Thursday, October 29, 2009

Markets overvalued by 20%?

I breathed a sigh of relief when I awoke this morning to a strong day on the markets. Yesterday I caught a brief glimpse of the Lang and O’Leary Exchange, when they brought on this investment banker to explain why he feels the stock market is overvalued by 20%. For starters, he is estimating a parameter that cannot be accurately measured. You could look at price to earnings ratios or equity/asset ratios and make an estimation as to the fair value of a stock, but since expectation of future performance (which cannot be reliably predicted) is also represented in the price of a stock, the aforementioned ratios cannot be used exclusively to draw the conclusion that stocks are overpriced. If we expect markets to completely rebound in another year or two, then that expectation is priced into the value of the stock whether or not today’s assets and revenues justify it. What he calls overvalued, I call tomorrow.

"The sun will come up tomorrow!"

To my "friends" over at the CBC, be “O’Weary” about inviting on a guest who is the Chief Economist at an investment bank to offer an expert opinion. He is just as likely to promote the positions of his investors as he is to tell the general public the truth. This "expert" admitted that he did not predict the 6 month incline of the market, therefore when he says that the market is overvalued by 20% he is validating his initial opinion. When he said the market would stay flat and it went up by 20%, rather than admit a mistake he simply begins promoting the idea that the market is 20% overpriced. If he is an investment banker, then he has rich clients whose money he invests with. Some of those clients may not be happy that their "expert" did not play the rising tide, and thus he has to sell the notion that the market is overvalued by the same error rate of his initial prediction to pacify his weary investors.

Basically all economists are all over the map right now in terms of predicting the future. Just because some guru in New York was right last time, that does not guarantee he will be right this time. There is more volatility than anyone can predict. Everyone knew there was a housing bubble and a credit bubble inflating at the same time, when far too much money was being handed out in loans. To compound the fracture, firms like Lehman's were buying these toxic assets and leveraging them into even more risky asset packages. They were building a great pyramid on top of a house of cards. That was the biggest mistake of the last downturn, a mistake that the majority of banks should be able to avoid making a second time. The popping of bubbles is a healthy component of our economy.

I will say that I want to see interest rates go up. Interest both the cost of borrowing and the benefit of saving. With rock bottom interest rates, we are making it easy to borrow and less rewarding to save. Sure there are benefits to easing the credit markets, but let's not get carried away here. Borrowing too much got us into this mess in the first place. Lowering the cost of borrowing down to zero seems inherently dangerous given what just happened.


  1. I too am relieved when the market creeps up but even more relieved that while I am still showing a substantial paper loss the dividends have remained consistent - which is important as I am retired with a moderate pension. So the vagaries of the market only matter when buying or selling as long as the income stream remains constant - which it has for several years now.

    What I don't know is whether an interest rate increase will impact distributions as companies may need to lower profit margin to pay the increased cost. If interest rates shoot up to the dizzying heights of the early 70s then obviously it becomes attractive to move investments based on rate of return which will have a negative impact on the stock market I suspect.

    All I know is that I am hanging on for the ride.

  2. I am not advocating really high interest rates, but we do need to put the breaks on the size of the money supply. There are downsides and upsides to both high interest rates and low interest rates.

  3. Most of the us stock market rally is based on the lower US dollar. Most of the Canadian market rally is in sympathy with the US rally. What needs to be noted is that in US terms it is mostly an illusion. The last time the dow was at 10,000 the dollar was worth 25% more. that would be equivalent to 7500. If you notice when the US dollar went up this week the markets tanked. It is not about the economy it is about the dollar.

  4. No anonymous, you assume some facts not in evidence. It is incorrect to assume that the stock market rally is based solely on the dollar. Equity markets have been steadily rising because more people have been buying than selling. You can guess as to why that is, but there is no certainty that a low dollar value is driving the market, and therefor your entire thesis is flawed. Your introduction and conclusion are both about a hypothesis, not fact.


    Arrogance has cost many a man his fortune.

  6. I reviewed the link, and have two questions. 1) What is the currency pair by which the American dollar is being valued, and 2) what does that picture look like on a 30 year time frame? There exists no accepted economic principal that there is a direct inverse correlation between currency value and market value. Maybe it is indeed happening this way right now, but that doesn't mean that it should or will continue.

    Since the collapse a year ago, currency trading has become the new fad. Forex I believe they call it. How this large population of traders entering the currency market will affect the financial markets, I don't think anyone really knows. There is no guarantee that all these investors will behave rationally once participating in the market, but eventually any inefficiency will correct itself unless prohibited by legislation. I suspect that the “Law of Averages” (aka “the gambler’s fallacy”) may swing the market independent of the real value of the currency.

    You must draw a difference between the Canadian dollar and the American dollar. Because of Canada's resource wealth and security, we should be in excellent shape no matter what Obama and Pelosi do to the greenback. But a lot of people are forecasting a collapse of the US dollar, which by your theory should send the stock markets skyrocketing. Nes pas?

    Which would still then support my conclusion that the economist I saw on the CBC was presenting a flawed argument, perhaps correct in a small window, but relied on parameters impossible to reliably calculate for evidence. That gentleman was pumping corporate bonds, which is a very high risk game in a challenging economic climate. Shit, I could have made this comment into a full blog post.

  7. I have been studying currency trends more recently, and it reminds me a lot of Roulette. If you merged Roulette and Musical Chairs, you would have the perfect game to describe currency markets.