Market Valuation Charts: 5/4/09

Bonds v Equities

Chart: Bond Yield over Equity Yield. 10-year treasury yield minus inverse of Graham P/E Ratio (10-year average equity earnings yield).
Current value: -2.8% (5/4/2009)
Low value: -4.9% (3/9/2009)

10-Year Return

Chart: Trailing 10-year return.
Current value: -3.8% (5/4/2009)
Low value: -5.9% (3/9/2009)

P/E Ratio 1881
P/E Ratio 1980

Chart: 10-year trailing Graham (“Real”) P/E Ratio. Price of the S&P 500 divided by the 10-year average of earnings, inflation adjusted.

Current value: 16.1x (5/4/2009)
Low value: 11.9x (3/9/2009)

One conclusion from the above charts is that based on the 128-year average, the market (as represented by the S&P 500) is fairly valued. (Data from S&P, Robert Shiller, and the St. Louis Fed.)

See also: Market Valuation Charts: 10/08

1908 – 2008 – 2108

The New York Times, 11/4/1907

In October of 1907, financial markets in the United States came to a complete halt. Credit markets froze, major banks collapsed, and the stock market plunged. Heads of industry, like J. P. Morgan, were forced to inject massive amounts of capital to prevent a complete collapse.

The circumstances of the Panic of 1907 are very similar to our current crisis. In both, the economy had experienced huge growth over the preceding decade. Banks lowered lending standards, which led people to take on more and more debt. When bank assets began to decline, depositors panicked, and there was a run on the financial system.

But for the rest of this post, I’d like to focus on the period that follows a financial crisis—not on the crisis itself. (Keep in mind that although I speak in terms of American progress, my point applies to any country around the world.)

* * *

The period following 1907 was monumental in American history. Continue reading “1908 – 2008 – 2108”

Market Valuation Charts: 10/08

PE Ratio
Chart: 10-year trailing Graham (“Real”) P/E Ratio. Price of the S&P 500 divided by the 10-year average of earnings, inflation adjusted.
Current value (10/31/08): 15.9x

Profit Margin
Chart: Profit Margin of U.S. Economy. Annualized corporate profits as a percentage of GDP. (A good reason why the Graham P/E Ratio is a better valuation measure than the TTM version.)
Current value (6/30/08): 9.40%

Bonds v Equities
Chart: Bond Yield over Equity Yield. 10-year treasury yield minus inverse of Graham P/E Ratio (10-year average equity earnings yield).
Current value (10/31/08): -2.4% (equities yield 2.4% more than bonds)

Ed Thorp & Over-betting

In today’s Wall Street Journal, there’s a great interview with Edward Thorp and Bill Gross.

Both investors are asked about current market conditions and their thoughts on investing in general.

Ed Thorp is a hedge fund manager who ran Princton-Newport Partners and has returns of 20% over a 28-year period (ending 1998). In addition to his investing skills, Thorp is best known for his work at the Blackjack tables. In 1962, he authored the book Beat the Dealer, which explained the methods he used to win at Blackjack.

For more information on Ed Thorp, check out the book Fortune’s Formula. It’s a great read that details the evolution of information theory, the Kelly Criterion, gambling strategies, hedge funds, and the mob’s involvement in all of the above. Math, gambling, the mafia, and investing. Who could ask for anything more? Also, if you’re interested in Thorp’s Blackjack strategies (card counting), the book Bringing Down the House is another great read. But I’ll stick to the subject of investing for this post.


Below is a section from the WSJ article where Gross and Thorp discuss hedge funds: Continue reading “Ed Thorp & Over-betting”

Berkshire Part 2: Selling Puts

Buffett has pulled it off again. He’s made a creative, favorable bet that may pay off handsomely for long-term Berkshire shareholders.

Over the past year, Berkshire Hathaway sold put options on the S&P 500 and three foreign indices. Expiration of these puts range from 12 to 20 years out, and Berkshire collected $4.5 billion in premiums. Unlike regular puts, these are exercisable only at their expiration dates. On those dates, Berkshire makes a payment only if the index has lost money over the period of the option.

Selling these puts is essentially saying: In 15 years, I promise to buy the S&P 500 from you at a price of $1,468 (closing 2007), if it trades below that price. In exchange, you give me $4.5 billion right away.

Buffett doesn’t disclose the size of the actual options. The $4.5 billion in premiums tells you they are big, but apparently not big enough relative to Berkshire to cause any problems.

The counterparties (the people who made the agreement and paid the premium) are most likely large financial institutions who are hedging their long-term bets in favor of the market. So it may turn out to be a dumb bet for them, but they’re essentially purchasing insurance on what they have or will have in the market.

For Berkshire to lose money, a few things have to happen. To keep it simple, let’s just talk about the S&P 500, because we don’t know which foreign indices were used.

  1. First, over the next 12 to 20 years, the market would have to have a negative cumulative return.
  2. Second, that negative return would have to be large enough to overcome the premiums received.

How large? Once again, we don’t know the size of the options. But the premiums, which were $4.5 billion at the time they were written, will have compounded for more than 15 years by the time of expiration. If Buffett (or future Berkshire managers) can achieve 15% annual returns, the premium cash will have grown to over $36 billion. So the aggregate losses on the put options—the size of the options times the amount of negative returns—would have to exceed $36 billion for any profits to be erased.

Because of their long-term length, it mitigates the risk of a short-term Black Swan-type event affecting the options. A “Black Monday” one day anomaly would have little effect, other than a temporary quarterly adjustment. Something could still happen (i.e. a long depression, or a nuclear war, God forbid) that would cause losses. But this bet seems pretty favorable as long as the world economy does alright in the long run. Chalk one up for the Oracle of Omaha.