Thursday, April 03, 2008

Does asset inflation help support stock prices?

An anonymous comment on the preceding post has set me speculating further. The commentator says:

You are right, but I believe that this time around it will be equities, rather than commodities or real estate that will provide the hedge against coming inflation. Tobin's Q will prevail due to the juxtaposition of equity prices vs. the other two asset classes (which already had their surges) and the market's increasing valuation sophistication compared to the last time we saw hyperinflation in developed economies (i.e. the 1970s). So I've been buying stocks as an inflation hedge, despite the statistical evidence that this is foolish...

Wikipedia offers an explanation of Tobin's Q here. Essentially, Q is a measure of the relationship between the value of all a company's shares, and the value of the company's assets. If Q is greater than 1, there is some reason (real or imaginary) why the company has extra value to offer; if less than 1, a share investor could buy a company's underlying assets at a discount.

In 2006, Michael Alexander wrote a series of articles for Safe Haven, about stock cycles. Below, from the second in the series, is his graph for Q in several bear markets, including the one which he suggests began in 2000:

According to this, Q was already below 1 in 2006, and since the market is now back to about where it was a couple of years ago, that would suggest that shares are now fairly valued in relation to company assets.

But if history repeats itself, the current bear market has a long way to go, since the other three lasted 15 - 20 years. And in each of the previous cycles, Q slumped below 0.4.

Another complicating factor, thanks to the lending boom, is the real estate bubble. Steve Moyer is firmly of the opinion that real estate is very heavily overvalued, even now. So a collapse in that market would push Tobin's Q back up for many companies, a technical indication that share prices would have to drop steeply to get back to fair value (let alone overshoot to below Q=0.5).

In this context, it's worth noting that one of Mike Alexander's books, published in 2000, is titled "Stock Cycles: Why stocks won't beat money markets over the next twenty years".


Semaj Mahgih said...

First it's commodities, then liquidity, then equities again? Does anyone know what they're doing?


It's a disaster zone, which is why it's every man for himself, which is why there can be no common agreement.

Gold has done very nicely in the last couple of years, but a combination of leveraged speculation and central bank manipulation has been pushing the price up and down the $900 - $1,000 corridor recently. If the credit crisis gets worse, the speculators may be forced to reduce their investment in gold in order to repay their creditors; but in the longer term, as the currency continues to weaken, I think gold and some other commodities will resume their upward course.

Personally, I don't buy the equity story, but then I have been bearish from around 1997 onwards. I missed a peak or two, but more importantly from my point of view, avoided the troughs. I'm interested to see that Michael Alexander felt the same way (and I think he must have been writing his book in 1999 to get it published in 2000) - and obviously he thinks the bear market will run for 20 years.

No-one can be certain - especially with all the lying, cheating and fudging going on - but currently my feeling is cash for now, plus purchases of commodities on the dips.

And if I could only persuade my loved ones, I'd sell out of residential property and live in a tent or caravan!

That's my feeling only, I am no more a prophet than anyone else. Hope this helps.