Detecting Asset Bubbles Before the POP

"...the Fed cannot reliably identify bubbles in asset prices"
Chairman Ben Bernanke, 2002

Some interesting commentary today from Google's CEO Eric Schmidt, which appears to reveal that there are people with 1) more clairvoyance than Mr. Bernanke or 2) more undeserved arrogance... history will tell us who is right (again, 1)

There are clear signs of a new Internet bubble in corporate valuations, Google's chief executive Eric Schmidt said in an interview with a Swiss magazine on Thursday.

Asked about the high valuations being put on companies such as social network company Facebook and game developer Zynga, Schmidt said in an interview with Bilanz: "There are clear signs of a bubble ... But valuations are what they are. People believe that these companies will achieve huge sales in the future."

The Wall Street Journal reported on Thursday that Google, Facebook and others have held low-level takeover talks with Twitter, valuing the company as high as $10 billion.

Good News for Investors...

This (WSJ: Decline of PE Ratio) is a pretty fluffy article...

However, the key implication is that more and more investors may be turning away from valuation in an effort to predict the macro-environment.  This is encouraging news for bargain-hunters like myself.

I worry considerably about the macro-environment.  However, as one investor once said, 'philosophize macro; invest micro'... as more investors worry about the macro-environment, I firmly believe that stocks will become cheaper and cheaper.  Once PE reaches 6x (1949) or 7x (1974), then it will be time to buy again... and buy alot!  Whether deflation or inflation, once valuations reach that levels I believe we should buy the best companies America has to offer (ie Coke, Proctor Gamble, Johnson & Johnson, Intel, etc.), as it's difficult to imagine a world without their products... and if such a world existed, I'm not sure I would want to be around to see it!

Currently at 12x-14x PE, I would want to see stocks fall by at least 50% before I'm ready to confidently say its time to buy.  In fact, considering that earnings will likely decline (considerably) in some future scenarios, we may well see a decline of greater than 50% before prices become truly attractive.  Buckle up!

Buy Cheap, Sell Dear

PE as a Predictor of 20-yr Returns (via Prof Robert Shiller)

This graph presents the relationship between P/E and 20-yr annualized returns of the S&P 500 (stock market).

• P/E (Price/Earnings) - The price you pay for each dollar earned/profit 
• Higher PE = more expensive
• Lower PE = less expensive
• Prof Shiller uses an adjusted PE which is the a price paid for the average annual dollars earned over the past 10 years

•  20-yr Annualized Returns - the average annual return over the next 20 years, after the purchase 

Professor Shiller has separated his data into 5 time periods (20-25 yrs per period).  The graph seems to provide evidence that, purchasing stocks at a lower PE (less expensive) typically results in a higher 20-yr return, than otherwise.  Just as importantly, this relationship between cheaper stocks and higher returns appears to be true for each of the 5 time periods, which covers the period from 1890-1985.

Where are stocks now?  At today's S&P value of approximately 1200, the 10-yr PE Ratio is currently at 22.  Looking at the graph, evidence indicates that we should perhaps expect 20-yr returns of less than 5% per year if we were to purchase stocks at current prices.  Macro-level indicators such as these are important for making investment decisions because they can often help us set the right expectations about future returns.  They also act as a guiding light during oscillating periods of Fear & Greed, affording us the fortitude to buy when prices are low, and the discipline to differ purchases (or sell) when valuations become frothy.