Value Investing: Tools and Techniques for Intelligent Investment

Chapter 36. Value Investors versus Hard-Core Bears: The Valuation Debate^[36]

My recent bout of bullishness has revealed that our mailing list has two distinct constituencies. One group might be best described as value investors. The other group are probably best characterized as hard-core bears. The first group understand my desire to become more bullish as valuations drop. The second tend to argue that my valuation measures are overly generous. In particular, they are arguing that the 10-year earnings behind the Graham and Dodd PE are overstated. My examination of both the top-down and bottom-up viewpoints finds little support for this accusation.

• Go back a few years and I was regularly told that my Graham and Dodd PEs (G&D) were making the market look expensive because they used 10-year average earnings which didn't reflect high secular growth rates. I am now being told that my measures make the market look artificially cheap as the earnings for the last 10 years have been overstated. I suspect these swings tell us more about market psychology than about valuation.

• To test the hard-core bears case I decided to conduct a robustness check on the valuation measure that I favour. The simplest check is just to look at the earnings deviations from trend over the last 10 years. On our measure the average deviation from trend for the S&P 500 (with the trend estimated since 1950) is – 1.4%. Effectively the last 10 years have seen both boom and bust, thus the G&D PE averages out the cyclical ...