Today’s Stock Market Bubble: Mr. Market Is Alive and Still Unwell
posted by Lawrence Cunningham
The stock market rallies while recession continues to plague America. Chief executives worry, companies hoard cash, uncertainty haunts our banking system. Gas prices are up, GDP growth is down, unemployment is up, government debt and size are up and political leaders do not show the ability to come to grips with any of it.
Yet the Dow Jones Industrial Average, heading for 15,0000, exceeds levels not seen since October 2007, a few months before the current crisis showed up. Believers in the efficiency of stock markets will take this as a sign of good times ahead, believing that markets reveal better than anything else the truth about business fundamentals. Skeptics will plan to cite this as the first sign of a bubble. Which view is the more plausible?
Believers in stock market efficiency buy the revolutionary ideas, hatched during the past 50 years, called modern finance theory. This elaborate theory boils down to the notion that the best estimate of the value of a stock is its prevailing market price. The practical implication, of course, is that it is a waste of time to study individual investment opportunities in public securities. According to this view, you will do better by randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense.
Reverence for these ideas is not limited to ivory tower academics, but became standard dogma throughout financial America, from Wall Street to Main Street. Many professionals still believe that stock market prices always accurately reflect fundamental values, that the only risk that matters is the volatility of prices, and that the best way to manage that risk is to invest in a diversified group of stocks.
But a distinguished line of investors stretching back to Ben Graham and forward to Warren Buffett challenges such dogma by logic and experience. Graham preached, and Buffett has successfully practiced, a different approach. Graham, who taught at Columbia Business School in the 1950s and ran an investment partnership, wrote a number of classic works, including The Intelligent Investor. There Graham argued that price is what you pay and value is what you get. These two things are rarely identical, but most people rarely notice any difference, he believed.
To illustrate, Graham created an allegorical character he called Mr. Market. A denizen of Wall Street, he is your hypothetical business partner who is daily willing to buy your interest in a business or sell you his at prevailing market prices. Mr. Market is moody, prone to manic swings from joy to despair. Sometimes he offers prices way higher than value; sometimes he offers prices way lower than value. The more manic-depressive he is, the greater the spread between price and value, and therefore the greater the investment opportunities he offers and perils he presents.
Estimating value is difficult, and those who believe in market efficiency spare themselves a considerable amount of effort by concluding that price, rather than analysis, provides the best estimate of value. Graham and Buffett favor analyzing whether after-tax returns on an investment are at least equal to the purchasing power of the initial investment plus a fair rate of return. The primary relevant factors are the long-term economic characteristics of a business, the quality and integrity of its management, and future levels of taxation and inflation.
Armed with an estimate of value based on that analysis, the final, and pivotal question, is whether the value is sufficiently high compared to price to give the investor a wide margin of safety. Buffett follows Graham’s margin-of-safety principle devotedly, noting that Graham had said that if forced to distill the secret of sound investment into three words, they would be: margin of safety.
While modern finance theory enthusiasts cite market efficiency to deny there is a difference between price (what you pay) and value (what you get), to Graham and Buffett, it makes all the difference in the world. Maybe the market is omniscient and today’s stock prices, accurately revealing fundamental values, spell good times ahead. But the common sense of Graham’s position, and the success of scores of investors such as Buffett in applying it, warrants a healthy dose of skepticism.