Is Wesbury Right? Are Stocks Undervalued by 65%? Unlikely on both.

Famous Failed Prediction

OK, So Wesbury Actually Predicts Dow 18,000 - But His Model Supports This Title

Brian Wesbury of First Trust is out with another piece on why stocks are undervalued. The perpetual cheerleader uses a model that actually forecasts a fair value of 40,000 for the dow (Remember Dow 35,000) – but the model is wrong according to Wesbury because bonds are “in a bubble”. Whether bonds are in a bubble or not (Japan, anyone) is irrelevant as Wesbury just makes up an input to replace the current rate in the model – that seems like a poor model to me. Regardless, here we have an economist making the case that stocks are significantly undervalued (putting Fair Value of S & P at 1,940) when others (Grantham & Hussman) who actually have a history of getting valuations correct & big downturns correct predict the exact opposite, see my post yesterday “Are Risk and Return Related”.
See also Here and Here.

Here is Wesbury’s missive and what follows is an excerpt from 2008 where he categorically denies any big problems are upon us:


Market turmoil and a cycle of shrill headlines and worrisome “breaking news” convinced many to evacuate the equity markets. That was a mistake. The odds of recession are low, but the stock market seems to have priced one in, anyway.
We use a capitalized profits model to value stocks, dividing corporate profits by the 10-year Treasury yield. We compare the current level of this index to that from each quarter for the past 60 years to estimate an average fair-value. Not only are 10-year yields low (2.2%), but corporate profits are growing strongly. As a result, and hold onto your hats, this top down model says that the fair-value for the Dow is currently 40,000.

However, we think the Treasury market is in a bubble. So, instead of a 2.2% yield, we use a more conservative discount rate of 5% for the 10-year Treasury. This generates a “fair value” of 18,500 on the Dow and 1,940 for the S&P 500. In other words, the US equity markets are currently undervalued by about 65%.

Obviously, there are many moving parts to this model. Interest rates could go higher than 5%, profits could fall or both could happen. Profits, for example, are now 12.9% of GDP, the highest in measured history (back to 1947) except for one quarter in 1950.

So what does our model say if profits revert to the historical mean of about 9.5% of GDP? Even in that scenario, and assuming a 5% yield on the 10-year Treasury, equities are about 21% undervalued, with fair value at 1430 for the S&P 500 and 13,700 for the Dow.
The problem with this scenario is that it takes the worst of both worlds: a major decline in profits and a surge in interest rates. In the real world, a large decline in profits would normally be accompanied by a drop in bond yields. In other words, our model says the risk of investing in equities today is very low.

This is the opposite of what was happening back in 1999/2000. Back then, the market was over-valued and an ounce of gold traded for roughly 4 shares of Intel (INTC). Today it is trading for about 75 shares. Stocks look cheap and we think fears about the economy are overblown.

Yes, it would be good to trade the ups and downs of this market, but we don’t know anyone who can do that consistently. Rather, we focus on valuation, risk and reward. And right now, we believe the reward outweighs the risk by more than many people seem to believe. Fear will not disappear overnight, but the model says it is overblown and stocks are extremely attractive.

1.28.2008 Wesbury in Wall Street Journal – The Economy is Fine (Really)

It is hard to imagine any time in history when such rampant pessimism about the economy has existed with so little evidence of serious trouble.

With housing so weak, the recent softness in production and durable goods orders is understandable. But housing is now a small share of GDP (4.5%). And it has fallen so much already that it is highly unlikely to drive the economy into recession all by itself. Exports are 12% of the economy, and are growing at a 13.6% rate. The boom in exports is overwhelming the loss from housing.

Models based on recent monetary and tax policy suggest real GDP will grow at a 3% to 3.5% rate in 2008, while the probability of recession this year is 10%.

Yet many believe that a recession has already begun because credit markets have seized up. This pessimistic view argues that losses from the subprime arena are the tip of the iceberg. An economic downturn, combined with a weakened financial system, will result in a perfect storm for the multi-trillion dollar derivatives market. It is feared that cascading problems with inter-connected counterparty risk, swaps and excessive leverage will cause the entire “house of cards,” otherwise known as the U.S. financial system, to collapse. At a minimum, they fear credit will contract, causing a major economic slowdown.

For many, this catastrophic outlook brings back memories of the Great Depression, when bank failures begot more bank failures, money was scarce, credit was impossible to obtain, and economic problems spread like wildfire.

This outlook is both perplexing and worrisome. Perplexing, because it is hard to see how a campfire of a problem can spread to burn down the entire forest. What Federal Reserve Chairman Ben Bernanke recently estimated as a $100 billion loss on subprime loans would represent only 0.1% of the $100 trillion in combined assets of all U.S. households and U.S. non-farm, non-financial corporations. Even if losses ballooned to $300 billion, it would represent less than 0.3% of total U.S. assets.

Because all debt rests on a foundation of real economic activity, and the real economy is still resilient, the current red alert about a crashing house of cards looks like another false alarm…… Dow 15,000 looks much more likely than Dow 10,000. Keep the faith and stay invested. It’s a wonderful buying opportunity.

So there you have it, Wesbury misses the greatest economic event of our time while predicting Dow 15,000 and now he is predicting Dow 18,000 (or 40,000 depending on what input he uses) in the midst of another collapse. Only time will tell if he is right, but history appears to be indicate he won’t be.

Scott Dauenhauer CFP, MSFP, AIF


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