Wicksell Rate Says Buy..

“Davidson” submits……

It is useful for value investors to see how this may be applied when investing in common stock as it reveals that the markets do indeed arbitrage with the principle of Relative Returns. For the many who have attempted the use of simple relationships, i.e. P/BV, Market Cap/GDP, P/E this will appear overly complicated, but I do not apologize. I only observe that the world of capital requires adjustments to valuation so that a competitive return can be had.

The basic formula is the long term Real GDP + adjustment for inflation = Wicksell Rate(proposed by Knut Wicksell in 1898).

In reality this comes down to using the Dallas Fed 12mo trimmed mean PCE as the measure of core inflation and for US investors the Real US GDP long term trend which today sits at 3.16% and over the next 10yrs will fall to 3.15% based on 80yrs of history. Based on the Feb 2009 Dallas Fed PCE release of 2.2%, the Wicksell Rate at the moment is ~5.4%. This is the moving Wicksell Rate(Capital Return Benchmark) that essentially rises and falls with core inflation while Real US GDP does not vary very much for 5yr forecasting purposes. This approach is not for next quarter’s GDP or even next year’s GDP as we all know that no one has ever forecasted these levels with precision. However, IF WE KNOW WHEN THE MARKET IS OVER VALUED OR UNDERVALUED VS. THE WICKSELL RATE, WE CAN KNOW WHEN TO COMMIT FUNDS AND WHEN TO REMOVE FUNDS BASED ON RELATIVE RATE OF RETURN.

In using this approach one needs to be cognizant that psychology plays a significant role in market valuations for periods as long as several years. I call attention to the sell signal given when the SP500 return fell below that of the Wicksell Rate in 1997 and did not provide a buy signal till August of 2002. In general this valuation approach would have sold during periods of excess valuation and bought only after corrections had mostly run their course. The fact that it resulted in a buy signal just prior to the Fall 2008 collapse demonstrates that when market valuation rules change so does the ability of the market players to know where the values are in the market place. They just sell out and wait for the dust to settle. This was the stark effect of imposing an artificial price-based Mark-to-Market valuation methodology to securities known to be of much higher quality than those prices reflected.

The other half of the process, i.e. developing a reliable forward return for the SP500, requires the knowledge that 1) SP500 ROE has been surprisingly steady at ~14%, 2) SP500 BV has had surprisingly growth of ~6% since 1978 and the SP500 represents ~90%+ of US market capitalization. Together, these facts let us assume that the next few years will run along the same trend. This method is to divide the 2yr forward SP500 Book Value into the current SP500 Index Price and multiply this by the ROE to get a measure of how much of this ROE the investor receives at the current SP500 Price level. The 2yr number is based on the rational that Value investors look at least 2yrs into the future.(Value investors are not traders) The calculation looks like this:

(SP500 Price)*(SP500 ROE Trend of 14.2%)/(2yr Forward SP500 Book Value) = 2yr Forward Return at the Current SP500 Price Level

This proves that the market does have a rational Relative Return process at work. It also proves just as simply that regulations and psychology can tamper with the relationship over shorter periods such as the one we find ourselves in today.

The current market is an extraordinary buying opportunity!!

Disclosure (“none” means no position):

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