The Meaning of 'Over-Valued'
On December 31st, 1930, White Motors' balance sheet reported cash of $8.5 million, receivables and merchandise of $15 million and net fixed assets of $14 million. Less liabilities of $1.3 million, the company had a net worth position of $36.2 million.
The company’s stock price was trading between $7 and $8 per share. At the 12/31 close, the stock price was 7 3/8, which multiplied by the 650,000 shares outstanding put the market value of the company at $4.8 million. This valuation represented about 60% of the company’s cash balances alone and only about one-fifth of the net quick assets. As the great Benjamin Graham noted, "The spectacle of a large and old established company selling in the market for such a small fraction of its quick assets is a startling one."
Such a spectacle was not uncommon then. Graham continued "But the picture becomes more impressive when we observe that there are literally dozens of other companies which also have a quoted value of less than their cash in bank… This means that a great number of American businesses are selling at much less than their liquidating value; that in the best judgement of Wall Street, these businesses are worth more dead than alive."
Flash forward to the year 2000. Take a look at Ariba, a hot company in today’s market and representative of new Internet-related businesses that have buffed up the returns of many portfolios. Over the past twelve months the company generated sales of $62 million with a net loss of $37 million. It's balance sheet is not indicative of anything much, as is typical for a technology-based company, with a book value of $1.22 per share. The company is currently trading for about $267 per share. Multiply that by the 96.1 million shares outstanding and you have the market's value of this company, which is an astounding $25.6 billion. That's a multiple of nearly 412 times sales.
Note the subtle differences in emphasis. With White Motors, we looked primarily to the balance sheet. The balance sheet is to a company what the backbone is to a man. With Ariba, we look at the income statement, or more specifically the top-line. Little else seems to matter in the New Economy; the importance of the balance sheet seems to have lost some degree of relevance. Profits too, seem to be an afterthought.
What would the inestimably wise Mr. Graham make of the market’s valuations put on these issues today? Granted, White Motors had the distinct disadvantage of laboring amidst the Great Depression, a time of paralysis and despair that Garet Garret labeled a "national psychosis." Ariba has the advantage of existing during the Mother of All Bull Markets, a period of unfailing optimism and outlandish expectations.
He would likely have fallen back on his concept of intrinsic value. He would likely have agreed with John Burr Williams’ assessment that "separate and distinct things not to be confused, as every thoughtful investor knows, are real worth and market price." Markets prices reflect the emotions of its participants, stock prices are the manifest creation of their optimism and pessimism, their sorting and grading of possibilities, the individual subjective appraisement of value. Market prices can swing wildly between emotional poles; and swing they have, as these two examples illustrate.
Markets make opinions. Opinions are not statements of fact; not all the actors in the market will consider the same securities attractive at their present market prices, whatever the price happens to be. Its true value is indeterminate except from the viewpoint of the individual actor in the market. As Williams noted "concerning [a stock’s] true worth, every man will cherish his own opinion."
Indeed, for the individual actor it is only his opinion that matters, only his opinion that causes him to act. The opinion of the crowd will change the data from which the individual must work, but only his own opinions, his own preferences, his own felt uneasiness and his desire to remove it, will cause him to act. Still, the reality facing every buyer and seller will be the market price; to try to determine any objective value is a hopeless quest.
Stock prices are determined by marginal opinion. That is to say, the least optimistic present owner and most optimistic non-owner determine the price. As John Burr Williams wrote in his 1938 treatise The Theory of Investment Value, "The margin will fall between owners and non-owners, the in and outs, the ayes and nays; and at this margin, opinion, mere opinion, will determine actual price."
Consider one hundred people holding the stock of a particular company. Suppose 99 people believe the stock is worth $50. One person believes it is only worth $40 and he sells it. For that instant, the market price is $40. Now this new holder (it could just as easily have been one of the other existing stockholders, assuming they have the funds to invest, or the ability to borrow) has his own opinion as to the stock’s worth. Perhaps he thinks it is worth $45. Let us say he finds a buyer willing to pay him his price and he sells. The market price at this instant is now $45. Remember too that the other shareholders that hold the stock believing it to be worth $50 can change their opinion too. Perhaps, one owner changes his appraisal and is willing to sell for $43. Let us suppose he finds a buyer. Now the price is $43. And on and on it goes.
One can imagine, with a stock trading millions of share per day and with literally millions of onlookers watching past transactions and putting bids of their own in the market, how much this price might move. The increments are typically small, but on certain days, perhaps due to new information, these prices can move significantly. Nonetheless, the process is the same. There must be buyers and sellers, and each are motivated by their own valuations, however arrived at.
