depending on the industry. They suggested that as more and more countries move from defined benefit pension schemes to defined contribution schemes and as more people believe that equities always generate greater returns in the long-run than fixed income instruments the flow of capital to equities will allow it to create a new much higher equilibrium floor. And, we have seen that throughout the last decade that has actually been the case.

However, what has even taken us by surprise is where the S&P 500 P/E ratio is today. According to Standard & Poor’s, and I hope I am wrong and that I have misread the data, the P/E ratio of the S&P 500 had by the end of 2009 reached triple digits, though it is now falling. Granted that this is caused by a sudden drop in earnings and major losses at some firms, but shouldn’t stock prices also fall to adjust for the drops in earnings, or have the relationships broken so badly that even we had underestimated it? Or, does this mean that the markets believe that the drop in earnings is going to be so short-lived that they knew they should not bother adjusting prices? If so, why all the talk about the risks of a double-dip recession? If markets are right, the only way from here is up, and way up.

The reality is that it will probably fall from such heights, but it will stay probably close to 3 times what the long-run average was prior to the Internet bubble. Consequently, investors will be focussed solely on capital gains and dividends will become even less important as we move forward. Feiger and Shojai (2003) had predicted that this would happen, and even suggested that the stock markets are now behaving like property markets, where there is no connection between prices and expected yields. People pay a given price for a house because that is what it is being sold for and traded on the market, not because that’s what the models state. They called this the greed premium, which is what investors pay to buy a house, or a share, on top of its fundamental prices, assuming of course that a fundamental price actually exists.

The only question is how would the markets react if the earnings uplift over the next two years is not as rapid as the current P/E ratios suggest. Should we be expecting a major correction in that case? That, in my opinion, is the question that many have overlooked while they are spending all their time trying to guesstimate when we will actually have a solid growth in major economies and deciding whether bankers should be allowed to keep their empires or not.

It is good to see that George Soros has also suggested that gold prices are now reaching major bubble status, as we had predicted a few weeks ago, but it would be interesting for us to see how investors view such outrageous P/E ratios and how they would react when they see earnings fail to catch up.

If you wish to read the paper by Feiger and Shojai please go to this site
http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID805768_code342721.pdf?abstractid=556214

If you wish to read Shojai and Feiger’s paper on asset pricing please go to
http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1481557_code342721.pdf?abstractid=1469462