Davidson "Looks Across the Valley" $$

“Davidson” submits:

When you are a value investor you are really an asset buyer with an expectation on ROE on those assets over an anticipated future period. The “science” that Ian Cumming references in his quote, “The science is in the “In”. The poetry is in the “Out”.”, is in the means that a value investor assesses the potential that the expected returns are likely to be realized. It is important to be cognizant of financial history, Hamilton, Fed Reserve history, economic philosophy of Hayek and etc as well as how this has played out since the 1871.

A powerful record of the effect of the Federal Reserve acting as a financial shock absorber has been in effect since 1933-see chart 1 (click to enlarge).

With all the manipulations of govt., war, high taxation, excess govt. spending leading to inflation and the recovery and disinflation under Reagan and Volcker, one can build a great deal of confidence in US society and the its economic underpinnings that can serve to let one see thru the current fog of issues clouding our economic future.

If one measures BV (the productive assets of public cos) growth of the SP500 (I see this as quite steady at ~6.2%) (see Chart 2, click to enlarge) and then when one examines the ROE on these assets and measures that regression analysis produces a quite steady 14.2%.

Between 1978 to Present, one can produce a forecast for SP500 earnings and convert this to an earnings yield. This earnings yield is compared to the Real US GDP trend which is 3.16% and the current core inflation rate which is 2.3%; the combination of these 2 rates becomes the benchmark against which all investments are compared. The market has priced the SP500 against this benchmark return since 1978 in a fairly close relationship with allowances for market psychology which is an important factor at all times (see Chart 3, click to enlarge).

The current relationship is that the SP500 is priced at an estimated 8.08% earnings yield while the Market Cap Rate (MCR) is 5.4%. For the SP500 to return back to a normalized rate of return, this means that it needs to rise by 49.6% to roughly 1,350 from 900 currently. This is how a value investor converts assets to future returns by assuming that a historical trend with many periods of in which problems like those we fear today will eventually be resumed and return to trend.

Can value investors be wrong? Absulutely!! But, there is a very strong trend of economic history that supports these assumptions and the Fed is easing like it has done in the past. The cry, “But, but, but…it is different this time!!!” has be uttered at every major low in our financial history, i.e. 1974, 1982, 1987, 1990, 1998, 2002-2003 and 2008-2009. The odds greatly favor recovery, strong recovery which few are forecasting.

Our greatest problem today is fear and a complete lack of perspective. Historical perspective is how value investors look across the valley.