This ought to dispel any notion that the market represents some sort of collective mind or social intelligence that exists apart from individual traders. To borrow once more from John Burr Williams: "Like a ghost in a haunted house, the notion of a soul possessing the market and sending it up or down, with a shrewdness uncanny and superhuman, keeps ever re-appearing." Since made from the stuff of mortal man, the market is equally prone to human folly. We can only speak of the market existing metaphorically.
The above discussion excludes monetary factors, of course. An increasing supply of money and credit serves as the rocket fuel to inflate the prices of stocks just as it does with other capital goods and all forms of investment. Stocks in essence are claims to a collection of resources employed in meeting the demands of consumers or other producers. As the new money weaves its way to buyers, these buyers bid up the prices of stocks.
As Mises has noted, "Very promptly these funds find outlets in the stock exchange or fixed investment. The notion that it is possible to pursue a credit expansion without making stock prices rise and fixed investment expand is absurd."
In the metallic money world of yesteryear, an increase in money and credit beyond that which was covered by specie was defined as inflation. Today, awash in fiat currency, inflation is often defined as a general increase in prices. This confuses cause and effect. The general increase in prices observed is the consequences of an increasing supply of money and credit.
An absence of observable price increases in the various price indexes does not necessarily mean that there is no inflation. It means that prices would be falling if not for the increase in money. Perhaps the best we can do to define inflation today is to say that inflation is any increase in money beyond that which would occur in a free market system (backed by specie), as elusive a concept as that is to measure.
Such inflationary increases in money and credit are clearly observable today. Easy money and easy credit are part and parcel of the 1990s boom. The December 17th issue of Grant’s Interest Rate Observer noted that "the Bank of Alan Greenspan is expanding its assets at a year-over-year rate of 14.4%." Over the last three months of 1999, Fed credit expanded at a blistering 32% pace (annualized). Grant quoted Benjamin Strong, former Governor of the New York Fed, on the Fed-engineered credit expansion of 1929. He called it "a little coup de whiskey to the stock market."
William McChesney Martin, governor of the Fed from 1951-1970, famously described the Fed’s role as taking away the punch bowl just when the party gets going. He neglected to mention that it was the Fed that provides the punch bowl in the first place.
The proliferation of credit has been truly staggering in some quarters. For example, the Federal Home Loan Bank System, which was created by Congress during the Great Depression, has become a huge force in the capital markets. The FHLB System issued nearly $3.1 trillion of debt in 1999, an increase of 21% over 1998. The other government-sponsored enterprises are all large players in today's capital markets that are inflating credit and distorting the market process.
Mises called the stock market the "focal point of the market economy" and "the ultimate device to make the anticipated demand of the consumers supreme in the conduct of business." The traders express opinions as to the employment of capital that can prevent additional investment in unprofitable ventures and expand other promising ones. The inflationary environment distorts this mechanism. It becomes difficult to separate what profits are attributable to inflationary gains (that is, gains that derive from a company experiencing a rise in its selling prices before its buying prices have risen). This creates the illusion of prosperity.
Even knowing that there is an inflationary environment does not alter the difficulty of separating real profits from illusory inflationary gains. The inflation does not affect all lines equally. To know ahead of time what prices will rise first, one will have to know what the value scales of buyers looks like before they become manifest in action. In other words, you would have to know ahead of time how the new money would be spent. All prices do not rise together or in the same proportions. The bottom line effect of all this is to make some companies appear more valuable than they really are.
Are stocks overvalued? One answer is that it depends on whom you ask. Those who are buying and holding apparently think that they will be able to sell them at higher prices. Maybe they believe in a new paradigm where the old yardsticks of value are useless. James Glassman and Kevin Hasset recently wrote a book called Dow 36,000 in which they maintain that the stock market is currently undervalued.
Looking back, future financial historians will likely relate the Glassman-Hasset thesis to Irving Fisher’s famous proclamation in 1929 that "stock prices have reached a permanent and high plateau." James Grant likes to say that there are three common features of a bubble: one part fundamental (i.e., a technological revolution), one part financial (i.e., a surge in money and credit) and one part psychological (i.e., a suspension of belief in traditional valuation measures). All the ingredients would appear to exist in the current bull market.
As is often said, only time will tell. Unfortunately, no theory of cycles or bubbles can tell us precisely when it will all end. Maybe twenty years from now, we will be able to definitively state whether these prices were reasonable or whether the boom time of the 1990s ended in a bust. From where I sit, heeding the teachings of the Austrians, I'll place my bet on the latter.